THEORETICAL MODEL

CHAPTER 3 METHODOLOGY

3.2 THEORETICAL MODEL

This research we study how relative government quality impacts on FDI inflow. So, the theory that we use to measure the impact on flow of FDI between two countries based on gravity model. The gravity model it used for expand the flow of trade between two countries (Koo et al., 1994). The flow of trade is a function of the economic size of both trading countries and cost of trading or transaction

between both trading countries (Krugman et al., 2014). The gravity model (in its log form) is show in Equation 1. (Castillo et al., 2016).

𝑙𝑛𝑇_𝑖𝑗 = 𝛽₀+ 𝛽₁𝑙𝑛𝑀_𝑖+ 𝛽₂𝑙𝑛𝑀_𝑗+ 𝛽₃𝑙𝑛𝑇𝐶_𝑖𝑗 (1) Where ^𝑙𝑛𝑇𝑖𝑗,𝑡 is natural logarithm of the flow of trade between exporting country and importing country, ^𝛽0is the constant, ^𝑙𝑛𝑀𝑖 is natural logarithm of market size of exporting and ^𝑙𝑛𝑀𝑗 is natural logarithm of market size of importing countries, and 𝑙𝑛𝑇𝐶_𝑖𝑗 is a total cost of trading between trading countries (Matteis et al., 2018). From the assumption of gravity theory, we fit the equation to a specific model that relates to our problem by using proxy trade value between trading countries to FDI inflow because FDI flow between large countries will be larger than FDI flow in small countries. And FDI flows will be high if the host and home countries are closer (Leibrecht and Riedl, 2012). market size on trade flow. It affects FDI inflow in terms of income, wealth, productivity and economic size including potential to save and invest in the source country (Lipsey, 2006). We exclude the market size of host country because our study is mainly interested in impact of government quality on FDI inflow (Zheng et al., 2017).

The variables that represent cost of trading flow are oil price, real effective exchange rate and inflation rate. First oil price variables affect FDI inflow because oil is an important energy to transport and transfer of FDI flow between source and host countries. If the price of oil increases the FDI flow cost will increase (Nanovsky, 2019).

While real effective exchange rate is also the one of variables that affect the cost of FDI flow because the real effective exchange rate change will make the value of currency of source and host countries change too that impacts cost of trade and flow between two countries (Irandoust, 2019). And the last variable that we use to represent the cost effect on FDI flow is the inflation rate of the host country, Inflation is an indicator that represents the economic stability and price level of a country (Chu et al., 2017).

Another variable that impacts on FDI inflow is government quality. Instability of government is high risk for business, domestic investors and also be risk for foreign investors to have FDI flow into that country. Due to the government has low reliability and high corruption make them have power to set and change rule, law and tax (Gani, 2007). The investors from source countries of FDI they sensitive to stability, political risk and quality of government in host countries Mengistuand Adhikary (2011) because the good government quality will improve economic development and launch good policy that increase productivity , rising the employment and improve technology and infrastructures in developing country (Hossain and Rahman, 2017).

So, we include this variable because the government quality can represent the stability of the source countries and host countries and impacts the investment costs and risks of the MNEs. And government regulations and law also affect foreign

business operations (Lien et al., 2005) to measure the relationship between government and FDI inflow. Then we add this variable that effect on FDI inflow to modify in Equation 2:

𝑙𝑛𝐹𝐷𝐼_{𝑖𝑗,𝑡} = 𝛽₀+ 𝛽₁𝑙𝑛𝐺𝐷𝑃_𝑖,𝑡+ 𝛽₂𝑙𝑛𝑂𝐼𝐿_{𝑖𝑗,𝑡} + 𝛽₃𝑙𝑛𝑅𝐸𝐸𝑅_{𝑖𝑗,𝑡}+ 𝛽₄𝑙𝑛𝐼𝑁𝐹𝐿_𝑗,𝑡 + 𝛽₅𝐺𝑂𝑉𝑇_{𝑖𝑗,𝑡}

(2) Where 𝐹𝐷𝐼_{𝑖𝑗,𝑡} is the FDI inflow from source country to host country at time 𝑡. Where ^𝐺𝐷𝑃𝑖,𝑡 is gross domestic product that represent the economics size of source countries at time ^𝑡. We expect GDP of source countries will have a positive relationship with FDI inflow into host countries that receive investment because if GDP is high, it means that the country has high income and has more potential to save and invest. So, GDP of the source country of FDI can drive investors to have more FDI outflow into other countries (Bano and Tabbada, 2015).

On three variables of cost on FDI. ^𝑂𝐼𝐿𝑖𝑗,𝑡 we expected the oil price variable to have a negative relationship with FDI inflow because the high cost of transportation affects flow of trade and investment falls because the partner of trading or investors needs the low cost to get high profit (Nilsson and Nilsson, 2000).

For the ^{𝑅𝐸𝐸𝑅}𝑖𝑗,𝑡exchange rate is one of the factors that impacts cost of tourism and trade flow between two countries (Irandoust, 2019). So, we expected the real exchange rate to have a negative impact on FDI inflow because the exchange rate can affect the cost of trading and investing then if cost increases trade and

investment from foreigners will fall (Kaufmann et al., 2003). While ^{𝐼𝑁𝐹𝐿}𝑗,𝑡We expect this variable to have a negative relationship to FDI inflow (Younsi and Bechtini, 2019).

The variable of government quality ^{𝐺𝑂𝑉𝑇}𝑖𝑗,𝑡 We expected government quality has positive impact on FDI inflow because the country that with transparent regulations and good governance are able to attract more of FDI (Dunning, 2002). And the quality of government is one of risk on investment because the poor quality of government makes instability of rule, law, tax and requirements of investment by foreigners and can change by power of government, then the investors they concern about this risk before decide to invest (Maiti and Mukherjee, 2013). Government quality is important to economic growth and economic growth is the one factors that can attack FDI from developed countries, due to government quality strong can attack more of FDI (Afza et al., 2014).