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Investors Prefer Regions with Developed Economies

Even a business climate that is not very favourable is not an obstacle for investors if the country is developing fast in general. Business leaders who invest in countries with underdeveloped institutions choose politically stable regions with high demand, qualified workforce and developed infrastructure, said Ksenia Gonchar, leading research fellow at the HSE Institute for Industrial and Market Studies (IIMS), in a paper.

It is believed that the better the institutional environment a country has, the more attractive the region is for foreign direct investment. Operational costs and risks decrease and property rights are better protected.

However, some recent trends in global investment dynamics cast doubt on this assertion. Countries without good institutional environments were among the leaders in terms of annual foreign investment inflow. For example, the top 20 largest receivers of investment in 2011 included China (2nd by investments and 96th by business environment conditions), Brazil (4th and 116th, respectively), and Russia (9th by investments and 92nd by business environment conditions).

Ksenia Gonchar and Evgenia Bessonova, senior economist at the Centre for Research and Development in Economics and Finance, decided to learn why investors entered the Russian market in the 2000s despite the condition of institutions.

They proposed several hypotheses and tested them:

  • in big countries with heterogeneous institutions there are regions where the advantages of location are much higher than the costs related to institutional problems (high consumer demand, developed infrastructure, etc.);
  • individual investors from countries of similar level of development ignore bad institutions (investors from a ‘bad’ country have experience working in ‘bad’ conditions);
  • offshore investors, who in other years generated up to half of the all market entrances, have the advantage over true investors specifically thanks to the complicated institutional environment.

The results of the study were presented at an HSE School of Applied Economics seminar as a report ‘Can foreign investors ignore weak institutions in a big economy that is catching up?’

The empirical research was based on the analysis of microeconomic data on foreign-owned companies from the RUSLANA database over 2001-2010, which includes data on accounting, owner and company location (about 6,000 companies), and BEEPS (Business environment and enterprise performance survey) database, which is maintained jointly by the World Bank and the International Bank for Reconstruction and Development, as well as Rosstat (Russian Federal State Statistics Service) regional statistics.

Profit more important than institutions

Developed institutions influence the decision on investment, Gonchar and Bessonova say. Transnational companies choose regions that combine high levels of demand and development with relatively effective institutions. At the same time, even if a country is on the lowest end of the investment rankings overall, its individual regions can be quite attractive. And investments go there, which influences the overall indicators.

‘Foreign investors choose regions that combine relatively high demand, a productive and qualified workforce, infrastructure and political stability’, Gonchar emphasized. In developed regions, investors tolerate some institutional weaknesses. ‘Institutional problems are largely compensated by growth prospects and potential’, she stressed, ‘but there is no inverse correlation: a qualified workforce cannot compensate for economic underdevelopment’.

Crime is no obstacle to investment

The study also showed that investors positively evaluate state presence in a region’s economy: the more state participation, the higher the investments. At the same time, the lack of a discouraging influence of regional crime levels, which is compensated by the level of economic development, was surprising. However, a political conflict (for example, between a governor and a mayor) is a serious factor that scares off investors from developed countries.

At the same time, Gonchar and Bessonova did not find any empirical evidence that offshore investors are more tolerant of corruption than the ‘true’ ones. Offshore and ‘true’ investors have similar requirements for institutions. A change in governors turned out to be important for offshore investors and not important for ‘true’ foreigners, which can likely be explained by the former’s greater dependency on local authorities.

The study showed that Moscow and Moscow region, as well as Central and Western Russia, are most attractive for investors, while southern regions and the Far East are the least attractive.

 

May 14, 2015