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Impact of Institutions and Distance on FDI Decisions


Subject Business Pages 5 Style APA



The intensive competition in some markets is forcing firms to internationalize. Iammarino (2018) observes that as much as operating in the home country is easier, entering a host market could be challenging and risky. As a result, businesses ought to understand how to identify the most suitable countries to target and enter. For this reason, there is extensive literature on the factors that influence successful internationalization, global business strategy, location choice, market selection, and market attractiveness. Nielsen, Asmussen, and Goerzen (2018) note that countries understand the need to attract investors, thus, make efforts to create attractive environments. For this reason, the legislations and policies on foreign direct investments (FDI) tend to touch on issues such as the cost of doing business abroad (CDBA) and liability of foreignness (LOF) (Papadopoulos et al., 2016). This literature on FDI forms the basis for this essay, which seeks to explain and analyze the statement that countries with quality institutions receive more FDI than countries with fewer ones, regardless of the distance between the host and home economies. This essay argues against this statement by emphasizing that both institutions and distance are key determinants of FDI.

Assessing the Attractiveness of a Country for FDI

A reflection on the decision process for internationalization and formulating global business strategy shows that firms consider various factors when selecting a suitable market. These factors include assessing firm-specific strategic assets, specifically the core competencies, location-specific issues such as political risk and market size, location industry-specific issues, namely factor costs, transportation, tariffs, and transaction costs associated with the internationalization process. Fainshmidt et al. (2018) elaborate further that key factors that influence the selection of a host market include evaluating the growth and size of the host economy. Dunning refers to this approach to selecting a market as market-seeking FDI. Secondly, Dunning’s efficiency-seeking FDI approach considers the labor costs associated with venturing into a given market. Other elements to consider while selecting a suitable market include quality of institutions, availability of natural resources (resource seeking FDI), cultural, geographical, and political factors, collectively known as CAGE distance (Magnani, Zucchella & Floriani, 2018). This exposition justifies that selection of a country is influenced by various factors and not necessarily, institutional quality and distance between host and home economies. As much as all these factors influence decision making, the statement alluding that countries with poor institutions receive less FDI than those with quality institutions regardless of distance is partially right. Thus the following sections justify why both institution and distance are important in market selection.

Impact of Institutional Quality on Selection of a Host Market

Countries with poor institutions indeed tend to attract less FDI compared to those with good ones. This challenge mostly afflicts the developing and emerging economies whose markets are characterized by low per capita income, low capital intensity, high inequality level, bad governance, and weak formal and informal institutions (Khanna, Palepu & Sinha, 2005). According to Eden and Miller (2004), institutions denote rules that govern businesses’ operations and their relationship with society. The term could also be used to describe constraints devised by humans that shape their interactions. Peng, Wang, and Jiang (2008) contribute to this topic by defining institutions as regulative, normative, and cognitive structures and activities that give meaning and stability to social behavior. The institutional theory influences the behavior of organizations as it dictates the behavior of firms and individuals. Whereas quality institutions make it easier for firms to operate, weak institutions, as seen in emerging and developing economies, make it hard for FDI to succeed (Li et al., 2018). For instance, the lack of information makes it hard for these firms to evaluate and find supportive trade partners. Besides, the contract based on incomplete information is bound to face challenges during enforcement. Paul and Feliciano-Cestero (2020) add that information asymmetries could result in higher transaction costs, which curtail market exchange. On the contrary, FDIs can capitalize on the shortcoming created by information asymmetries to create opportunities by creating and sharing knowledge. This illustration justifies that weak or poor institutions heighten market failure chances since they increase market transaction costs. For example, firms incur higher costs to either collect or search for information on market participants.

The FDIs further become vulnerable to opportunism due to weak contracts, which expose firms to property rights risks. Williamson (2000) explains that market failures arising from information asymmetries are known as institutional voids. They are mostly manifested in the absence of intermediaries, namely inefficient judiciary, few recruitment agencies, limited external providers of quality information, limited access to credit information, limited audit firms, and few private equity providers or venture capital firms. Institutional voids make FDI operations very expensive. Hammami et al. (2020) add that institutional void is mostly reported in emerging and developing economies, which is why they attract less FDI than developed economies. These countries are exposed to unpredictable shocks emanating from macroeconomic fluctuations, violence, and political instability. Apart from these formal institutional voids, information institutions such as ethics, norms, culture, and social arrangements could also impede FDIs as they increase operation costs (Blanc-Brude et al., 2014). For these reasons, countries with poor institutions tend to attract less FDI than those with quality institutions. On the contrary, developed countries with good formal and informal institutions attract more inward and outward FDI, mostly enforced through bilateral trade agreements between countries. A case in point being Sherritt’s entry into Cuba. There were massive institutional barriers between Canada and Cuba, yet the management found a way around the issues. This included seeking international arbitrators from France, just if any legal challenges arose during the FDI process (Musacchio & Schlefer, 2010). Notably, Sherritt needed to operate in Cuba to access its rich natural resources, namely nickel, and cobalt.

Distance between host and home economies

In the same manner that institutions either reinforce or undermine decisions to make FDI investments in a given country, distance equally plays a significant role in influencing FDI decisions. It is not uncommon for investors to favor countries with poor institutions but with short CAGE distance. According to Belderbos, Du, and Slangen (2020), CAGE is a synonym for cultural distance, administrative distance, geographic distance, and economic distance. Cultural distance refers to the degree of differences in the informal institutions between host and home economies. Administrative distance denotes the differences between policies across countries. Geographic distance reflects the differences in transaction costs, while economic distance is the variation in labor costs, wealth, and income across countries in FDI arrangement. In Sherritt’s case, the management had to consider the difference in cultural dynamics, namely language, ethnicity, work systems, tradition, religion, values, dispositions, and social norms between Cuba and Canada (Musacchio & Schlefer, 2010). As much as the formal institutions were weak, the information institution which determines cultural distance was grounded on the socialist economic system. This included strict rules and guidelines on the conduct of organizations. For instance, the employees could not be awarded more than $20 to reward good performance (Annushkina & Regazzo, 2020). Such cultural practices reduced operation costs, thus compensating for the high cost of doing business abroad (CDBA) and foreignness liability (LOF).

Regarding the administrative distance, firms consider the colonial ties, trade agreements, currency, legal systems, government policies, political hostility, requirements for a work permit and visa, in addition to the corruption index. Low administrative distance attracts more FDI compared to high administrative distance. Despite the high distance in Cuba, Sherritt opted to make FDI investments, contributing significantly to its rise to a big multinational firm. This means that in some cases, the nature of the business and the industry influence whether the investors value institution over distance or vice versa. As evident with Sherritt’s entry into Cuba, some businesses value both poor institutions and low distance (Musacchio & Schlefer, 2010). Another significant element of distance is economic distance. It focuses on analyzing attributes such as per capita income, cost of labor, economic size, organizational capabilities, and human resource availability. Da Cruz, Floriani, and Amal (2020) explain that unlike developed economies where these factors are available and well balanced, emerging, and developing economies have shortcomings in achieving high scores across all the attributes. In such a case, the investors make FDI decisions depending on the most suitable attribute. For Sherritt, the management opted to venture into Cuba because of its low labor costs and human resources availability.

Kang (2018) seconds this observation noting that Cuba is a high skilled country, which is why companies consider it for inward FDI. Geographic distance encapsulates elements such as physical distance, common land border, time zones, climate, landlockedness, communication, and transportation costs (Al Qur’an, 2020). Some industries, especially those dealing with bulky goods, prefer FDI with low geographic distance countries because of accessibility. On the other hand, service industries do not regard distance as an undermining factor when making FDI decisions (Papadopoulos & Martín, 2017). This statement insinuates that different industries and businesses have varied needs that might benefit from an either high or low geographic distance. In such cases, the firms might want FDI arrangements that enable them to capitalize on the variations. For instance, a company might want an FDI in a host in a different time zone to ensure it operates 24/7 because its activities can be switched between countries, thus eliminating the 9-5 work schedule.


To this end, this essay makes the affirmative that as much as institutions are important, distance is important too. This realization negates the statement claiming that countries with poor institutions receive less FDI than countries with good ones regardless of the distance between the host and home economies. As evident with Sherritt’s entry and subsequent success in Cuba, countries with poor institutions have a higher chance of attracting more FDI, especially when they possess unique resources attractive to some industries. This statement is noted in how Sherritt disregards the institutional void to venture into Cuba for its natural resources. Contrary to the question, which suggests that only institutions matter, this elaborates how CAGE distance is equally important to some industries and businesses.




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