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The effects of good governance on foreign directinvestment inflows in Arab countriesAlamedin Bannaga a Yagoub Gangi b Rafid Abdrazak b amp Bashar Al-Fakhry ba The Arab Monetary Fund The Arab Monetary Fund PO Box 2818 Abu Dhabi AbuDhabi - UAE United Arab Emiratesb Ahmed Bin Mohammed Military College-Qatar Business Studies Doha QatarPublished online 25 Jun 2013

To cite this article Alamedin Bannaga Yagoub Gangi Rafid Abdrazak amp Bashar Al-Fakhry (2013) The effects of goodgovernance on foreign direct investment inflows in Arab countries Applied Financial Economics 2315 1239-1247 DOI101080096031072013802088

To link to this article httpdxdoiorg101080096031072013802088

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The effects of good governance on

foreign direct investment inflows in

Arab countries

Alamedin Bannagaa Yagoub Gangib Rafid Abdrazakb

and Bashar Al-Fakhryb

aThe Arab Monetary Fund The Arab Monetary Fund Abu Dhabi - UAE POBox 2818 Abu Dhabi United Arab EmiratesbAhmed Bin Mohammed Military College-Qatar Business Studies Doha Qatar

The recent research on foreign direct investment stressed the significance of goodgovernance A number of multinational reports confirmed that the Arab regionhas one of the lowest governance indicators in the world This article assesses theeffects of governance on foreign direct investment inflows in Arab countriesusing panel regression based on an augmented gravity model The regressionresults lend a strong support for the significance of good governance to foreigndirect investment inflows

Keywords governance foreign direct investment (FDI) Arab countriesempirical evidence

JEL Classification F21 F23 F65 O16

I Introduction

The role of foreign direct investment (FDI) as a key driverof economic development has been proved by manyresearchers (Borensztein et al 1995) It contributes toeconomic development through raising capital accumula-tion increasing production capacity enhancing technol-ogy transferring knowledge creating employmentopportunities improving management practices enhan-cing competitiveness and fostering macroeconomic stabi-lity However for most of the countries success inattracting sufficient amount of FDI inflows is not an easyjob Because of diversity in nature of factors affecting FDIinflows between countries it is difficult to assess all thesefactors provided some of them are related to governmentpolitical system Governance indicators are identified bymany researchers as significant determinants of FDI Theresearch acknowledges the gap in literature on the rela-tionship between governance indicators and FDI flows

particularly with respect to Arab countries This articletries to contribute by filling this gap It applies a modifiedgravity model on panel data of 18 Arab countries coveringthe period 1998 to 2010

The remainder of the article is organized as followsSection II reviews the relevant literature Sections III andIV outline macroeconomic and FDI trends in Arab coun-tries Section V discusses the state of governance in Arabcountries Section VI describes the theoretical frameworkand econometric analysis adopted in this article SectionVII concludes the article

II Literature Review on the RelationshipBetweenGoodGovernance and FDI Inflows

Recently good governance has emerged as a key issue inglobalization process and international capital movementGovernance refers to theway a society sets andmanages the

Corresponding author E-mail abannagahotmailcom abannagagmailcom

Applied Financial Economics 2013Vol 23 No 15 1239ndash1247 httpdxdoiorg101080096031072013802088

copy 2013 Taylor amp Francis 1239

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rules that guide policy-making and policy implementationA number ofmultilateral organizations have reflected on theelements of good governance and on their relation to invest-ment and development processes The United Nations hasconsidered good governance as an essential component ofthe Millennium Development Goals and a framework forfighting poverty and inequality (Rotberg 2004ndash2005) Theorganization views good governance as participatory trans-parent and accountable Furthermore the organizationregards it as the cornerstone for stable and successful econo-mies (United Nations 2007)

Kaufman Kraay and Zoido-Lobaton have aggregated adatabase of hundreds of cross-country governance indica-tors into six fundamental indicators voice and account-ability (VACR) political stability and absence of violence(PSR) government effectiveness (GER) regulatory qual-ity (RQE) rule of law (RLR) and control of corruption(CCR) The VACR indicator is about political freedom ofgovernment selection and freedom of media while thePSR indicator reflects the likelihood of government main-taining order in case of destabilization by unconstitutionalmeans Further the GER indicator reveals the quality ofpublic and civil services and the policy formulation andcredibility Furthermore the RQE indicator representspolicies and regulations that permit and promote privatesector development The RLR indicator illustrates agentsrsquoconfidence in and abidance by the rules of society FinallyCCR shows the extent of using public power for privategain (Kaufmann et al 1999a b) (see the Appendix formore explanation of the indicators)

Good governance is highly associated with FDI giventhe relative irreversible nature of this type of capital flowsCorruption loss of public confidence in the governmentlikelihood of destabilization of the government by uncon-stitutional means rent-seeking and uncertainties aboutlaw enforcement will all create a highly risky atmospherefor FDI

However the relationship between governance indica-tors and FDI remained debatable in empirical research for along period of time Some of the studies focused on onlyone indicator such as political stability corruption RLR andRQE while the others examined all the six indicatorsInvestigation of this relationship is given in Lucas(1990) La Porta et al (1999) Edwards (1990) Jaspersen

et al (2000) Hausmann and Fernandez-arias (2000)Globerman and Shapiro (2002) Kim (2010) Asiedu(2002 2011) Woo (2009) and Samimi and Ariani (20102011) While some of these studies failed to find significantrelationship between governance indicators and FDI themajority of them confirmed the significance of the relation-ship For instance Globerman and Shapiro (2002) find thatimproving governance attracts foreign capital and createsconducive conditions under which MNCs operate Gangiand Abdrazak (2012) investigate the impact of governanceon FDI flows using a panel data of 50 African countriesThey find that three out of the sixWorld Bankrsquos governanceindicators are statistically significant VACR GER andRLR The rest of the indicators (ie political stabilityCCR and RQE) are insignificant

III Macroeconomic Environment in ArabCountries

GDP performance

One of the key macroeconomic performance indicators isGDP growth rates Table 1 provides a comparison ofeconomic growth between different regions in the worldThe table shows that the average growth rate of the Arabregion during the period 2000 to 2011 is higher than that ofEurope and Central Asian and Latin America but lowerthan that of South Asia East Asia and sub-Saharan AfricaThe economic performance during this period wasaffected negatively by the global financial crisis espe-cially in Europe However output volatility in Arab coun-tries is generally high especially in oil-exportingcountries due to vulnerability of terms of trade shocks

Economic stability

The key indicators of economic stability are inflation ratesand exchange rates TheArab region has the lowest levels ofinflation in the world as shown in Table 1 For the last twodecades the Arab countries have succeeded in containinginflation by targeting exchange rate through pegging theircurrencies to a low-inflation currency such as the euro or theUS$ However many countries witnessed losses of inter-national competitiveness large balance of payments deficitrise in public debt and fiscal deficits

Table 1 Global comparison of macroeconomic indicators (2000ndash2011)

Growth rate Inflation rate Trade ( of GDP)

Arab world 45 39 814Latin America and Caribbean (developing only) 36 53 444South Asia 67 65 409Sub-Saharan Africa (all income levels) 46 62 671East Asia and Pacific (developing only) 89 49 746Europe and Central Asia (all income levels) 19 76 655World 27 43 532

Source The World Bank database

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Openness to international trade

We focus on the share of trade in the GDP Trade is takenas the sum of exports and imports of goods and servicesTable 1 shows that the Arab region has one of the highestlevels of openness to internal trade in the world based onthis indicator The majority of the countries in this regiondepend on international trade for income generation suchas oil production and exportation in Gulf countries andtourism in Egypt Tunisia Morocco Lebanon and Jordan

IV Trends of FDI Inflows in Arab Countries

The last two decades have witnessed rapid growth of FDIinflows to developing countries and Arab countries are noexception The share of the Arab countries in the WorldFDI flows has increased from 1 in 2000 to more than 4in 2010 Despite its rapid growth FDI inflow is still fallingshort of expectations given the economic potentials of theArab countries Graph 1 shows the FDI inflows in theArab countries during the period 1999 to 2010 Fromthis graph the total value of the FDI inflow to Arabcountries was less than $10 billion in 1999 It increased

gradually to reach a maximum of about $100 billion in2008 and then declined to less than $70 billion in 2010The decline was due to the global financial crisis In 2011there was a sharp divestment in the region especially inNorth Africa because of political crisis

Graph 2 provides a comparison of FDI investment as apercentage of GDP in different regions in the world duringthe period 2000 to 2010 Further the graph compares theFDI performance in specific years across different regionsThe graph indicates that the overall performance of theArab countries was equivalent to the average world per-formance level for the period 2000 to 2010 It also showsthat the FDI in Arab countries was higher than that of EastAsia and Pacific South Asia and marginally higher thanthat of sub-Saharan Africa but lower than that of the EuroArea and Latin America and the Caribbean Furthermorethe graph shows that the FDI inflows in the Arab regionstarted at a low value in the year 2000 and grew signifi-cantly over time and declined in 2010

Within the Arab countries FDI inflows show dispari-ties between different countries and country groups SaudiArabia was the highest recipient during the period 1999 to2010 reaching $150 billion followed by the United Arab

0

20

40

60

80

100

120

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

FDI net inflows

Graph 1 FDI net inflows in Arab World (in billion US dollars)Source The World Bank Indicators

0

5

10

15

20

25

Arab World East Asia amp

Pacific (all

income levels)

Euro area Latin America

amp Caribbean

(all income

levels)

South Asia Sub-Saharan

Africa

(developing

only)

World

2010

2008

2006

2004

2002

2000

Graph 2 Global comparison of FDI as percentage of GDPSource The World Bank

Effects of good governance on foreign direct investment inflows 1241

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Emirates with a total of $80 billion and Egypt with a totalof $60 billion during the same period When we considerFDI inflows as a percentage of GDP we find that thehighest performance was achieved by Lebanon followedby Mauritania Jordan and Bahrain (see Graph 3)

If we classify the Arab countries as oil-exporting coun-tries and oil-importing diversified countries we find that theFDI inflows to the latter have declined sharply from theirpre-global crisis peak of $22 billion per annum The crisistook a strong toll on FDI flows resulting in a drop of 20 inthe year 2009 (a decline of $4 billion) The decline continuedin 2010 with a further edging down of $2 billion (a fall of10 in the year) with the decline spread fairly evenly acrossthe diversified economies The report of UNCTAD (2010)stated that the FDI advanced by 5 at the global level in2010 or by $58 billion with the Middle East and NorthAfrica one of the few regions witnessing decline in the flows(World Bank 2012) The situation was exacerbated by thepolitical crisis in the region in 2011 and 2012

V State of Governance in Arab Countries

To understand governance situation in Arab countries wewill adopt the six governance indicators of the WorldBank VACR PSR GER RQE RLR and CCR

In explaining the state of governance inArab for the period1999 to 2009 we computed the average values of the indica-tors for each country assuming that themaximumvalue of theindicator is 25 which signifies good governance and thelowest value is (minus25) which signifies bad governanceTable 2 shows the results of the calculation The table showsthat with the exception of a few countries the governancesituation in Arab countries for the period 1999 to 2009 waspoor Governance indicators for the majority of the countriesfell below the zero level Some exceptions are theUnitedArabEmirates Qatar Bahrain Oman Kuwait Jordan and Tunisia

Among the governance indicators the worst perfor-mance was registered in the VACR indicator with negativevalues for all Arab countries Poor governance is the result

0

2

4

6

8

10

12

14

LBN MRT JOR BHR SDN UAE TUN QAT EGY KSA MAR OMN IRQ LBY SYR YEM ALG KWT

FDI as of GDP

Graph 3 FDI as of GDP in Arab countries average values (2000ndash2009)Source The World Bank

Table 2 Governance indicators in Arab countries (1999ndash2009)

CountryControl ofcorruption

Rule oflaw

Regulatoryquality

Governmenteffectiveness

Voice andaccountability

Politicalstability Average

UAE 086 056 070 079 minus081 083 071Qatar 084 064 028 048 minus069 101 059Oman 048 058 050 040 minus087 090 052Kuwait 073 060 024 006 minus043 031 052Bahrain 036 065 078 048 minus083 minus003 060Jordan 021 038 027 013 minus061 minus031 029Tunisia 005 008 minus001 049 minus102 015 004Morocco minus018 minus005 minus018 minus012 minus065 minus037 minus014KSA minus021 014 001 minus024 minus158 minus032 minus002Mauritania minus032 minus062 minus034 minus047 minus089 minus015 minus043Egypt minus049 minus003 minus038 minus037 minus105 minus055 minus030Lebanon minus062 minus042 minus022 minus030 minus043 minus117 minus042Algeria minus067 minus076 minus066 minus065 minus102 minus141 minus069Syria minus082 minus047 minus115 minus091 minus161 minus028 minus082Libya minus091 minus084 minus142 minus105 minus181 016 minus106Yemen minus085 minus117 minus072 minus090 minus106 minus154 minus091Sudan minus120 minus143 minus132 minus122 minus167 minus220 minus132Iraq minus144 minus169 minus158 minus165 minus152 minus238 minus157

Source Compiled by the authors using the World Bank (2010) database on governance

1242 A Bannaga et al

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of lack of democracy lack of freedom of expression andprevalence of government-controlled media during thatperiod The rest of the indicators have registered verylow values for most of the Arab countries Eight out ofthe eighteen countries have not registered a single positivevalue for any of the governance indicators these countriesare Morocco Mauritania Egypt Lebanon Algeria SyriaYemen Sudan and Iraq This reflects a very poor govern-ance situation in the Arab countries These results confirmthe World Bank Report (2004) in relation to the quality ofinstitutions in the Middle East and North Africa Thereport found that the region lies on the bottom of theworld with an average value of minus057 preceded by LatinAmerica with an average of minus021 and East Asia with anaverage of +003 The OECD was on the top with anaverage of +139 The Graphs 4 5 and 6 show somegovernance indicators in Arab countries for selectedyears These graphs confirm the poor situation of govern-ance in these countries

VI Theoretical Framework The GravityModel

In this section we will adopt panel data analysis to assessthe effects of governance on FDI inflow in the Arab

countries Our analysis will be based on an augmentedgravity model The model is an adaptation of theNewtonrsquos law of universal gravitation which states thattwo celestial bodies are attracted to each other with aforce that is directly proportional to their mass and indir-ectly proportional to their distance The law was appliedto human behaviour in social sciences and has becomethe lsquoworkhorsersquo baseline model for estimating the effectsof flows of trade people and capital between countriesApplications for the model are given in Tinbergen(1962) Anderson (1979) Bergstrand (1985) Helpmanand Krugman (1985) Helpman (1987) Maacutetyaacutes (19971998) Deardoff (1998) Egger (2002) Anderson and vanWincoop (2003) Haveman and Hummels (2004) ChengandWall (2005) Debaere (2005) Talamo (2007) Helpmanet al (2008) and more recently Aderson (2011) andBerdeny et al (2012)

The augmented gravity model relates the amount oftrade or capital flows between two countries to the sizeof the GDP population geographical distance and a set ofvariables that capture institutional characteristics includ-ing governance

A simple form of the gravity model of bilateral trade is

Xij frac14 AYiYiDij

(1)

minus8

minus6

minus4

minus2

0

2

4

QAT OMN UAE KWT TUN LBY BHR JOR KSA MAR MRT EGY SYR LBN ALG YEM IRQ SDN

2000 2005 2009

Graph 4 Political stability index for selected years

minus2

minus15

minus1

minus05

0

05

1

QAT OMN KWT BHR UAE JOR KSA TUN EGY MAR LBN SYR MRT ALG LBY YEM SDN IRQ

Median (1996minus2010)

Graph 5 Rule of law median value (1996ndash2010)

Effects of good governance on foreign direct investment inflows 1243

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where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

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sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

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014

rules that guide policy-making and policy implementationA number ofmultilateral organizations have reflected on theelements of good governance and on their relation to invest-ment and development processes The United Nations hasconsidered good governance as an essential component ofthe Millennium Development Goals and a framework forfighting poverty and inequality (Rotberg 2004ndash2005) Theorganization views good governance as participatory trans-parent and accountable Furthermore the organizationregards it as the cornerstone for stable and successful econo-mies (United Nations 2007)

Kaufman Kraay and Zoido-Lobaton have aggregated adatabase of hundreds of cross-country governance indica-tors into six fundamental indicators voice and account-ability (VACR) political stability and absence of violence(PSR) government effectiveness (GER) regulatory qual-ity (RQE) rule of law (RLR) and control of corruption(CCR) The VACR indicator is about political freedom ofgovernment selection and freedom of media while thePSR indicator reflects the likelihood of government main-taining order in case of destabilization by unconstitutionalmeans Further the GER indicator reveals the quality ofpublic and civil services and the policy formulation andcredibility Furthermore the RQE indicator representspolicies and regulations that permit and promote privatesector development The RLR indicator illustrates agentsrsquoconfidence in and abidance by the rules of society FinallyCCR shows the extent of using public power for privategain (Kaufmann et al 1999a b) (see the Appendix formore explanation of the indicators)

Good governance is highly associated with FDI giventhe relative irreversible nature of this type of capital flowsCorruption loss of public confidence in the governmentlikelihood of destabilization of the government by uncon-stitutional means rent-seeking and uncertainties aboutlaw enforcement will all create a highly risky atmospherefor FDI

However the relationship between governance indica-tors and FDI remained debatable in empirical research for along period of time Some of the studies focused on onlyone indicator such as political stability corruption RLR andRQE while the others examined all the six indicatorsInvestigation of this relationship is given in Lucas(1990) La Porta et al (1999) Edwards (1990) Jaspersen

et al (2000) Hausmann and Fernandez-arias (2000)Globerman and Shapiro (2002) Kim (2010) Asiedu(2002 2011) Woo (2009) and Samimi and Ariani (20102011) While some of these studies failed to find significantrelationship between governance indicators and FDI themajority of them confirmed the significance of the relation-ship For instance Globerman and Shapiro (2002) find thatimproving governance attracts foreign capital and createsconducive conditions under which MNCs operate Gangiand Abdrazak (2012) investigate the impact of governanceon FDI flows using a panel data of 50 African countriesThey find that three out of the sixWorld Bankrsquos governanceindicators are statistically significant VACR GER andRLR The rest of the indicators (ie political stabilityCCR and RQE) are insignificant

III Macroeconomic Environment in ArabCountries

GDP performance

One of the key macroeconomic performance indicators isGDP growth rates Table 1 provides a comparison ofeconomic growth between different regions in the worldThe table shows that the average growth rate of the Arabregion during the period 2000 to 2011 is higher than that ofEurope and Central Asian and Latin America but lowerthan that of South Asia East Asia and sub-Saharan AfricaThe economic performance during this period wasaffected negatively by the global financial crisis espe-cially in Europe However output volatility in Arab coun-tries is generally high especially in oil-exportingcountries due to vulnerability of terms of trade shocks

Economic stability

The key indicators of economic stability are inflation ratesand exchange rates TheArab region has the lowest levels ofinflation in the world as shown in Table 1 For the last twodecades the Arab countries have succeeded in containinginflation by targeting exchange rate through pegging theircurrencies to a low-inflation currency such as the euro or theUS$ However many countries witnessed losses of inter-national competitiveness large balance of payments deficitrise in public debt and fiscal deficits

Table 1 Global comparison of macroeconomic indicators (2000ndash2011)

Growth rate Inflation rate Trade ( of GDP)

Arab world 45 39 814Latin America and Caribbean (developing only) 36 53 444South Asia 67 65 409Sub-Saharan Africa (all income levels) 46 62 671East Asia and Pacific (developing only) 89 49 746Europe and Central Asia (all income levels) 19 76 655World 27 43 532

Source The World Bank database

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Openness to international trade

We focus on the share of trade in the GDP Trade is takenas the sum of exports and imports of goods and servicesTable 1 shows that the Arab region has one of the highestlevels of openness to internal trade in the world based onthis indicator The majority of the countries in this regiondepend on international trade for income generation suchas oil production and exportation in Gulf countries andtourism in Egypt Tunisia Morocco Lebanon and Jordan

IV Trends of FDI Inflows in Arab Countries

The last two decades have witnessed rapid growth of FDIinflows to developing countries and Arab countries are noexception The share of the Arab countries in the WorldFDI flows has increased from 1 in 2000 to more than 4in 2010 Despite its rapid growth FDI inflow is still fallingshort of expectations given the economic potentials of theArab countries Graph 1 shows the FDI inflows in theArab countries during the period 1999 to 2010 Fromthis graph the total value of the FDI inflow to Arabcountries was less than $10 billion in 1999 It increased

gradually to reach a maximum of about $100 billion in2008 and then declined to less than $70 billion in 2010The decline was due to the global financial crisis In 2011there was a sharp divestment in the region especially inNorth Africa because of political crisis

Graph 2 provides a comparison of FDI investment as apercentage of GDP in different regions in the world duringthe period 2000 to 2010 Further the graph compares theFDI performance in specific years across different regionsThe graph indicates that the overall performance of theArab countries was equivalent to the average world per-formance level for the period 2000 to 2010 It also showsthat the FDI in Arab countries was higher than that of EastAsia and Pacific South Asia and marginally higher thanthat of sub-Saharan Africa but lower than that of the EuroArea and Latin America and the Caribbean Furthermorethe graph shows that the FDI inflows in the Arab regionstarted at a low value in the year 2000 and grew signifi-cantly over time and declined in 2010

Within the Arab countries FDI inflows show dispari-ties between different countries and country groups SaudiArabia was the highest recipient during the period 1999 to2010 reaching $150 billion followed by the United Arab

0

20

40

60

80

100

120

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

FDI net inflows

Graph 1 FDI net inflows in Arab World (in billion US dollars)Source The World Bank Indicators

0

5

10

15

20

25

Arab World East Asia amp

Pacific (all

income levels)

Euro area Latin America

amp Caribbean

(all income

levels)

South Asia Sub-Saharan

Africa

(developing

only)

World

2010

2008

2006

2004

2002

2000

Graph 2 Global comparison of FDI as percentage of GDPSource The World Bank

Effects of good governance on foreign direct investment inflows 1241

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Emirates with a total of $80 billion and Egypt with a totalof $60 billion during the same period When we considerFDI inflows as a percentage of GDP we find that thehighest performance was achieved by Lebanon followedby Mauritania Jordan and Bahrain (see Graph 3)

If we classify the Arab countries as oil-exporting coun-tries and oil-importing diversified countries we find that theFDI inflows to the latter have declined sharply from theirpre-global crisis peak of $22 billion per annum The crisistook a strong toll on FDI flows resulting in a drop of 20 inthe year 2009 (a decline of $4 billion) The decline continuedin 2010 with a further edging down of $2 billion (a fall of10 in the year) with the decline spread fairly evenly acrossthe diversified economies The report of UNCTAD (2010)stated that the FDI advanced by 5 at the global level in2010 or by $58 billion with the Middle East and NorthAfrica one of the few regions witnessing decline in the flows(World Bank 2012) The situation was exacerbated by thepolitical crisis in the region in 2011 and 2012

V State of Governance in Arab Countries

To understand governance situation in Arab countries wewill adopt the six governance indicators of the WorldBank VACR PSR GER RQE RLR and CCR

In explaining the state of governance inArab for the period1999 to 2009 we computed the average values of the indica-tors for each country assuming that themaximumvalue of theindicator is 25 which signifies good governance and thelowest value is (minus25) which signifies bad governanceTable 2 shows the results of the calculation The table showsthat with the exception of a few countries the governancesituation in Arab countries for the period 1999 to 2009 waspoor Governance indicators for the majority of the countriesfell below the zero level Some exceptions are theUnitedArabEmirates Qatar Bahrain Oman Kuwait Jordan and Tunisia

Among the governance indicators the worst perfor-mance was registered in the VACR indicator with negativevalues for all Arab countries Poor governance is the result

0

2

4

6

8

10

12

14

LBN MRT JOR BHR SDN UAE TUN QAT EGY KSA MAR OMN IRQ LBY SYR YEM ALG KWT

FDI as of GDP

Graph 3 FDI as of GDP in Arab countries average values (2000ndash2009)Source The World Bank

Table 2 Governance indicators in Arab countries (1999ndash2009)

CountryControl ofcorruption

Rule oflaw

Regulatoryquality

Governmenteffectiveness

Voice andaccountability

Politicalstability Average

UAE 086 056 070 079 minus081 083 071Qatar 084 064 028 048 minus069 101 059Oman 048 058 050 040 minus087 090 052Kuwait 073 060 024 006 minus043 031 052Bahrain 036 065 078 048 minus083 minus003 060Jordan 021 038 027 013 minus061 minus031 029Tunisia 005 008 minus001 049 minus102 015 004Morocco minus018 minus005 minus018 minus012 minus065 minus037 minus014KSA minus021 014 001 minus024 minus158 minus032 minus002Mauritania minus032 minus062 minus034 minus047 minus089 minus015 minus043Egypt minus049 minus003 minus038 minus037 minus105 minus055 minus030Lebanon minus062 minus042 minus022 minus030 minus043 minus117 minus042Algeria minus067 minus076 minus066 minus065 minus102 minus141 minus069Syria minus082 minus047 minus115 minus091 minus161 minus028 minus082Libya minus091 minus084 minus142 minus105 minus181 016 minus106Yemen minus085 minus117 minus072 minus090 minus106 minus154 minus091Sudan minus120 minus143 minus132 minus122 minus167 minus220 minus132Iraq minus144 minus169 minus158 minus165 minus152 minus238 minus157

Source Compiled by the authors using the World Bank (2010) database on governance

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of lack of democracy lack of freedom of expression andprevalence of government-controlled media during thatperiod The rest of the indicators have registered verylow values for most of the Arab countries Eight out ofthe eighteen countries have not registered a single positivevalue for any of the governance indicators these countriesare Morocco Mauritania Egypt Lebanon Algeria SyriaYemen Sudan and Iraq This reflects a very poor govern-ance situation in the Arab countries These results confirmthe World Bank Report (2004) in relation to the quality ofinstitutions in the Middle East and North Africa Thereport found that the region lies on the bottom of theworld with an average value of minus057 preceded by LatinAmerica with an average of minus021 and East Asia with anaverage of +003 The OECD was on the top with anaverage of +139 The Graphs 4 5 and 6 show somegovernance indicators in Arab countries for selectedyears These graphs confirm the poor situation of govern-ance in these countries

VI Theoretical Framework The GravityModel

In this section we will adopt panel data analysis to assessthe effects of governance on FDI inflow in the Arab

countries Our analysis will be based on an augmentedgravity model The model is an adaptation of theNewtonrsquos law of universal gravitation which states thattwo celestial bodies are attracted to each other with aforce that is directly proportional to their mass and indir-ectly proportional to their distance The law was appliedto human behaviour in social sciences and has becomethe lsquoworkhorsersquo baseline model for estimating the effectsof flows of trade people and capital between countriesApplications for the model are given in Tinbergen(1962) Anderson (1979) Bergstrand (1985) Helpmanand Krugman (1985) Helpman (1987) Maacutetyaacutes (19971998) Deardoff (1998) Egger (2002) Anderson and vanWincoop (2003) Haveman and Hummels (2004) ChengandWall (2005) Debaere (2005) Talamo (2007) Helpmanet al (2008) and more recently Aderson (2011) andBerdeny et al (2012)

The augmented gravity model relates the amount oftrade or capital flows between two countries to the sizeof the GDP population geographical distance and a set ofvariables that capture institutional characteristics includ-ing governance

A simple form of the gravity model of bilateral trade is

Xij frac14 AYiYiDij

(1)

minus8

minus6

minus4

minus2

0

2

4

QAT OMN UAE KWT TUN LBY BHR JOR KSA MAR MRT EGY SYR LBN ALG YEM IRQ SDN

2000 2005 2009

Graph 4 Political stability index for selected years

minus2

minus15

minus1

minus05

0

05

1

QAT OMN KWT BHR UAE JOR KSA TUN EGY MAR LBN SYR MRT ALG LBY YEM SDN IRQ

Median (1996minus2010)

Graph 5 Rule of law median value (1996ndash2010)

Effects of good governance on foreign direct investment inflows 1243

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where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

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sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

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014

Openness to international trade

We focus on the share of trade in the GDP Trade is takenas the sum of exports and imports of goods and servicesTable 1 shows that the Arab region has one of the highestlevels of openness to internal trade in the world based onthis indicator The majority of the countries in this regiondepend on international trade for income generation suchas oil production and exportation in Gulf countries andtourism in Egypt Tunisia Morocco Lebanon and Jordan

IV Trends of FDI Inflows in Arab Countries

The last two decades have witnessed rapid growth of FDIinflows to developing countries and Arab countries are noexception The share of the Arab countries in the WorldFDI flows has increased from 1 in 2000 to more than 4in 2010 Despite its rapid growth FDI inflow is still fallingshort of expectations given the economic potentials of theArab countries Graph 1 shows the FDI inflows in theArab countries during the period 1999 to 2010 Fromthis graph the total value of the FDI inflow to Arabcountries was less than $10 billion in 1999 It increased

gradually to reach a maximum of about $100 billion in2008 and then declined to less than $70 billion in 2010The decline was due to the global financial crisis In 2011there was a sharp divestment in the region especially inNorth Africa because of political crisis

Graph 2 provides a comparison of FDI investment as apercentage of GDP in different regions in the world duringthe period 2000 to 2010 Further the graph compares theFDI performance in specific years across different regionsThe graph indicates that the overall performance of theArab countries was equivalent to the average world per-formance level for the period 2000 to 2010 It also showsthat the FDI in Arab countries was higher than that of EastAsia and Pacific South Asia and marginally higher thanthat of sub-Saharan Africa but lower than that of the EuroArea and Latin America and the Caribbean Furthermorethe graph shows that the FDI inflows in the Arab regionstarted at a low value in the year 2000 and grew signifi-cantly over time and declined in 2010

Within the Arab countries FDI inflows show dispari-ties between different countries and country groups SaudiArabia was the highest recipient during the period 1999 to2010 reaching $150 billion followed by the United Arab

0

20

40

60

80

100

120

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

FDI net inflows

Graph 1 FDI net inflows in Arab World (in billion US dollars)Source The World Bank Indicators

0

5

10

15

20

25

Arab World East Asia amp

Pacific (all

income levels)

Euro area Latin America

amp Caribbean

(all income

levels)

South Asia Sub-Saharan

Africa

(developing

only)

World

2010

2008

2006

2004

2002

2000

Graph 2 Global comparison of FDI as percentage of GDPSource The World Bank

Effects of good governance on foreign direct investment inflows 1241

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014

Emirates with a total of $80 billion and Egypt with a totalof $60 billion during the same period When we considerFDI inflows as a percentage of GDP we find that thehighest performance was achieved by Lebanon followedby Mauritania Jordan and Bahrain (see Graph 3)

If we classify the Arab countries as oil-exporting coun-tries and oil-importing diversified countries we find that theFDI inflows to the latter have declined sharply from theirpre-global crisis peak of $22 billion per annum The crisistook a strong toll on FDI flows resulting in a drop of 20 inthe year 2009 (a decline of $4 billion) The decline continuedin 2010 with a further edging down of $2 billion (a fall of10 in the year) with the decline spread fairly evenly acrossthe diversified economies The report of UNCTAD (2010)stated that the FDI advanced by 5 at the global level in2010 or by $58 billion with the Middle East and NorthAfrica one of the few regions witnessing decline in the flows(World Bank 2012) The situation was exacerbated by thepolitical crisis in the region in 2011 and 2012

V State of Governance in Arab Countries

To understand governance situation in Arab countries wewill adopt the six governance indicators of the WorldBank VACR PSR GER RQE RLR and CCR

In explaining the state of governance inArab for the period1999 to 2009 we computed the average values of the indica-tors for each country assuming that themaximumvalue of theindicator is 25 which signifies good governance and thelowest value is (minus25) which signifies bad governanceTable 2 shows the results of the calculation The table showsthat with the exception of a few countries the governancesituation in Arab countries for the period 1999 to 2009 waspoor Governance indicators for the majority of the countriesfell below the zero level Some exceptions are theUnitedArabEmirates Qatar Bahrain Oman Kuwait Jordan and Tunisia

Among the governance indicators the worst perfor-mance was registered in the VACR indicator with negativevalues for all Arab countries Poor governance is the result

0

2

4

6

8

10

12

14

LBN MRT JOR BHR SDN UAE TUN QAT EGY KSA MAR OMN IRQ LBY SYR YEM ALG KWT

FDI as of GDP

Graph 3 FDI as of GDP in Arab countries average values (2000ndash2009)Source The World Bank

Table 2 Governance indicators in Arab countries (1999ndash2009)

CountryControl ofcorruption

Rule oflaw

Regulatoryquality

Governmenteffectiveness

Voice andaccountability

Politicalstability Average

UAE 086 056 070 079 minus081 083 071Qatar 084 064 028 048 minus069 101 059Oman 048 058 050 040 minus087 090 052Kuwait 073 060 024 006 minus043 031 052Bahrain 036 065 078 048 minus083 minus003 060Jordan 021 038 027 013 minus061 minus031 029Tunisia 005 008 minus001 049 minus102 015 004Morocco minus018 minus005 minus018 minus012 minus065 minus037 minus014KSA minus021 014 001 minus024 minus158 minus032 minus002Mauritania minus032 minus062 minus034 minus047 minus089 minus015 minus043Egypt minus049 minus003 minus038 minus037 minus105 minus055 minus030Lebanon minus062 minus042 minus022 minus030 minus043 minus117 minus042Algeria minus067 minus076 minus066 minus065 minus102 minus141 minus069Syria minus082 minus047 minus115 minus091 minus161 minus028 minus082Libya minus091 minus084 minus142 minus105 minus181 016 minus106Yemen minus085 minus117 minus072 minus090 minus106 minus154 minus091Sudan minus120 minus143 minus132 minus122 minus167 minus220 minus132Iraq minus144 minus169 minus158 minus165 minus152 minus238 minus157

Source Compiled by the authors using the World Bank (2010) database on governance

1242 A Bannaga et al

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of lack of democracy lack of freedom of expression andprevalence of government-controlled media during thatperiod The rest of the indicators have registered verylow values for most of the Arab countries Eight out ofthe eighteen countries have not registered a single positivevalue for any of the governance indicators these countriesare Morocco Mauritania Egypt Lebanon Algeria SyriaYemen Sudan and Iraq This reflects a very poor govern-ance situation in the Arab countries These results confirmthe World Bank Report (2004) in relation to the quality ofinstitutions in the Middle East and North Africa Thereport found that the region lies on the bottom of theworld with an average value of minus057 preceded by LatinAmerica with an average of minus021 and East Asia with anaverage of +003 The OECD was on the top with anaverage of +139 The Graphs 4 5 and 6 show somegovernance indicators in Arab countries for selectedyears These graphs confirm the poor situation of govern-ance in these countries

VI Theoretical Framework The GravityModel

In this section we will adopt panel data analysis to assessthe effects of governance on FDI inflow in the Arab

countries Our analysis will be based on an augmentedgravity model The model is an adaptation of theNewtonrsquos law of universal gravitation which states thattwo celestial bodies are attracted to each other with aforce that is directly proportional to their mass and indir-ectly proportional to their distance The law was appliedto human behaviour in social sciences and has becomethe lsquoworkhorsersquo baseline model for estimating the effectsof flows of trade people and capital between countriesApplications for the model are given in Tinbergen(1962) Anderson (1979) Bergstrand (1985) Helpmanand Krugman (1985) Helpman (1987) Maacutetyaacutes (19971998) Deardoff (1998) Egger (2002) Anderson and vanWincoop (2003) Haveman and Hummels (2004) ChengandWall (2005) Debaere (2005) Talamo (2007) Helpmanet al (2008) and more recently Aderson (2011) andBerdeny et al (2012)

The augmented gravity model relates the amount oftrade or capital flows between two countries to the sizeof the GDP population geographical distance and a set ofvariables that capture institutional characteristics includ-ing governance

A simple form of the gravity model of bilateral trade is

Xij frac14 AYiYiDij

(1)

minus8

minus6

minus4

minus2

0

2

4

QAT OMN UAE KWT TUN LBY BHR JOR KSA MAR MRT EGY SYR LBN ALG YEM IRQ SDN

2000 2005 2009

Graph 4 Political stability index for selected years

minus2

minus15

minus1

minus05

0

05

1

QAT OMN KWT BHR UAE JOR KSA TUN EGY MAR LBN SYR MRT ALG LBY YEM SDN IRQ

Median (1996minus2010)

Graph 5 Rule of law median value (1996ndash2010)

Effects of good governance on foreign direct investment inflows 1243

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where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

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sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

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Emirates with a total of $80 billion and Egypt with a totalof $60 billion during the same period When we considerFDI inflows as a percentage of GDP we find that thehighest performance was achieved by Lebanon followedby Mauritania Jordan and Bahrain (see Graph 3)

If we classify the Arab countries as oil-exporting coun-tries and oil-importing diversified countries we find that theFDI inflows to the latter have declined sharply from theirpre-global crisis peak of $22 billion per annum The crisistook a strong toll on FDI flows resulting in a drop of 20 inthe year 2009 (a decline of $4 billion) The decline continuedin 2010 with a further edging down of $2 billion (a fall of10 in the year) with the decline spread fairly evenly acrossthe diversified economies The report of UNCTAD (2010)stated that the FDI advanced by 5 at the global level in2010 or by $58 billion with the Middle East and NorthAfrica one of the few regions witnessing decline in the flows(World Bank 2012) The situation was exacerbated by thepolitical crisis in the region in 2011 and 2012

V State of Governance in Arab Countries

To understand governance situation in Arab countries wewill adopt the six governance indicators of the WorldBank VACR PSR GER RQE RLR and CCR

In explaining the state of governance inArab for the period1999 to 2009 we computed the average values of the indica-tors for each country assuming that themaximumvalue of theindicator is 25 which signifies good governance and thelowest value is (minus25) which signifies bad governanceTable 2 shows the results of the calculation The table showsthat with the exception of a few countries the governancesituation in Arab countries for the period 1999 to 2009 waspoor Governance indicators for the majority of the countriesfell below the zero level Some exceptions are theUnitedArabEmirates Qatar Bahrain Oman Kuwait Jordan and Tunisia

Among the governance indicators the worst perfor-mance was registered in the VACR indicator with negativevalues for all Arab countries Poor governance is the result

0

2

4

6

8

10

12

14

LBN MRT JOR BHR SDN UAE TUN QAT EGY KSA MAR OMN IRQ LBY SYR YEM ALG KWT

FDI as of GDP

Graph 3 FDI as of GDP in Arab countries average values (2000ndash2009)Source The World Bank

Table 2 Governance indicators in Arab countries (1999ndash2009)

CountryControl ofcorruption

Rule oflaw

Regulatoryquality

Governmenteffectiveness

Voice andaccountability

Politicalstability Average

UAE 086 056 070 079 minus081 083 071Qatar 084 064 028 048 minus069 101 059Oman 048 058 050 040 minus087 090 052Kuwait 073 060 024 006 minus043 031 052Bahrain 036 065 078 048 minus083 minus003 060Jordan 021 038 027 013 minus061 minus031 029Tunisia 005 008 minus001 049 minus102 015 004Morocco minus018 minus005 minus018 minus012 minus065 minus037 minus014KSA minus021 014 001 minus024 minus158 minus032 minus002Mauritania minus032 minus062 minus034 minus047 minus089 minus015 minus043Egypt minus049 minus003 minus038 minus037 minus105 minus055 minus030Lebanon minus062 minus042 minus022 minus030 minus043 minus117 minus042Algeria minus067 minus076 minus066 minus065 minus102 minus141 minus069Syria minus082 minus047 minus115 minus091 minus161 minus028 minus082Libya minus091 minus084 minus142 minus105 minus181 016 minus106Yemen minus085 minus117 minus072 minus090 minus106 minus154 minus091Sudan minus120 minus143 minus132 minus122 minus167 minus220 minus132Iraq minus144 minus169 minus158 minus165 minus152 minus238 minus157

Source Compiled by the authors using the World Bank (2010) database on governance

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of lack of democracy lack of freedom of expression andprevalence of government-controlled media during thatperiod The rest of the indicators have registered verylow values for most of the Arab countries Eight out ofthe eighteen countries have not registered a single positivevalue for any of the governance indicators these countriesare Morocco Mauritania Egypt Lebanon Algeria SyriaYemen Sudan and Iraq This reflects a very poor govern-ance situation in the Arab countries These results confirmthe World Bank Report (2004) in relation to the quality ofinstitutions in the Middle East and North Africa Thereport found that the region lies on the bottom of theworld with an average value of minus057 preceded by LatinAmerica with an average of minus021 and East Asia with anaverage of +003 The OECD was on the top with anaverage of +139 The Graphs 4 5 and 6 show somegovernance indicators in Arab countries for selectedyears These graphs confirm the poor situation of govern-ance in these countries

VI Theoretical Framework The GravityModel

In this section we will adopt panel data analysis to assessthe effects of governance on FDI inflow in the Arab

countries Our analysis will be based on an augmentedgravity model The model is an adaptation of theNewtonrsquos law of universal gravitation which states thattwo celestial bodies are attracted to each other with aforce that is directly proportional to their mass and indir-ectly proportional to their distance The law was appliedto human behaviour in social sciences and has becomethe lsquoworkhorsersquo baseline model for estimating the effectsof flows of trade people and capital between countriesApplications for the model are given in Tinbergen(1962) Anderson (1979) Bergstrand (1985) Helpmanand Krugman (1985) Helpman (1987) Maacutetyaacutes (19971998) Deardoff (1998) Egger (2002) Anderson and vanWincoop (2003) Haveman and Hummels (2004) ChengandWall (2005) Debaere (2005) Talamo (2007) Helpmanet al (2008) and more recently Aderson (2011) andBerdeny et al (2012)

The augmented gravity model relates the amount oftrade or capital flows between two countries to the sizeof the GDP population geographical distance and a set ofvariables that capture institutional characteristics includ-ing governance

A simple form of the gravity model of bilateral trade is

Xij frac14 AYiYiDij

(1)

minus8

minus6

minus4

minus2

0

2

4

QAT OMN UAE KWT TUN LBY BHR JOR KSA MAR MRT EGY SYR LBN ALG YEM IRQ SDN

2000 2005 2009

Graph 4 Political stability index for selected years

minus2

minus15

minus1

minus05

0

05

1

QAT OMN KWT BHR UAE JOR KSA TUN EGY MAR LBN SYR MRT ALG LBY YEM SDN IRQ

Median (1996minus2010)

Graph 5 Rule of law median value (1996ndash2010)

Effects of good governance on foreign direct investment inflows 1243

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where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

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sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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014

the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

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of lack of democracy lack of freedom of expression andprevalence of government-controlled media during thatperiod The rest of the indicators have registered verylow values for most of the Arab countries Eight out ofthe eighteen countries have not registered a single positivevalue for any of the governance indicators these countriesare Morocco Mauritania Egypt Lebanon Algeria SyriaYemen Sudan and Iraq This reflects a very poor govern-ance situation in the Arab countries These results confirmthe World Bank Report (2004) in relation to the quality ofinstitutions in the Middle East and North Africa Thereport found that the region lies on the bottom of theworld with an average value of minus057 preceded by LatinAmerica with an average of minus021 and East Asia with anaverage of +003 The OECD was on the top with anaverage of +139 The Graphs 4 5 and 6 show somegovernance indicators in Arab countries for selectedyears These graphs confirm the poor situation of govern-ance in these countries

VI Theoretical Framework The GravityModel

In this section we will adopt panel data analysis to assessthe effects of governance on FDI inflow in the Arab

countries Our analysis will be based on an augmentedgravity model The model is an adaptation of theNewtonrsquos law of universal gravitation which states thattwo celestial bodies are attracted to each other with aforce that is directly proportional to their mass and indir-ectly proportional to their distance The law was appliedto human behaviour in social sciences and has becomethe lsquoworkhorsersquo baseline model for estimating the effectsof flows of trade people and capital between countriesApplications for the model are given in Tinbergen(1962) Anderson (1979) Bergstrand (1985) Helpmanand Krugman (1985) Helpman (1987) Maacutetyaacutes (19971998) Deardoff (1998) Egger (2002) Anderson and vanWincoop (2003) Haveman and Hummels (2004) ChengandWall (2005) Debaere (2005) Talamo (2007) Helpmanet al (2008) and more recently Aderson (2011) andBerdeny et al (2012)

The augmented gravity model relates the amount oftrade or capital flows between two countries to the sizeof the GDP population geographical distance and a set ofvariables that capture institutional characteristics includ-ing governance

A simple form of the gravity model of bilateral trade is

Xij frac14 AYiYiDij

(1)

minus8

minus6

minus4

minus2

0

2

4

QAT OMN UAE KWT TUN LBY BHR JOR KSA MAR MRT EGY SYR LBN ALG YEM IRQ SDN

2000 2005 2009

Graph 4 Political stability index for selected years

minus2

minus15

minus1

minus05

0

05

1

QAT OMN KWT BHR UAE JOR KSA TUN EGY MAR LBN SYR MRT ALG LBY YEM SDN IRQ

Median (1996minus2010)

Graph 5 Rule of law median value (1996ndash2010)

Effects of good governance on foreign direct investment inflows 1243

Dow

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rary

] at

04

18 0

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ctob

er 2

014

where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

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rary

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014

sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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rsity

Lib

rary

] at

04

18 0

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014

the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

Dow

nloa

ded

by [

Um

earing U

nive

rsity

Lib

rary

] at

04

18 0

7 O

ctob

er 2

014

where Xij is the flow such as trade FDI migration andtourism A is constant of proportionality Yi and Yj are therelevant economic mass or sizes such as GDP populationand GDP per capita and Dij is the distance between coun-tries (usually between their economic centres)

The gravity equation assumes that the amount of flowbetween two countries increases when their economicsizes increase and decreases when the cost of transporta-tion measured by the distance between their economiccentres increases

In addition to these variables the augmented gravitymodel may incorporate variables that account for differ-ences in languages culture and institutions A commonspecification for the augmented gravity which will beadopted in this research is as follows

ln FDIijt frac14 β0 thorn β1 lnGDPit thorn β2 lnGDPjt thorn β3 lnPOPit

thorn β4 lnPOPjt thorn β5 lnDISTij thorn β6 ln TRit

thorn β7 ln TRjt thorn κZijt thorn Cij thorn εijt

(2)

whereFDIijt is the inflowofFDI into host countryGDP is thegross domestic product POP is the population size DIST isthe geographic distance between economic centres of hostand home economy TR is the trade liberalization indicator ora proxy of level of economic liberalization Zijt is a vector ofother variables which are related to governance Cij is anindividual country-pair specific effect and εijt is an error term

Our specification for the gravity model in Equation 2suggests that the FDI inflow in the Arab countries isexplained by the size of the economy (GDP value) andpopulation size (POP) These two variables are related tothe economic masses associated with the original gravitymodel However they reflect the market size in a countrybesides that the GDP size reflects the economic structureIncrease in the value of these variables is expected to increasethe FDI inflow Further we added the variable DIST torepresent the geographical distance (physical distance andcost of transportation) and the variable TR to reflect the

level of trade liberalization as a proxy for the level of eco-nomic liberalization in the country assuming that an increasein economic liberalization will increase the FDI inflow to thecountry in question The trade liberalization is taken as thevalue of total trade percentage of the GDP Moreover weaugmented the model by a set of variables that capturegovernance characteristics such as RLR CCR PSRVACR RQE and GER The data for all the variables weretaken from the World Bank and completed from the ArabMonetary Fund (AMF 2010 2011) in case of missing dataThe data for geographical distance were obtained from theCEPII website (see Mayer and Zignago 2011)

In evaluating the relationship between the FDI and thevariables on the right-hand side of Equation 2 we estimatethe equation using panel data analysis However allowingfor fixed effects or random effects in the FDI gravity modelis controversial One the one hand the fixed effect isregarded by some authors as an inappropriate approachfor the gravity model estimation because of the time-invar-iant variables such as distance which is one of the funda-mental variables in the model On the other hand it isargued that introducing fixed effects into the gravitymodel will allow for controlling heterogeneity in tradingrelationship (Chen andWall 2005) In this respect distanceand other time-invariant variables are eliminated from themodel (Chen and Wall 2005 Talamo 2007) By contrastthe random effects approach is regarded as an adequateapproach for models with time-variant and -invariant vari-ables Consequently we will use both fixed and randomeffects in our specification for reasons related to evaluationand comparison Distance variables will be excluded fromthe fixed effect equation because they are time invariants

Empirical results

We begin our regression analysis by estimating thegravity Equation (2) allowing for fixed effect Theequation is estimated using the generalized least-square estimator (EGLS) In cross-sectional dimensionwe allowed for fixed effects and selected cross-

0

10

20

30

40

50

60

70

80

90

UAE QAT BHR TUN OMN JOR KWT MAR KSA LBN EGY ALG MRT SYR YEM LBY SDN IRQ

Graph 6 Government effectiveness rank (median value 1996ndash2010)Source The World Bank (2010)

1244 A Bannaga et al

Dow

nloa

ded

by [

Um

earing U

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rsity

Lib

rary

] at

04

18 0

7 O

ctob

er 2

014

sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

Dow

nloa

ded

by [

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nive

rsity

Lib

rary

] at

04

18 0

7 O

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014

the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

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sectional weights for the GLS estimator assuming het-eroscedasticity in this dimension We chose Whiteperiod for robust coefficient covariance to computethe standard errors that are robust to serial correlationTable 3 shows the results of the panel estimationallowing for fixed effects The results indicate thatthe FDI inflow in the Arab countries is affected sig-nificantly and positively by the size of the GDP (or thesize of the domestic market) and the level of economicor trade (TR) liberalization in the country Moreoverthe FDI is affected significantly by all governanceindicators except the RLR and corruption controlindicator (CCR) This means that the FDI inflow inthe Arab countries is affected significantly by politicalstability VACR REQ and government efficiencyHowever population size is not significant for theFDI inflow in the Arab countries which is not a sur-prising result given the economic success of somesmall Arab countries

We tested for joint significance of the fixed effectestimates in our least-squares specifications using

redundant fixed effect tests The redundancy of thefixed effect is rejected at (0000) probability confirm-ing the significance of the fixed effects in thespecification

Table 4 shows the results of the panel estimation allow-ing for random effects We included the distance variablein this estimation and excluded the population variableThe results confirm the previous findings on the factorsaffecting FDI inflow in the Arab countries In particularthe size of GDP trade liberalization and governance indi-cators of VACR RQE and GER are found to be highlysignificant to the FDI inflow Moreover the distance vari-able is significantly and negatively associated with FDIindicating that an increase in geographical distance or costof transportation decreases the FDI inflow However thegovernance indicators of political stability RLR and CCRare not significant in the random effects specification

We conducted the Hausman test for correlated randomeffects to examine the assumption that the random effectsare uncorrelated with the explanatory variables The testresults rejected the correlation hypothesis verifying that

Table 3 Fixed effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C minus7782861 2659956 minus2925936 00040LGDP 0535893 0241507 2218958 00281LTR 1331198 0566222 2351019 00201LRLR minus0296718 0223323 minus1328648 01861LPSR 0126339 0056342 2242360 00265VACR minus0041169 0014273 minus2884342 00045RQE 1125796 0280090 4019406 00001CCR minus0000719 0010266 minus0070025 09443GER minus0005527 0002336 minus2365716 00194LPOP minus0366845 0517055 minus0709490 04792

Note R2 0821300 Adjusted R2 0787874 SE of regression 0760870 DurbinndashWatson stat 1478554F-statistic 2457076 Prob(F-statistic) 0000000

Table 4 Random effects estimation of the relationship between FDI and governance indicators in the Arabcountries (2000ndash2009) Dependent variable LFDI

Variable Coefficient SE t-Stat p-Value

C 2097208 1168404 1794935 00746LGDP 0304814 0145836 2090117 00382LTR 1686767 0419125 4024494 00001LRLR minus0222270 0272001 minus0817166 04151LPSR minus0171991 0172106 minus0999335 03192VACR minus0060541 0015199 minus3983345 00001RQE 1136444 0335823 3384058 00009CCR 0001570 0009338 0168150 08667GER minus0006531 0003006 minus2172773 00313LDIST minus3030065 1261862 minus2401266 00175

Note R2 0340018 Adjusted R2 0301942 SE of regression 0839700 DurbinndashWatson stat 1195762F-statistic 8930001 Prob(F-statistic) 0000000

Effects of good governance on foreign direct investment inflows 1245

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the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

Dow

nloa

ded

by [

Um

earing U

nive

rsity

Lib

rary

] at

04

18 0

7 O

ctob

er 2

014

the random effects are uncorrelated with the explanatoryvariables

The above findings lend strong support for the signifi-cance of good governance to FDI inflows in the Arabcountries

VII Conclusions

Significance of good governance to stable and successfuleconomy in general and to FDI inflows in particular hasbeen confirmed by multinational organizations and indi-vidual researchers The research investigates the effects ofgood governance on FDI inflows in the Arab countriesThe research adopted descriptive statistics and panelregression to assess the relationship between FDI andgovernance indicators for 18 Arab countries during theperiod 2000 to 2009 The analysis is based on an augmen-ted gravity model The model specification suggests thatthe FDI inflow in the Arab countries is influenced by thesize of the economy size of the population the geogra-phical distance between economic centres of the host andhome economy a proxy of trade liberalization and the sixgovernance indicators

Our estimation results have shown that the FDI inflow inthe Arab countries is affected significantly and positively bythe size of the GDP and the level of trade liberalization in thecountry Moreover the FDI is affected significantly by allgovernance indicators except the RLR and CCRFurthermore the distance variable is significantly and nega-tively associated with FDI indicating that an increase ingeographical distance or cost of transportation decreasesthe FDI inflow However population size is not significantfor the FDI inflow in the Arab countries

References

Anderson J E (1979) A theoretical foundation for the gravityequation American Economic Review 63 106ndash16

Anderson J E (2011) The gravity model Annual Review ofEconomics 3 133ndash60

Anderson J E and van Wincoop E (2003) Gravity with grav-itas a solution to the border puzzle American EconomicReview 93 170ndash92

Arab Monetary Fund (AMF) (2010 2011) Unified EconomicReport Different reports Economic and TechnicalDepartment Abu Dhabi United Arab Emirates

Asiedu E (2002) On the determinants of foreign direct invest-ment to developing countries is Africa different WorldDevelopment 30 107ndash19

Asiedu E (2011) Democracy foreign direct investment and naturalresources Journal of International Economics 84 99ndash111

Berden K Bergstrand J H and van Etten E (2012) Governanceglobalization and selection into Foreign Direct InvestmentAvailable at httpwww3ndedu~jbergstrWorking_PapersGovernancepdf (accessed 22 May 2013)

Bergstrand J H (1985) The gravity equation in InternationalTrade some micro-economics foundations and empiricalevidence Review of Economics and Statistics 67 474ndash81

Borensztein E De-Gregorio J and Lee J W (1995) How doesForeign Direct Investment affect economic growthNBER Working Paper Series No 5057 National Bureauof Economic Research Inc Cambridge MA

Cheng I and Wall H (2005) Controlling for heterogeneity ingravity models of trade Federal Reserve Bank of St LouisReview 87 49ndash63

Deardoff A V (1998) Determinants of bilateral trade doesgravity work in a neoclassical world in Frankel J A(ed) The Regionalization of the World EconomyUniversity of Chicago Press Chicago IL

Debaere P (2005) Monopolistic competition and trade revisitedtesting the model without testing for gravity Journal ofInternational Economics 36 249ndash66

Edwards S (1990) Capital flows Foreign Direct Investmentand debt-equity swaps in developing countries NBERWorking Paper Series No 3497 National Bureau ofEconomic Research Inc Cambridge MA

Egger P (2002) An econometric view on the estimation ofgravity models and the calculation of trade potentials TheWorld Economy 25 297ndash312

Gangi Y A and Abdulrazak R S (2012) The impact of gov-ernance on FDI flows to African countriesWorld Journal ofEntrepreneurship Management and SustainableDevelopment 8 162ndash9

Globerman S and Shapiro D (2002) Global foreign directinvestment flows the role of governance infrastructureWorld Development 30 1899ndash919

Hausmann R and Fernandez-arias E (2000) Foreign DirectInvestment good cholesterol Inter-AmericanDevelopment Bank Working Paper No 417 Inter-American Development Bank Washington DC

Haveman J and Hummels D (2004) Alternative hypotheses andthe volume of trade the gravity equation and the extent ofspecialization Canadian Journal of Economics 37 199ndash218

Helpman E (1987) Imperfect competition and internationaltrade evidence from fourteen industrial countries Journalof the Japanese and International Economies 1 62ndash81

Helpman E and Krugman P (1985) Market Structure andForeign Trade MIT Press Cambridge MA

Helpman E Melitz M and Rubinstein Y (2008) Estimatingtrade flows trading partners and trading Quarterly Journalof Economics 23 441ndash87

Jaspersen F Aylward A and Knox A (2000) The effects of riskon private investment Africa compared with other develop-ing areas in Collier P and Pattillo C (eds) Investment andRisk in Africa St Martinrsquos Press New York

Kaufmann D Kraay A and Zoido-Lobaton P (1999a)Aggregating governance indicators World Bank PolicyResearch Working Paper No 2195 World BankWashington DC Available at httpwwwworldbankorgwbigovernancewp-governancehtml (accessed 20 May2013)

Kaufmann D Kraay A and Zoido-Lobaton P (1999b)Governance matters World Bank Policy ResearchWorking Paper No 2196 World Bank Washington DCAvailable at httpwww worldbankorgwbigovernancepubsgovmattershtml (accessed 20 May 2013)

Kim H (2010) Political stability and Foreign Direct InvestmentInternational Journal of Economics and Finance 2 59ndash71

1246 A Bannaga et al

Dow

nloa

ded

by [

Um

earing U

nive

rsity

Lib

rary

] at

04

18 0

7 O

ctob

er 2

014

La Porta R Loacutepez de Silanes F Shleifer A et al (1999) Thequality of government Journal of Law Economics andOrganizations 15 222ndash79

Lucas R E (1990) Why does not capital flow from Rich topoor countries The American Economic Review 8092ndash6

Magravetyagraves L (1997) Proper econometric specification of the grav-ity model The World Economy 20 363ndash8

Magravetyagraves L (1998) The gravity model some econometric con-siderations The World Economy 21 397ndash401

Mayer T and Zignago S (2011) Notes on CEPIIrsquos distancesmeasures the GeoDist database CEPII document No(2011 ndash 25) December Available at httpwwwcepiifranglaisgraphworkpappdf2011wp2011-25pdf (accessed20 May 2013)

Rotberg R I (200405) Strengthening governance ranking coun-tries would help The Washington Quarterly 28 71ndash81

Samimi J A and Ariani F (2010) Governance and FDI inMENA region Australian Journal of Basic and AppliedSciences 4 4880ndash2

Samimi J A Monfared M Moghaddasi R et al (2011)Political stability and FDI in OIC countries Journal ofSocial and Development Sciences 1 18ndash23

Talamo G (2007) Institution FDI and the Gravity ModelAvailable at growthgroup3ecunipiitSiena2007paper_talamo_sienapdf (accessed 20 May 2013)

Tinbergen J (1962) Shaping the World Economy Suggestionsfor an International Economic Policy The TwentiethCentury Fund New York

United Nations (2007) Public governance indicators a literaturereview Department of Economic and Social Affairs UnitedNations publication No STESAPADSERE100

United Nations Conference on Trade and Development (2010)UNCTAD Statistical DatabaseAvailable at httpunctadstatunctadorgReportFoldersreportFoldersaspx (accessed 22May 2013)

Woo J-Y (2009) Corruption and Foreign Direct Investmentattractiveness in Asia Asian Politics and Policy 1 223ndash38

World Bank (2010) World Resource Institute GovernanceIndicators Available at httpwwwwriorg (accessed 20May 2013)

World Bank (2012) Global Economic Prospects June 2012Available at httpsiteresourcesworldbankorgINTPROSPECTSResources334934-13225933055958287139-1339427993716GEP12bMNA_RegionalAnnexpdf (accessed 20 May 2013)

Appendix

Governance Indicator Definitions

These indicators are defined by the World Bank Instituteas follows

Voice and accountability Reflects perceptions ofthe extent to which a countryrsquos citizens are able toparticipate in selecting their government as well asfreedom of expression freedom of association and afree media

Political stability and absence of violence Reflectsperceptions of the likelihood that the governmentwill not be destabilized or overthrown by unconsti-tutional or violent means including politicallymotivated violence and terrorism

Government effectiveness Reflects perceptions ofthe quality of public services the quality of the civil

service and the degree of its independence frompolitical pressures the quality of policy formulationand implementation and the credibility of the gov-ernmentrsquos commitment to such policies

Regulatory quality Reflects perceptions of the abil-ity of the government to formulate and implementsound policies and regulations that permit and pro-mote private sector development

Rule of law Reflects perceptions of the extent towhich agents have confidence in and abide by therules of society particularly the quality of contractenforcement property rights the police and thecourts as well as the likelihood of crime and violence

Control of corruption Reflects perceptions of theextent to which public power is exercised for pri-vate gain including both petty and grand forms ofcorruption as well as lsquocapturersquo of the state by elitesand private interests

Effects of good governance on foreign direct investment inflows 1247

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