The three pillars of institutional theory and FDI in Latin America: An institutionalization process

ARTICLE IN PRESS international business review International Business Review 17 (2008) 118–133 www.elsevier.com/locate/ibusrev

The three pillars of institutional theory and FDI in Latin America: An institutionalization process Len J. Trevinoa,, Douglas E. Thomasb,1, John Cullena,2 a

Department of Management and Operations, College of Business, Washington State University, P.O. Box 644736, Pullman, WA 99164-4736, USA b Anderson School of Management, University of New Mexico, MSC 05-3090, 1924 Las Lomas NE, Albuquerque NM 87131-0001, New Mexico, USA Received 5 March 2007; received in revised form 28 August 2007, 27 September 2007; accepted 30 October 2007

Abstract This paper describes the process of institutionalization and legitimization in countries in Latin America and its impact on organizational decision-making regarding inward foreign direct investment (FDI). It argues that institutionalization is a process that works through all three pillars—cognitive, normative, and regulative—and that this process can legitimize a host market for foreign investors. The study examines institutional reform in 16 Latin American countries using several indices of institutional change occurring between 1970 and 2000. Results indicate that institutional processes that legitimize more effectively through the cognitive and normative pillars (e.g. educational attainment, bilateral investment treaties, privatization, and political uncertainty) are better indicators of inward FDI than those that legitimize primarily through the regulative pillar (e.g. tax reform, trade reform, and financial account liberalization). r 2007 Elsevier Ltd. All rights reserved. Keywords: Foreign direct investment; Institutionalization process; Latin America

1. Introduction Although the relationship between organizational decision-making, foreign direct investment (FDI), and institutional theory has been widely studied, knowledge of this subject stems primarily from the economic version of ‘‘New Institutionalism’’ that focuses almost exclusively on economic efficiency (Mudambi & Navarra, 2002; North, 1990; Williamson, 1985). The international business community’s understanding of this subject may be limited, however, inasmuch as all forms of institutions that manage human interactions via cognitive, normative, and regulative processes influence organizational decision-making (Scott, 1995). In fact, although Grosse and Trevino (2005) acknowledged that all three institutional pillars provide a basis for analysis when it comes to organizational decision-making and FDI, their research failed to incorporate either Corresponding author. Tel.: +1 509 335 3085; fax: +1 509 335 7736.

E-mail addresses: [email protected] (L.J. Trevino), [email protected] (D.E. Thomas), [email protected] (J. Cullen). Tel.: +1 505 277 8892; fax: +1 505 277 7108. 2 Tel.: +1 509 335 4440; fax: +1 509 335 7736. 1

0969-5931/$ - see front matter r 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.ibusrev.2007.10.002

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the cultural-cognitive or the normative dimensions. Failure to include the cognitive or normative pillars into models of FDI location leads to an incomplete understanding of the impact that institutions have on FDI decision-making. The present study on FDI in Latin American corrects for this gap in extant literature and extends institutional theory in several ways. First, this study answers the call to develop a more comprehensive understanding of the institutional environment–FDI decision-making interface in developing economies (Hoskisson, Eden, Lau, & Wright, 2000). We develop such a model by incorporating all three pillars of institutional theory in a single model. Second, in contrast to the approach taken by Scott (1995) and Kostova (1997), we posit that institution building is a process and not a typology. Under this approach, we do not force institutional constructs that may influence behavior into categories such as cognitive, normative, or regulative. Rather, we theorize that these pillars represent the underlying processes that lead to institutional change, ultimately influencing firm-level organizational outcomes. Third, liberalization policies, market reforms, and inflows of FDI have varied considerably in Latin America, both cross-sectionally and longitudinally. As such, and in response to North (1990), who said that change is decidedly incremental, the present study examines the impact of institutionalization over an extended timeframe (31 years), thus allowing for the emergence of institutions. In summary, the objective of the current paper is to demonstrate that host country institution building is a process that works through all three pillars of institutional theory to affect foreign investors’ perceptions of the host country as a potential production location. 1.1. FDI in Latin America Latin America is a unique region with a long and varied history of FDI (Trevino, Daniels, & Arbelaez, 2002), often dating back to the nineteenth century (Behrman, 1974). Early FDI in the region was primarily export-oriented and driven by multinational enterprises (MNEs) seeking access to natural resources (Grosse, 1989). Governments in Latin America, often at odds with MNEs over policy issues, have had a pervasive influence on business, at times exerting significant regulative powers and enforcing them arbitrarily. This created sectors that excluded foreign companies or required them to compete against subsidized domestic firms. Import substitution industrialization in the post WWII era led to a shift in FDI toward manufacturing for domestic consumption and further insulated the domestic economy from foreign competition (Biglaiser, 2006). Although the economies of most Latin American countries grew rapidly from the post WWII era until the 1980s, lack of international competition eventually set the stage for abrupt halts in economic growth. By prohibiting most imports, and by placing severe restrictions on FDI, governments in many Latin American countries created a non-innovative business climate. Compounding the problem, foreign exchange shortages became a crisis for many countries in the region in the 1980s because they could not generate sorely needed hard currency through the exportation of inferior products. These policies led to closed nationalistic economies and this continued in many countries until the late 1980s. This economic and institutional landscape led to capital flight and chronic foreign exchange shortages, and eventually to economic and institutional reform. Lacking hard currency in the 1980s, many governments in Latin America began to open up their markets in a return to export-oriented FDI, and many of the traditional roles of government were transformed (Thomas & Grosse, 2001). Governments in Latin America also have decentralized economic decision-making by shifting it from the state to the private sector, thus allowing market forces to drive competition. Over the past several decades, Latin American countries’ institutional profiles have changed dramatically and it has become accepted that the old model of state directed import substitution industrialization was unsustainable. The time period in which institutional reforms occur varies depending on the country under study, however. For example, while Chile’s reforms began in the early 1970s, most reforms in the region slowed during the early 1980s, a period of debt crisis, and many other Latin American countries began increasing reform only after that period. Further, different types of institutional reforms began in different periods. ‘‘Trade reform and domestic financial liberalization were the first components to be widely adopted [in Latin America], with 11 countries reaching [a high level of reform] by 1990, and all but one of the rest reaching [a high] level by 1995. However, there is much less convergence and more variance in y privatization

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and tax reform’’ (Morley, Machado, & Pettinato, 1999, p. 1). These reforms are institutional because they reflect a change in ideological orientation with respect to the best way to encourage FDI. 1.2. Institutional theory and foreign direct investment Although applied widely in developed countries, there is limited theoretical and empirical research applying an institutional framework in developing countries (Meyer, 2001), even though some argue that institutional theory is the most applicable paradigm for explaining organizational behavior in these settings (Shenkar & von Glinow, 1994). Additionally, even though institutions play a prominent role in the location decisions of foreign investors (Bevan, Estrin, & Meyer, 2004; Sethi, Guisinger, Ford, & Phelan, 2002), research on inward FDI has typically emphasized market (e.g. labor costs, market size, and growth,) rather than other institutional factors to explain this phenomenon (e.g. Trevino & Daniels, 1995; Trevino & Grosse, 2002). Of those studies that have emphasized institutional factors to explain FDI, most have focused on those institutions that work primarily through regulative processes, even though it is impossible to understand the emergence of an institution without also considering the impact of the cognitive and normative pillars (e.g. Grosse & Trevino, 2005). We posit that one reason, if not the main reason, why studies have emphasized the regulative pillar is because it is easier to classify constructs as regulative rather than as cognitive or normative. In support of this line of reasoning, ‘‘[e]xcessive bureaucracies, unclear and arbitrarily enforced rules, monopoly control of the real sector’’ are examples of regulative institutional barriers to efficient FDI (Pournarakis & Varsakelis, 2004, p. 80). However, ‘‘the impact of different [non-regulative] aspects of the institutional framework on inward FDI has rarely been addressed’’ (Bevan et al., 2004, p. 44). We add to the literature on the New Institutional Economics by studying the impact of the institution building process, as seen through the three pillars of institutional theory—cognitive, normative, and regulative—on organizational decision-making regarding FDI. We argue that, while the New Institutional Economics is not a unified theory, it does provide a foundation for the theoretical argument that ‘institutions matter’ for either encouraging or discouraging FDI. When combined with the more sociological view of institutional structures based on regulative, normative, and cognitive processes, it is possible to consider institutional effects on FDI that are more complex than market characteristics alone, and this is the rationale for our model. 2. Literature review and hypotheses 2.1. Institution building and FDI A nation’s institutional environment is the set of political, economic, social, and legal conventions that establish the foundational basis for production and exchange (Oxley, 1999; Sobel, 2002). Institutions make up the constraints and incentive systems of a society that structure human interactions, and thus they provide rules and enforcement mechanisms that constrain actors and limit their best-choice options to generally predictable outcomes (North, 1998). Social institutions influence organizational characteristics within and between nations (Meyer & Rowan, 1977; Scott, 1995; Whitley, 1994). A nation’s institutional profile affects managerial actions including, for example, the choice to become an entrepreneur (Busenitz, Go´mez, & Spencer, 2000), managers’ ethical reasoning and behavior (Cullen, Parboteeah, & Ho¨gel, 2004; Martin, Cullen, Johnson, & Parboteeah, 2007), or which industry to enter (Biggart & Guille´n, 1999). The institutional mosaic of a society also influences the behaviors of multinational organizations regarding investment in that society (Delios & Henisz, 2000). 2.2. Institutional pillars as processes Although social institutions influence managerial actions through a variety of processes, previous research and theory often begins with the assumption that institutions fit neatly into a typology, with each type having a unique process of affecting outcomes. Perhaps the most well known of these typologies is Scott’s (1995) cognitive, normative, and regulative ‘‘pillars’’ of institutional structure. Borrowing from Scott’s institutional

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approach, Kostova (1997) applied the pillars at the country level to produce a three-dimensional country institutional profile, consisting of a country’s governmental policies (regulative dimension), widely shared social knowledge (cognitive dimension), and value systems (normative dimension). In this paper, we argue that the more appropriate view of the institutional pillars does not emphasize the classification of institutions into type but, instead, examines the processes by which institutions influence managerial and organizational actions. This shift from a classification of institutional types to a classification of institutionalization processes allows us to develop theoretical arguments showing that a nation’s institutions can influence inward FDI through the processes associated with all three pillars, often simultaneously, although not necessarily equally. Drawing on Scott (1995), Kostova (1997, p. 180) defines the regulative component of a country’s institutional characteristics as those ‘‘existing laws and rules in a particular national environment that promote certain types of behaviors and restrict others.’’ The enforcement mechanism, and thus the key process identified, is largely coercive through rules, boundaries, laws and regulations, and sanctions (North, 1990). The cognitive pillar of social institutions emphasizes cognitions and actors’ generally shared perceptions of what is typical or taken for granted (Busenitz et al., 2000; Scott, 1995). Thus, the cognitive component of a nation’s institutional profile reflects the cognitive structures and symbolic systems shared among individuals (e.g. shared knowledge). As Kostova (1999, p. 314) points out, ‘‘cognitive programs such as schemas, frames, inferential sets, and representations affect the way people notice, categorize, and interpret stimuli from the environment.’’ In Scott’s (1995) view, the cognitive component of institutions leads to an isomorphism of activities via processes that encourage imitating patterns of activities that have strong cultural support. The normative component of a nation’s institutional profile consists of ‘‘social norms, values, beliefs and assumptions that are socially shared and carried out by individuals’’ (Kostova, 1997: 180). Scott (1995) argues that normative components of institutions define what is appropriate and ‘‘right’’ for a society’s members. As such, when an institution (e.g. an educational system, religion, or government) promotes the ‘‘correct’’ way of behavior, even in the absence of legal or other sanctions, that institution influences organizational and individual actions by normative processes. 2.3. Theory and hypotheses: an institutional process approach Rather than assuming that a nation’s social institutions fit neatly into cognitive, normative, and regulative types, we propose that the majority of institutions develop and legitimize an FDI platform through one or more of the processes associated with each pillar. In this study, we identify seven institutional characteristics, namely the educational system, bilateral investment treaties (BITs), privatization, political risk, tax reform, trade reform, and financial account liberalization that may affect the likelihood of inward FDI. We selected these institutions based not only on prior literature but also because they have the potential to affect inward FDI through institutional processes associated with the institutional pillars. Although Henisz and his colleagues (i.e. Delios & Henisz, 2000; Henisz & Delios, 2001; Henisz & Zelner, 2005) have demonstrated that regulative aspects of a society’s institutions influence the mode and extent of FDI, the question of how the normative and cognitive components of a nation’s institutional profile can influence inward FDI remains unanswered. Thus, examining these institutions though their cognitive, normative, and regulative effects on society offers a useful framework for increased understanding of FDI decision-making beyond the traditional economic, political, and financial dimensions of the typical ‘‘determinants of FDI’’ approach. To operationalize our model, we posit that each independent variable under study legitimizes FDI more effectively through either the processes associated with the cognitive/normative pillars or through those associated with the regulative pillar. Those variables that possess more (or fewer) tangible and more (or fewer) regulative characteristics are more likely to legitimize through the regulative (cognitive/normative) pillar. We propose that those variables that exhibit fewer such characteristics, such as educational attainment, legitimize more strongly through the cognitive/normative pillars. Conversely, those that exhibit more tangible and regulative characteristics, such as tax reform, legitimize more dominantly through the regulative pillar. Importantly, this is not a classification of institutional types but a view of dominant patterns of influence.

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High Education BITS

Cognitive/Normative

Political Uncertainty

Privatization

Trade Reform

Financial Account Liberalization

Tax Reform

Low

Low

High Regulative

Fig. 1. Three pillars and the institutionalizing processes of the independent variables.

To illustrate these general tendencies, we categorize each of the seven independent variables under study according to their proposed dominant institutional processes (see Fig. 1). Note that the figure is suggestive of dominant tendencies regarding FDI and not a precise point estimate. 2.3.1. The educational system Education is a central component of a country’s institutional profile in that it provides ‘‘socializing experiences which prepare individuals to act in society’’ (Meyer, 1977, p. 55). Education also plays an important role in the transmission of societal norms and beliefs from generation to generation (Turner, 1997). Fundamentally, educational systems socialize by transmitting values such as, for example, respect for others, politeness and rejection of violence (Van Deth, 1995), and perhaps openness to foreigners. Education levels in a society can have two fundamental impacts on FDI inflows. First, educational levels may act as a proxy for labor quality because foreign investors should be interested in establishing operations in countries with higher educational attainment, as long as it does not come at a prohibitively high cost. In support of this line of reasoning, Borensztein, DeGregorio, and Lee (1998) concluded that developing countries need a minimum threshold of human capital to attract FDI. Multinational firms also may increase the demand for education in developing countries because their plants often are more skilled-labor intensive then the rest of the economy (Feenstra & Hanson, 1997). From the perspective of institution building, we argue that higher educational attainment enables one to understand the degree to which the nation state is more (or less) open to foreigners, with nations becoming more geocentric as they become more educated. This construct legitimizes through cultural-cognitive processes because educational attainment represents an internalized symbolic representation and a way of acting (i.e. openness to FDI). For a country to become less sovereign and more open to foreigners operating within their boundaries, an actor or group of actors must propose a shift in the educational system from one that is ethnocentric-based to one that is geocentric-based. Once this shift becomes permanent, we argue that educational attainment legitimizes through the normative pillar because it acts as a normative expectation, guiding behavior, and facilitating the shift from ethnocentrism to geocentrism. Influence processes associated with the regulative pillar have some functions as well because regulations impose minimum educational standards for a society, and failure to follow these standards may result in sanctions. Because the focus of this

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study is on foreign investors’ perceptions of the host country institutional profile, we believe that the cognitive and normative pillars are dominant for educational attainment and we posit: H1. The level of the host country’s educational attainment is positively associated with the level of its inward FDI. 2.3.2. Bilateral investment treaties The adoption of BITs can be considered one of the elements of institutional reform that has fostered the perception that Latin American countries are moving toward market-based economies. BITs generally offer investors additional and higher standards of legal protection and guarantees for foreign investments than those offered under national laws. BITs often have provisions for the avoidance of double taxation of income and capital and, as such, they may act to signal a more favorable investment platform. In a recent study on FDI in Central and Eastern Europe, Grosse and Trevino (2005) found a significant and positive relationship between the number of BITs signed and inward FDI in this region. Because BITs represent a challenge to the existing institutional structure, they legitimize through the cognitive pillar. Similar to the educational attainment construct, an actor or actors must challenge the existing ethnocentric belief system and support moving the nation toward geocentrism by proposing the adoption of BITs. Concomitantly, the host country’s adoption of BITs acts as a symbolic representation between the host country and the rest of the world and this manifests change via the normative pillar. Although there are some instances of adjudication or arbitration between host-country governments and MNEs, due to post-investment non-compliant behavior by either party, the institutionalization process for BITs is more strongly embedded in the normative and cognitive lenses than it is in regulative processes. We submit that BITs may act both as an instrument for the international protection of foreign investment, thereby reducing uncertainty and FDI-related costs, while at the same time signaling to foreign investors that the host country has undertaken institutional reforms toward building a market economy and we posit: H2. The number of the host country’s bilateral investment treaties is positively associated with the level of its inward FDI. 2.3.3. Privatization Privatization of state-owned enterprises (SOEs) is considered one of the fundamental elements of institutional reform driving the development of the transitional economies (Frydman, Hessel, & Rapaczynski, 1998). In related research on Latin American privatization programs, several studies concluded that privatization has given foreign companies more opportunities to invest in host Latin American countries by eliminating institutional barriers that constrain FDI (Devlin & Cominetti, 1994; Hartenek, 1995; Trevino et al., 2002). In general, privatization programs tend to indicate a government’s willingness to allow the private sector to play a larger role in the economy, thus supporting the entry and growth of foreign MNEs as well as domestic firms. This represents a challenge to the existing institutional profile and suggests that there is a significant cognitive role that actors play in creating institutional change. Concurrently, societal acceptance of this shift from the state to the private sector represents the normative pillar. Of course, there are restrictions placed on the transition process, but they are often not punitive, implying that privatization is not operationalized as strongly through the regulative pillar as it is through the cognitive and normative pillars. H3. The level of host country privatization is positively associated with the level of its inward FDI. 2.3.4. Political uncertainty Another element of the institutional environment in the host country revolves around its political uncertainty profile. Because the uncertainty and costs associated with each country’s political uncertainty index alter returns to foreign investors (Bailey & Chung, 1995), a risk-averse firm, ceteris paribus, will underallocate capital to host countries in the presence of high political uncertainty. The political uncertainty profile of the host country acts as part of a nation’s symbolic representation to the rest of the world (cognitive pillar) and, if change is to occur, it must originate from actors willing to challenge the status quo with respect to, for example, corruption. There are also certain moral obligations present in political decisions but, in general,

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behavioral outcomes operating through the normative pillar are not predictable. Because of this, there is also ambiguity in terms of the rewards and sanctions that accrue to actors as the nation shifts from one institutional profile to another. Nations in Latin America have experienced waves of political uncertainty (depending on the country) over the past half century. Both dictators and democracy (e.g. Chile) have emerged at different times in different countries. Major political upheavals have occurred, including those related to civil wars (e.g., countries in Central America), the rise of new political parties (e.g., Mexico), coups (e.g., Chile), military-led governments (e.g., Brazil), among others. Investors in Latin America often have had little reason to trust that the political climate would remain stable. We argue that because the political uncertainty construct is less tangible and regulative than other constructs, such as tax reform, that it legitimizes more effectively through the cognitive and normative pillars. H4. The level of political constraints in the host country is positively associated with the level of its inward FDI. 2.3.5. Tax reform Latin American countries have adopted two major components of tax reform, value-added tax and marginal tax rates on corporate and personal income. Latin American countries initiated tax reforms beginning in 1970, the first year of our study, and this coincided with the shift from import substitution industrialization to open markets. Tax reforms can be seen through the lens of the cognitive pillar because initially actors had to challenge the existing institutional structure that favored domestic firms over MNEs. Additionally, tax reform legitimizes through the normative pillar to the extent that geocentrism and openness to foreignness become taken for granted. However, we posit that organizational legitimization takes place primarily through the lens of the regulative pillar because of the tangibility of reforms and due to the presence of sanctions for non-compliant behavior. To the extent that all taxes have distorting effects on organizational decision-making, we posit that: H5. The degree of tax reform in the host country is positively associated with the level of its inward FDI. 2.3.6. Trade reform In an effort to open their internal markets, trade reform in Latin America began in the 1970s, with significant policy changes in the southern cone countries, including Argentina, Chile, and Uruguay. Before trade reform, and in concert with import substitution industrialization, Latin American countries used onerous tariff structures to protect selective industries. After the debt crisis of 1982, Latin America witnessed a temporary reversion in trade liberalization, but by 1995, tariff rates had fallen dramatically across the region. Because this construct is tangible and restrictive, we view trade reform as operating primarily through the regulative pillar. Because institution building is a process, however, it also operates through both the cognitive and normative pillars. Because actors from outside of protected sectors had to overcome resistance to trade protection in protected sectors, this institutional construct legitimizes through the cognitive pillar. Similarly, acceptance of the shift from state control to open markets suggests that this variable also works through the normative pillar. Because of the presence of non-trivial sanctions in the presence of non-compliance, however, we submit that the institutional impact of this construct is rooted most deeply in the regulative pillar. H6. The level of trade reform in the host country is positively associated with the level of its inward FDI. 2.3.7. Financial account liberalization Over the last several decades, high levels of financial instability characterized governments in Latin America. This has resulted from the imposition of controls on capital movements, controls on the international activities of financial institutions, and restrictions on the entry of foreign financial institutions. More recently, however, governments in Latin America have opened their financial systems by liberalizing capital flows and the rules governing financial intermediaries’ operations. Financial account liberalization works through the cognitive pillar because governments in developing countries have a strong incentive to maintain capital controls, as increased financial integration holds governments hostage to foreign exchange and capital markets, forcing them to exhibit greater fiscal and monetary discipline than they might otherwise

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Table 1 Institutionalization, independent variables and the three pillars Independent variables

Expected sign

Cognitive (symbolic)

Normative (taken for granted behavior)

Regulative (laws, rules, sanctions for noncompliance)

Educational attainment

+

Learning how to deal with foreigners and differences

Societal compliance is the norm

Bilateral investment treaties

+

Privatization

+

Challenge to existing institutional profile, advocating shift from sovereignty to openness to FDI Challenge to institutional profile, advocating divestment of SOEs

Resistance/acceptance of shift from sovereignty/ ethnocentricity to geocentricity Resistance/acceptance of belief that FDI is beneficial

Political uncertainty



Tax reform

+

Trade reform

+

Challenge to institutional profile representing importcompeting industries

Financial account liberalization

+

Challenge to protected financial sectors and government

Challenge to existing institutional profile, pushing toward democracy and transparency Challenge to existing institutional profile, leading to reform and FDI

Resistance/acceptance of shift from state-controlled production to private sector

Resistance/acceptance of shift from opaqueness and corruption to transparency and increased certainty Resistance/acceptance of shift from sovereignty/ ethnocentricity to geocentricity/ openness to level playing field and FDI Resistance/acceptance of shift from state-controlled trade to open markets

Resistance/acceptance of shift from sovereignty/ ethnocentricity to geocentricity/ openness to FDI

Protection for MNEs, sanctions for noncompliance; may lead to adjudication or arbitration in rare cases Restrictions on transition process, positively encouraging investment; ambiguity of sanctions and rewards as determined by normative and cognitive processes Ambiguity of sanctions/ rewards, determined by normative and cognitive processes Creates even-playing field for domestic and foreign firms; significant sanctions for non-compliance In general, penalizes previously protected sector while positively encouraging trade and openness; significant sanctions for non-compliance Increased integration constrains government choice; significant sanctions for non-compliance

choose (Andrews, 1994). Although this variable works through both the cognitive and normative pillars to establish organizational legitimacy, we submit that the regulative pillar has the most influence on the legitimization process of financial account liberalization because of the significant rules and regulations that are a part of this process and due to the presence of sanctions for non-compliant behavior. H7. Financial account liberalization in the host country is positively associated with its inward FDI. See Table 1 for a summary of the independent variables and their proposed effects on institutional change via processes associated with the three pillars. 2.4. Control variables 2.4.1. Inflation Other factors should help to explain FDI into Latin America, and other countries, and we have controlled for those that we think have the potential to make the most significant impact. First, we consider the level of

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macroeconomic instability or risk, given that studies have shown that economic instability makes FDI particularly challenging for foreign investors (Meyer, 2001). Because our study examines institutionalization over a 31-year period, and considering that inflation and exchange rate instability manifested varying degrees of problems in the region during that time, we control for both of these factors. Under the import substitution industrialization environment in Latin America in the 1970s and 1980s, where imports were not permitted, hyperinflation was rampant because manufacturers did not have to compete with imports. A high and/or variable rate of inflation is a sign of internal economic instability and of the host government’s inability to maintain consistent monetary policy. When firms operate in a high inflationary environment, their capital commitment becomes riskier due to increased uncertainty and costs. In support of this line of reasoning, several studies have uncovered negative and significant relationships between inflation and FDI, with Trevino et al. (2002) finding this relationship in Latin America, and Aspergis and Katrakilidis (1998) reaching the same conclusion in a study of FDI flows into Portugal, Spain, and Greece. There is sufficient cross-country variability in inflation in Latin America to justify an examination of its effect on FDI inflows in the region. H8. The level of inflation in the host country is negatively associated with its level of inward FDI. 2.4.2. Currency valuation Another potential impediment to FDI is the absence of a stable, well-accepted currency. Unanticipated depreciation in the host country exchange rate makes long-term planning difficult and increases the risk associated with long-term capital outlays. Currency devaluation and volatility may result from economic or political upheaval, and foreign investors must incur costs to prevent transaction and translation losses when host country currencies depreciate. If they believe that depreciation will continue after they enter the host country, they may conclude that costs will be too high to justify their investment. Thus, ceteris paribus, foreign investors should undertake more FDI in countries whose currencies are stable. An opposing argument suggests that currency overvaluation is an example of market disequilibrium. In this case, there is an incentive to locate production of internationally traded commodities in countries with undervalued currencies and to purchase production capacity with overvalued foreign exchange. This second line of reasoning is consistent with studies of developed countries (Froot & Stein, 1991; Grosse & Trevino, 1996; Klein & Rosengren, 1994). If this argument holds in Latin America, it may be that foreign investors possess the international experience to overcome the increased costs of operating in these markets. Since exchange rate devaluation creates both problems and opportunities for MNEs, requiring them to incur costs to manage the risks inherent in a devaluing currency, but also presenting the opportunity of acquiring host country production facilities with overvalued foreign exchange, we develop this argument as an empirical question. H9. The level of depreciation of the host country’s currency is positively (negatively) associated with the level of the host country’s inward FDI. 2.4.3. Economic development Since market size, which is a measure of the level of economic development in a market, has been widely used to explain global patterns of FDI, we employ it as a control variable in our model. This suggests that more FDI will flow into more economically developed markets, because they have higher disposable incomes (i.e. purchasing power) and higher levels of consumption. Evidence from recent studies comparing FDI flows to different emerging economies has been relatively consistent. Trevino et al. (2002) used gross domestic product (GDP) as a surrogate for market size (economic development) and found it to be highly significant in explaining FDI into Latin American countries. Similarly, Jermakowicz and Bellas (1997) concluded that inward FDI in CEE countries made to gain access to local markets is positively correlated with the population of the host country and their purchasing power. In a study of FDI in China, Wei (2000) found that GDP growth strongly influenced FDI there. The United Nations (UNCTAD, 1998, p. 139) found that across all emerging markets, for separate analyses in three 5-year periods during 1980–1995, nominal GDP was a strong positive factor explaining FDI into those countries. Based on the broad literature on FDI location, we expect that: H10. The level of the host country’s economic development is positively associated with its level of inward FDI.

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2.4.4. International trade We also controlled for the level of international trade, measured by the sum of imports and exports. This variable may help to explain FDI into Latin America because higher levels of trade may act as an indicator of the degree of openness in a given country. After the failure of import substitution industrialization was recognized, Latin American countries became increasingly interested in integrating with the world economy because they believed that previous policies fostered inefficient production. In addition, industrial countries and inter-governmental organizations put pressure on emerging economies to reduce their import barriers. Therefore, almost all Latin American countries have undertaken microeconomic reforms that promote freer trade. Logically, MNEs need more trade and more open economies for resource-seeking operations, especially as they integrate their global production with vertical and horizontal value-chain linkages. For a country to be an inherent part of this integration, it must allow MNEs to easily import and export. H11. The level of trade in the host country is positively associated with the level of its inward FDI. 3. Data sources and methodology In this paper, we study institutional reform in 16 Latin American nations: Argentina, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Paraguay, Peru, Uruguay, and Venezuela. The dependent variable, inward foreign direct investment, was measured by the US dollar (inflation adjusted) amount of inflows into each of the 16 countries, divided by the size of the country (measured by total population). These data were obtained from UNCTAD. The key independent variables in this paper dealt with institutional reforms. We used several indices of institutional change that covered the 31-year period between 1970 and 2000. We describe each below. Educational attainment was measured by the percentage of college-age students enrolled in tertiary education. These data were taken from CEPAL’s BADEINSO (Database of Statistics and Social Indicators), the World Bank’s World Development Indicators, and UNESCO’s Institute for Statistics. The number of bilateral investment treaties were obtained from UNCTAD. Privatization reform was measured by the ratio of value-added in state-owned enterprise to non-agricultural GDP subtracted from one. This reform measure has been implemented in previous research in political science (Armijo & Faucher, 2002; Biglaiser & DeRouen, 2004; Byun, 2003) and economics and business (Paus, Reinhardt, & Robinson, 2003; Suarez & Oliva, 2002). The index was developed by staff members at the United Nations’ Economic Commission for Latin America and the Caribbean (Samuel A. Morley, Roberto Machado, and Stefano Pettinato) and published in a document entitled Indexes of Structural Reform in Latin America (available at www.elac.cl). Henisz’s Policy Constraints Index measured political uncertainty, which captured the likelihood or risk of a major political or policy change in the host country (http://www-management.wharton.upenn.edu/henisz/). The index ranges from 0 (lowest uncertainty) to 1 (highest uncertainty) and it captures the likelihood of unconstrained policy change in a given year. Tax reform included four measures: the maximum marginal tax rate on corporate and personal incomes, the value-added tax rate, and the efficiency of the VAT. Trade reform was the average of two trade-related measures, the average level and the dispersion of tariffs. Financial account reform represented the average of four measures: the extent of government control of foreign investment, the limits on profit and interest repatriation, and controls on external borrowing and capital outflows. Unlike the other indexes, this one represented a subjective interpretation of the descriptions in the IMF’s annual Balance of Payments Arrangements publication (Escaith & Morley, 2000). Tax reform, Trade reform, and Financial account reform were each obtained from Indexes of Structural Reform in Latin America. Each of these three indices (plus Privatization reform) was normalized to be between 0 and 1, where higher values reflect more reform. Inflation was measured by the annual percentage change in the consumer price index in real terms. These data were obtained from the IMFs International Financial Statistics. Currency valuation was measured by the annual percentage change in the real exchange rate (host country currency per US dollar). These data were obtained from the IMFs International Financial Statistics and Matthew Shane in Economic Research Services at the USDA. Annual inflation-adjusted gross domestic product (GDP) in billions of US dollars measured economic development. These data were obtained from the World Bank’s World Development Indicators. Trade

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was measured as the sum of the volume of imports and exports in billions of US dollars (adjusted for inflation). These data were obtained from the World Bank’s World Development Indicators. In a few cases, data for these variables were missing for some years; data were extrapolated using values for other years in these cases. Because our sample covers multiple years (31) and countries (16), we used a fixed-effects model to control for period and country effects. We included dummy variables to control for both year and target country effects. Because of missing data for one country (Guatemala) in some years (1970–1974), the final sample included 493 country-year observations (i.e. annual data on 31 countries multiplied by 16 years minus missing observations). To reduce the potential for multicollinearity, we centered each continuous independent variable. Variance inflation factors (VIFs) also did not indicate evidence of multicollinearity (mean VIF ¼ 4.28). In addition, we ran a test for autocorrelation and did not find evidence of it. 4. Empirical findings Table 2 presents summary statistics and correlations. Correlations do not indicate that multicollinearity is a problem; the highest correlation between independent variables is 0.73 (market size and trade reform). Table 3 reports results from the regression. Year and country dummy variables are omitted for brevity of presentation. The F-statistic for the model is significant (po0.001), providing support for our overall model. In addition, the R2 is 0.67, indicating that the variables explain a high amount of the variance in inward FDI. Educational attainment, BITs, and privatization are statistically significant (po0.001) and positively related to inward FDI, providing strong support for H1–3. Political uncertainty is negatively related to inward FDI and statistically significant (po0.10), providing modest support for H4. Economic development is positive and statistically significant (po0.05), providing support for H10. Additionally, trade, is statistically significant and positive (po0.001), providing strong support for H11. Three of our institutional variables, trade reform, tax reform, and financial account liberalization, are not statistically significant; hence, we find no support for those hypothesized relationships with inward FDI. Finally, two of the hypothesized control variables (inflation and currency valuation) are not statistically significant. The results provide strong support for our hypotheses that the process of institutionalization works through all three pillars—normative, cognitive and regulative—but that those variables that legitimize most effectively through the cognitive and normative pillars (i.e. privatization, BITs, educational attainment, and political uncertainty) are the most significant indicators of inward FDI in Latin America. The control variables, trade, and market size also relate to inward FDI in the region.

Table 2 Correlation matrix

1 2 3 4 5 6 7 8 9 10 11 12

Variable

Mean S.D.

Inward FDI Inflation Currency valuation Market size Trade Educational attainment Bilateral investment agreements Privatization Political constraints Tax reform Trade reform Financial account liberalization

35.77 0.92 0.15 78.26 19.2 16.28 2.25 0.75 0.29 0.38 0.72 0.69

1

2

3

4

5

6

7

8

9

10

11

66.29 4.55 0.06 1.05 0.06 0.29 140.46 0.19 0.21 0.00 39.2 0.37 0.07 0.03 0.73 9.31 0.38 0.13 0.08 0.09 0.14 6.13 0.68 0.06 0.05 0.05 0.13 0.43 0.19 0.09 0.03 0.03 0.05 0.03 0.00 0.19 0.20 0.31 0.08 0.04 0.12 0.18 0.29 0.26 0.06 0.19 0.38 0.10 0.03 0.25 0.20 0.41 0.36 0.18 0.21 0.22 0.39 0.02 0.11 0.09 0.24 0.22 0.35 0.07 0.29 0.50 0.21 0.38 0.11 0.13 0.09 0.12 0.29 0.37 0.10 0.22 0.40 0.50

Correlations with absolute value greater than 0.09 are statistically significant at the 0.05 level.

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Table 3 Results Model 1

Model 2

Educational attainment Bilateral investment treaties Privatization Political uncertainty Tax reform Trade reform Financial account liberalization Inflation Currency valuation Market size Trade Constant

0.85 (0.54) 2.66 (2.17) 0.06 (0.07) 0.46 (0.14) 104.50 (14.68)

1.95 (0.41) 4.69 (0.47) 73.47 (19.15) 23.23y (13.07) 3.85 (21.83) 2.81 (15.89) 1.52 (17.54) 0.51 (0.45) 0.97 (1.83) 0.14 (0.06) 0.44 (0.12) 58.23 (18.75)

# of observations F-statistic Adjusted R2

493 11.70 0.52

493 17.84 0.67

Standard errors in parentheses. Year and country dummy variables omitted for brevity of presentation. All continuous independent variables are centered. y po0.10.  po0.05. po0.01. po0.001.

5. Discussion This study combines institutional theory’s often-studied regulative pillar with the less studied normative and cognitive dimensions of institutions in an examination of inward FDI in Latin America. The study makes several important contributions to extant literature on the relationship between institution building in developing country settings and MNEs’ international investment decisions. First, and perhaps most importantly, we advance institutional theory and its impact on organizational decision-making by extending the theory from a classification of institutional types to a classification of the processes of institutional effects. Within this context, we develop a more complete model of the institutional environment–FDI decisionmaking interface by incorporating all three pillars of institutional theory in a single model. We argue that a nation’s institutional environment consists not only of laws, regulations and enforcement mechanisms (e.g. regulative pillar), but also of social institutions (e.g. normative, cognitive pillars) that lead to predictable organizational outcomes in the form of inward FDI. We demonstrate that all three pillars matter when it comes to attaining organizational legitimacy, leading to an FDI-friendly institutional profile and that, consistent with Delios and Henisz (2000), it is the institutional mosaic of a society that influences the decisions of multinational organizations regarding investment in that society. We extend The New Institutional Economics by demonstrating that not only do institutions matter in the context of organizational decision-making and FDI but also that it is the processes that matter most, and the processes work through all three lenses of institutional theory. However, some of the institutions we studied legitimize more effectively through some lenses than through others, and this has important implications about our understanding of the process of institutionalization. Turning to the relationship between specific independent variables, institution building and inward FDI, our finding that educational attainment emerged as a positive and significant predictor of inward FDI in Latin America is important because it is perhaps the variable that is most strongly associated with institutionalization and legitimization through social institutions (e.g. cognitive and normative pillars). This construct works through the cultural-cognitive pillar because educational attainment represents an internalized symbolic representation and a way of acting (i.e. openness to FDI). Educational attainment also works through the normative pillar because it acts as a normative expectation, guiding behavior and

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facilitating the shift from ethnocentrism to geocentrism. This is perhaps the variable under study that works the least efficiently through the regulative pillar and this is important for several reasons. First, as a nation increases its education level, it increases its ability to compete internationally and the socialization process that occurs simultaneously prepares individuals to act in an increasingly global environment. In the case of establishing an institutional profile that is legitimate in the eyes of foreign investors, the impact of education is decidedly positive because it means that this country’s educated population is open to all things foreign, including investors. Although we did not test this relationship, MNEs may perceive educational levels as acting as a proxy for labor quality. This relationship may work both ways, with MNEs increasing the demand for education in developing countries. And of course, MNEs may both learn from locals and help to enhance the shift from ethnocentrism to geocentrism as they employ workers at their plants. Although the first BIT is nearly 40 years old, it was not until the late 1980s that they came to be universally accepted instruments for the promotion and legal protection of foreign investments, and it is about this time that inward FDI in Latin America began to flourish. In addition to determining the scope and application of the treaty, that is, the investments and investors covered by it, virtually all BITs cover four substantive areas: admission, treatment, expropriation, and settlement of disputes. We argue that, although BITs work through the regulative framework, it is the operationalization of this construct through the cognitive and normative pillars that most significantly contributes to institutionalization and legitimization processes at the level of the nation state. Similar to privatization, the signals BITs send through the cognitive and normative pillars are more dominant than those sent through the regulative pillar. As such, we believe that the process of institutionalization is more deeply rooted in the cognitive and normative pillars than in the regulative pillar, although the country’s institutional profile cannot stand without all three pillars operating effectively. Privatization emerges as one of the most significant explanatory variables. Because privatization is deeply embedded in the cognitive and normative pillars, this supports our contention that it is the process that occurs within social institutions that has the most significant influence on institutionalization and legitimization, leading to higher levels of inward FDI. Although privatization sends a strong signal to the investing community that the government is willing to allow the private sector to play an increasingly larger role in the economy, this process must be initiated by actors who support an institutional shift (e.g. cognitive pillar) and accepted by society at large as a willingness to open its economy to foreigners (normative pillar). We believe that privatization is more deeply embedded in the cognitive and normative pillars and that the regulative pillar can be seen as tangential. As expected, we found an inverse and significant relationship between political uncertainty and FDI. This finding supports our institution building argument in which we posit that political uncertainty increases costs for foreign investors. This variable represents an extreme challenge to the existing institutional profile, working effectively through the cognitive pillar, because the old institutional guard will experience a loss of power, money, and prestige if an institutional shift occurs. Ultimately, it is the resistance or acceptance by society in general, as seen through the lens of the normative pillar, which determines whether an institutional shift will become permanent. Although there is significant ambiguity regarding rewards and sanctions, mostly determined by the normative and cognitive processes, the regulative pillar still plays a significant role. The common thread for the aforementioned four independent variables is that they are all more deeply rooted in social (i.e. cognitive, normative) than regulative institutions. We hypothesized that tax reform, trade reform, and financial account liberalization would be positively associated with inward FDI. We found directional support for tax reform but not for the other two variables, and none of them was significant in explaining inward FDI into Latin America. These findings have several important implications for understanding the process of institution building in developing country settings. Most importantly, although all three of these variables work through both the cognitive and normative pillars in the process of institutionalization and legitimization, their influence is dominant through the regulative pillar. While economic-oriented measures of reform, such as tax reform and trade reform, on the surface, would appear to help establish a more transparent landscape and equal playing field for foreign investors, investors may view these only as strong as the broader sociological institutional platform. In other words, countries that exhibit a strong regulative pillar without the backing of broader sociological institutions may not be as appealing to foreign investors.

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We hypothesized and found directional but insignificant support that lower inflation leads to greater levels of FDI. One could argue that MNEs have become so accustomed to operating in high inflationary environments that the presence of inflation does not factor into MNEs’ FDI decisions. In spite of theoretical arguments that suggest that a country’s bilateral exchange rate can have multiple effects on international investment decisions, our findings regarding this variable were insignificant. At least in Latin America, a country’s bilateral exchange rate is not a critical factor in the institutionalization process. Consistent with previous findings in developed and developing countries, we found that economic development and the level of international trade were positive and significant determinants of inward FDI in Latin America. The first finding suggests that foreign firms still seek to locate in the largest markets in order to be able to sell their products therein. Higher levels of trade may act as a proxy for the degree of openness as all Latin American countries have undertaken microeconomic reforms that promote freer movement of international trade. Because MNEs require free trade, especially for resource-seeking operations, countries must allow MNEs to easily import and export, and this appears to be a significant part of institutionalization and legitimization in Latin America. 6. Conclusion Our approach to institution building and inward FDI in Latin America advances conventional wisdom of institutional theory that sees institutional constructs as fitting neatly into typologies. Instead, we have demonstrated that all three pillars—cognitive, normative, and regulative—matter in terms of institution building in Latin America, but that different constructs legitimize more efficiently through some lenses than through others, and that this affects the process of institutionalization. We extend extant literature on institutional theory by arguing that, in addition to the need to classify institutional types (cognitive, normative, and regulative), it is critical to classify the process within which institutionalization and legitimization works through all three pillars. Interestingly, those constructs that legitimize more strongly through the cognitive and normative pillars (i.e. educational attainment, BITs, privatization, and political uncertainty) were found to be significant indicators of inward FDI in Latin America, whereas those constructs which rested more firmly on the regulative pillar (i.e. tax reform, trade reform, and financial account liberalization) were not significant indicators of inward FDI in the region. We have undertaken exploratory research that demonstrates that all institutions work through a process, the foundation of which is the three pillars of institutional theory. Unlike previous studies, we have not attempted to force fit constructs into typologies. We argue that an actor or a group of actors (i.e. cognitive pillar) must initiate institutional change at the level of the nation state. Once a construct begins to take hold, the initial cognitive action can lead to normative social institutions. We have argued that the regulative component of a country’s institutional profile has been widely studied in previous FDI research because these constructs are tangible, and hence easier to quantify than constructs that are rooted more firmly in either the cognitive or the normative pillars. Because the enforcement mechanisms of constructs rooted in the regulative pillar are largely coercive, such as in the case of tax reforms, we believe that this inhibits their ability to influence organizational behavior of outside actors who have choices (e.g. foreign direct investors). Rather, it is constructs such as privatization and education, whose regulative component is not nearly as strong, but whose symbolic representation has a greater impact on organizational choice, at least in the case of the decision to initiate production in a country that has undergone significant institution building. The present study suggests that, although governments should focus on initiating reform at all levels (i.e. cognitive, normative, and regulative), it is those changes that have fewer regulations and that are intangible that demonstrate a commitment to openness to foreigners. It is only when foreign actors believe that institutional change has occurred and is permanent that they will make an organizational commitment in the form of inward FDI. By breaking away from the conventional approach to institutional change (Kostova, 1997; Scott, 1995) that sees constructs as largely categorical, we have demonstrated that institutionalization is a process that works through all three pillars and is one that takes time. We have provided empirical evidence that those constructs that are intangible and that focus less on regulations lead to greater levels of inward FDI. This study has several limitations. Although we believe that our results will prove to be generalizable, our focus on Latin American prevents us from making broad generalizations. As data bases become available for

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