Regional Governance Infrastructure : The Positive Externality on the Inflow of Foreign Direct Investment

A standard neoclassical model of growth predicts convergence of income levels across countries and geographical regions. Recent empirical evidence, however, has shown that the gap between rich and poor countries has increased over the last thirty years. One of the key regularities that are at odds with the neoclassical theory is the lack of capital flows from rich to poor countries. Two competing, but not mutually exclusive theories that explain this regularity are new economic geography and institutional economics. The first theory emphasizes the importance of increasing returns and agglomeration to explain the divergence in economic development across different geographical regions. The second theory stresses the crucial role of good institutions that generate economic growth and improve investment climate inside the country.To investigate the role of institutions and geography on economic development, we look at inflows of foreign direct investment (FDI) in 24 transition countries from 1993 to 2003. We set up an econometric panel data model that takes into account spatial spillovers and spatially correlated error terms and estimated the model by applying a recently developed generalized method of moment (GMM) three-stage procedure. Our results show that the regional quality of institutions is an important factor that explains variations in FDI inflows. The positive effect of good regional governance dominates the effect of better developed regional markets. The effect of regional governance is both statistically significant and of the same order of magnitude as the effect of good governance inside the country. We also have found some evidence that EU membership and high oil and gas resources are important determinants of FDI inflows in transition countries