One-way effect or multiple-way causality: foreign direct investment, institutional quality and shadow economy?

Abstract

Abstract This paper empirically investigates the three-way linkages amongst foreign direct investment (FDI), shadow economy and institutional quality by applying the panel dynamic simultaneous-equation modelling approach for a sample of 19 developing Asian countries over the period of 2002–2015. The empirical results by two-step System GMM show that institutional quality attracts inward FDI and FDI in its turn improves institutional quality, institutional quality is not only the cause but also the consequence of the shadow economy, and FDI inflows help reduce shadow economies though the channel of institutional improvement and lower shadow economies – which increase institutional quality – encourage FDI inflows. The empirical insights suggest helpful policy implications to deal with these dynamics simultaneously.