THE EFFECT OF GOVERNANCE ON FOREIGN DIRECT INVESTMENT IN LATIN AMERICA — ISSUES OF MODEL SELECTION

Abstract

This paper examines the impact of good governance on foreign direct investment (FDI) in the Latin American countries. Even though the FDI inflows in the region are relatively high, which can be explained by the level of development of the target countries, their connections with developed countries and the available natural resources, only a few papers have examined what kind of other factors make these countries more attractive for foreign investments. This study has two main goals. First, the gravity model is used to show whether the quality of governance measured by any of the World Governance Indicators (WGI) affects the inward FDI in Latin America. Second, following the recent trend in the gravity literature, the performance of different ordinary least squares (OLS) specifications are tested and compared to the Poisson pseudo-maximum likelihood (PPML) estimator which is a natural alternative approach. Results according to the most efficient estimation show that good governance is mostly a factor of attractiveness but its significance depends on which indicator is used to proxy it. Our analysis also demonstrates that using a truncation on the sample or manipulating the data by adding a small number to the dependent variable makes the OLS parameter estimates extremely sensitive and yields biased, inconsistent, and inefficient results together with bad estimation of total FDI. Furthermore, the PPML method provides far better value for several indicators of goodness of fit. Thus, we argue that the PPML method should be preferred not just in trade but also in FDI gravity models.