The Governance-FDI Nexus: A Factor-Augmented Fixed Effect Analysis of ASEAN World Governance Indicators and Foreign Direct Investment Inflows

Utilizing a factor-augmented fixed effect model, this study investigates the intricate relationship between governance indicators and Foreign Direct Investment (FDI) inflows. Panel data from six ASEAN countries covering 26 years (1996 to 2022) is examined, incorporating World Governance Indicators (WGI) alongside derived institutional factors. The research methodology employs the Exploratory Factor Analysis with a fixed effects specification to mitigate multicollinearity and covers broader governance construct. The findings uncover distinct dynamics in the relationship between governance dimensions and FDI. Notably, Control of Corruption displays a significant positive relationship. Furthermore, a resulting Institutional Quality factor positively affects FDI dwelling on the significance of comprehensive institutional environments. Conversely, the Economic Environment factor depicts a negative relationship, inferring intricate trade-offs in investment decision-making and underlining the concept of governance paradox counterintuitive results in the relationship between WGI and FDI. The model explains a moderate FDI variance featuring the importance of governance factors while recognizing unexplained variables. Diagnostics assessments, including Hausman, Breusch-Pagan, and Pesaran, guide the methodological decisions, leading to estimation with Driscoll-Kraay standard errors. The findings contribute to the discussions on the institutional determinants of FDI, focusing on the requisite for detailed policy frameworks. Succeeding research should investigate non-linear associations and sector-specific dynamics to refine the comprehension of governance-FDI interactions. The methodological approach to examining governance and FDI relationship, this study offers policymakers and researchers a more holistic framework to comprehend and influence foreign investment trends within the realm of institutional.