Effective Legal Systems and Foreign Direct Investment: In Search of the Evidence
Posted: 10 Feb 2005
What do we know about the role of legal systems as determinants of the location of foreign direct investment (FDI)? The short answer to this question is: not enough. In recent decades, most governments have come to believe that FDI is an important source of the capital and technology necessary for economic development, and to seek new ways to induce foreign investors to locate within their jurisdiction. Commentators and development agencies regularly argue or imply that FDI flows are to some extent determined by the effectiveness of the host state's legal system. That is, it is suggested that the manner in which laws are implemented in a state can act as a deterrent or an attraction to potential foreign investors.
There are well developed theoretical arguments why the effectiveness of legal systems should be a determinant of FDI (Part I). However, there is little empirical evidence to suggest that such a relationship actually exists; and there are existing theoretical arguments, including the concept of bounded rationality and the importance of informal business relationships, why any such relationship will be limited (Part II). In addition, there is good reason to expect that investors with different characteristics, such as size or nationality, will have varying degrees of sensitivity to the effectiveness of legal systems - a possibility which has generally been ignored by commentators (Part III). This article concludes that if legal reform aimed at attracting FDI is to be efficient and effective, then further research must be conducted into the existence and nature of any relationship between the effectiveness of legal systems and FDI flows (Part IV).
Throughout the article, reference is made to a study of the role of the Sri Lankan legal system as a determinant of FDI, conducted by the author.
Keywords: Foreign Direct Investment, host state legal system, investor characteristics
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