The Effects of the Governance Environment on the Choice of Investment Mode and the Strategic Implications

Abstract

Direct investment and indirect (portfolio) investment require different governance mechanisms for investor protection. The literature on the effect of the governance environment (such as the legal system) on investment, which had been relatively underdeveloped, has begun to draw more attention recently. However, existing studies have largely ignored the differences between the two modes of investment in terms of investor protection. Their finding that a poor governance environment deters foreign direct investment is mis-specified and fails to explain why countries with a poor governance environment attract relatively large amount of direct investment as opposed to portfolio investment.

We introduce a framework that measures the level of rule-based governance environment in a capital receiving economy, with a special attention to the information and enforcement mechanisms for investor protection facilitated by different governance environments. We argue that in countries with a weak rule-based governance environment, investors prefer direct investment to indirect (portfolio) investment, because the former can be better protected by private means. Our empirical test strongly supports our hypotheses. Strategic implications for investors are drawn in conclusion.

Keywords: Governance environment, direct investment, indirect (portfolio) investment, public ordering, private ordering, rule-based, relation-based

JEL Classification: F12, F23, G32, K40, P50