Political institutions and FDI inflows in autocratic countries*

ABSTRACT

Why do some autocratic countries attract more foreign direct investment (FDI) than others? Surprisingly, few studies have explored the considerable variation in FDI inflows to non-democratic countries. In this article, I argue that non-democratic countries with seemingly democratic political institutions, such as elected legislatures, attract more FDI inflow than others. This is because these institutions can (1) reduce the transaction costs of investment activities due to the relative transparency of the policy-making process, and (2) act as veto players, making the existing market-friendly policy changes difficult, and thus, promising a more stable investment environment. My empirical results support the main expectation that autocratic countries with legislatures attract more FDI than other autocratic countries, and the institutions’ effects are conditionally modified by the quality of market protecting institutions.     

When BITs have some bite: The political-economic environment for bilateral investment treaties

Political risk frequently impedes the flow of capital into developing countries. In response, governments often adopt innovative institutions that aim to attract greater flows of international investment and trade by changing the institutional environment and limiting the risk to outside investors. One primary example of this is the Bilateral Investment Treaty (BIT), aimed specifically at increasing the flow of foreign direct investment (FDI) to developing countries. Yet the literature in political science and economics is inconclusive about whether or not BITs do indeed stimulate FDI, and it provides conflicting theoretical reasoning for the claimed connection. This article argues that BITs do attract FDI to developing countries, but the story is a complicated one. Two important factors must be taken into account. First, BITs cannot entirely substitute for an otherwise weak investment environment. Countries must have the necessary domestic institutions in place that interact with BITs to make these international commitments credible and valuable to investors. Second, as the coverage of BITs increases, overall FDI flows to developing countries increase. However, although remaining positive, the marginal effect of a country’s BITs on its own FDI may fall because of heightened competition for FDI from other BIT countries. Using data from 97 countries for 1984–2007, we provide empirical evidence consistent with both of these theoretical claims.     

The Effects of Political Risk on Different Entry Modes of Foreign Direct Investment

Although numerous studies document the effect of political institutions on foreign direct investment (FDI), few works in the political economy literature have investigated the link between political institutions and the mode of entry chosen by investors, be it mergers and acquisitions, joint ventures, or greenfield investments. Using panel data for 111 developing countries covering 1980–2006, we find that countries with political institutions that uphold good governance tend to attract higher levels of mergers and acquisitions, as opposed to joint ventures and greenfield investments, because such institutions help to mitigate the special risks faced by merger and acquisition investors. Our findings provide a nuance for understanding the different effects of political institutions based on the particular mode of entry.     

The Politics of Foreign Direct Investment in Authoritarian Regimes

While political scientists find that democracy reduces political risk, little scholarship analyzes how authoritarian regimes attract foreign direct investment (FDI). This article argues that while authoritarian countries are generally risky, this risk can be minimized when authoritarian regimes are constrained from both “above” and “below.” Signing international investment treaties are critical for authoritarian countries to signal a commitment to FDI-friendly policies. However, only authoritarian signatories that allow some degree of public deliberation in their policymaking are then constrained from deviating from the policies of the international investment treaties. Panel statistical regressions and a case analysis support the hypothesis.     

Economic Policy,Political Constraints,and Foreign Direct Investment in Developing Countries

As foreign direct investment (FDI) has become increasingly important in the world economy, a large body of literature has emerged regarding the determinants of FDI flows. Some scholars argue that democracy attracts FDI through the mechanism of political constraints, which reduce the risk of negative policy changes. However, the value of policy stability should be conditional on the attractiveness of contemporary FDI-relevant policies. I therefore propose a theoretically more comprehensive argument: political constraints are attractive to investors when the host country policy environment is FDI-friendly, because these political constraints reduce the probability of negative policy changes in the future. When the policy environment is hostile to FDI, on the other hand, political constraints will have little positive effect, and, to the extent they indicate that FDI-relevant policies are unlikely to improve, may even deter FDI. This argument helps explain why the positive relationship between democracy and FDI seems to emerge after a global shift toward FDI-friendly polices. I find robust empirical support for the argument in tests covering more than 100 developing countries from 1970 to 2014, indicating significant effects using a variety of policy and political constraint measures.     

Improving Reputation BIT by BIT: Bilateral Investment Treaties and Foreign Accountability

The literature on foreign direct investment (FDI) has paid an increasing interest to international institutions such as bilateral investment treaties (BITs), but whether BITs help attract FDI is an unsettled question. Building on the existing literature, this article argues that BITs can change investors’ perceptions and the corresponding investment they make because signing BITs signals the involvement of another powerful country that is able to compel the host government to comply. This implies that the effect of BITs is not constant across signatory countries: BITs are more effective when they are signed with rich and influential countries. Using monadic and dyadic FDI data, this article finds that BITs signed with powerful countries (defined as the top six largest economies) lead to an increase in FDI inflows (both from these signatory countries and from other countries). BITs signed with other countries, despite in a larger quantity, have little influence on FDI inflows.     

Political Investment Cycles in Democracies and Autocracies

Extant research has shown considerable interest in whether host countries’ political uncertainty impedes foreign direct investment (FDI). Building upon the scholarly consensus on the adverse impact of political uncertainty on FDI, this article demonstrates that the extent to which investment climates are unpredictable varies cyclically, on the basis of election timing in democracies and leadership turnover in autocracies. The empirical results show that in presidential democracies, FDI tends to slowly increase after an executive election and then decline as the next executive election nears. However, I find that an electoral investment cycle is not found in parliamentary democracies where election timing is irregular, less predictable, and endogenous to domestic economic conditions. I also find that a similar political investment cycle exists in autocracies not through electoral cycle but through leadership tenure cycle. The level of FDI inflows tends to be relatively low early in autocrats’ tenure when political uncertainty is high and rise as autocratic leadership tenure increases over time but eventually wane again as autocratic leadership is destabilized in the late period of power transition. The findings indicate the existence of heterogeneous political investment cycles, depending on regime type.     

Impact of Political Risk on FDI Revisited—An Aggregate Firm-Level Analysis

Unlike previous studies on political risk and foreign direct investment (FDI) that used macro-level FDI data to test micro-level theories, I make use of aggregate data on U.S. firms' investment activities in 101 developing countries during the period 1997–2007 to reassess the propositions. Using a multilevel mixed-effects linear instrumental variable approach, I find that lower political risk is associated with (a) an increase in U.S. firms with equity stake of 51% and above, (b) a higher proportion of fixed assets, and (c) an increase in the return on investments, after controlling for a host of relevant factors. Further analysis reveals the relationship is also strong with respect to investments in total assets and sales. The results are robust to alternative data, instruments, and estimation techniques. These results bring to fore the multiple risk hedging strategies available for foreign firms operating in high risk environments.     

Foreign direct investment and the risk of regime transition in autocracies

Economic globalization and, in particular, foreign direct investment (FDI) have often been considered to be catalysts for economic reform and political liberalization. It is argued that openness to foreign investment spurs democratization by empowering pro-liberalization actors and undermining elite cohesion. This article explores and tests three alternative hypotheses linking FDI and autocratic regime survival. The liberalization hypothesis claims that FDI promotes democratization. The state-capture hypothesis suggests that FDI, by increasing the value of power, may raise the risk of an autocratic transition. Lastly, the stabilization hypothesis, contrary to the first two, claims that FDI can enhance dictatorships’ stability by opening new opportunities for distributing benefits to regime elites. The empirical analysis, covering about 100 countries for the time period 1970–2008, uses data on autocratic breakdowns and transition types to test the above hypotheses. The reported evidence does not support the liberalization or the state-capture hypothesis. FDI is found to reduce the likelihood of democratic transitions.     

Bringing the Company Back In: A Firm-Level Analysis of Foreign Direct Investment

The industry standard for studying multinational corporations (MNCs) has been to evaluate patterns in aggregate country-level measures of foreign direct investment (FDI). Though certainly related, these data are at best a proxy for the actual commercial and productive activities of multinationals that most political scientists purport to be interested in. Simply put, this is a very indirect way of testing theories about the sociopolitical and economic factors that motivate MNCs’ choice of host countries. This article introduces a new firm-level data set designed to get around this problem by permitting more direct analysis of multinationals’ foreign operations. It then revisits the relationship between regime type and direct investment, finding evidence that MNCs are more likely to establish new subsidiaries in democracies than in nondemocracies. However, further analysis reveals that the strength of this relationship varies by context. Specifically, MNCs rely on regime type as an indicator of political risk when they lack an existing relationship with the host state. In addition, those operating in extractive industries are generally less responsive to political institutions than those operating in manufacturing or services. These results suggest that firm- and sector-specific factors deserve greater consideration than they have been given in the existing literature.     

The Political Determinants of Foreign Direct Investment: A Firm-Level Analysis

Many large-N cross-national studies claim to show that political institutions and phenomena determine where foreign direct investment (FDI) flows. In this article, I argue that these studies tend to overemphasize statistical significance and often neglect to assess the explanatory or predictive power of their theories. To illustrate the problem, I estimate variations of a statistical model published in an influential article on “Political Risk, Institutions, and FDI.” I find that none of the political variables that the authors consider accounts for much of the variation in aggregate FDI inflows. To ensure that this underwhelming result is not driven by misspecification or measurement error, I leverage a large firm-level data set on the investment location decisions of thousands of multinational firms. Using nonparametric machine-learning techniques and out-of-sample tests, I show that gravity variables can help us develop very accurate expectations about firm behavior but that none of the 31 “political determinants” of FDI that I consider can do much to improve our expectations. These findings have important implications because they suggest that governments retain some room to move in the face of economic globalization.     

Contracting with Whom? The Differential Effects of Investment Treaties on FDI

Under what conditions can governments use international commitments such as Bilateral Investment Treaties (BITs) to attract foreign direct investment (FDI)? Although numerous studies have attempted to answer this question, none considers how investment treaties may have heterogeneous affects across industry. I argue BIT effect is strongest when the obsolescing bargaining problem between firms and governments is most protracted, namely, when FDI relies on strong contracts between firms and states. Using a time series cross-sectional data set of 114 developing countries from 1985 to 2011, I find BITs are associated with increases in infrastructure investment, an industry particularly reliant on the sanctity of government contracts, but not with total FDI inflows. Moreover, BITs with strong arbitration provisions display the strongest statistical effect on infrastructure investment, while BITs that do not provide investors with such protections are not associated with increased investment. My results have implications for both scholarship on the relationship between governments and multinational firms as well as for the study of international institutions more broadly. To properly ascertain the effects of international treaties and institutions, scholars should consider not just whether institutions constrain or inform—or matter at all—but also the extent to which the targets of institutions have heterogeneous responses to them.     

States Sued: Democracy,the Rule of Law,and Investor-State Dispute Settlement (ISDS)

Investor-state dispute settlement (ISDS) cases have increased dramatically in recent decades, and the institutions of investment arbitration to resolve investor-state disputes constitute the core of the modern investment regime. In this article, we seek to explain the variation in the host governments’ risk of being challenged by foreign investors before international arbitration tribunals. We argue that such risk is greatest at the intermediate level of democracy where some democratic elements such as elections are strong, but the system of rule of law remains weak. In those regimes, “regulatory risk” runs higher than in autocratic regimes as the host governments are under greater pressure for regulating matters of broad public concern. At the same time, more traditional political risk of arbitrary, discriminate, and abusive acts remains considerable at that level of democracy due to weak rule of law, exacerbating the former risk. Empirical analysis provides a good deal of support for the argument.     

Investors,turbulence, and transition: Democratic transition and foreign direct investment in nineteen developing countries

Do profit‐seeking foreign direct investors value a country's transition to democracy? If they do, they should vote with their pocketbooks, resulting in a post‐transition increase in foreign direct investment flows. This study attempts to uncover links between transition to democracy and foreign direct investment (FDI) in Asia, Latin America, and the Caribbean, In doing so, it addresses existing arguments about connections between democracy and investor behavior. The regions examined have not only experienced democratic transitions, they also account for the majority of the increasing flow of FDI to the developing world. This research employs time‐series cross‐sectional (TSCS) economic and political data, using ordinary least squares with panel corrected standard errors. The central finding is that transition to democracy has a negative effect on FDI. Secondarily, political instability and higher levels of democracy also deter foreign direct investors.     

The Impact of Military Interventions on the Integration of Muslim Immigrants in Western Countries, 1990–2013

While there is an indication that some democratic institutions and public policies have been effective in integrating ethnic minorities, social classes and immigrants in Western countries, recent studies show that they have not succeeded equally in incorporating Muslim immigrants. This difference begs the question of what particular circumstances are required for Muslim integration in the West. This article uses the level of violence between Muslim immigrants and host societies as an indication of their social cohesion or lack thereof. Conducting a quantitative analysis of 16 Western countries for the period 1990–2013, we find that militarised interstate disputes between Western states and predominantly Muslim countries substantially increase the likelihood of violence between Muslim immigrants and the respective host societies. Multicultural policies and consensual political systems mitigate these adverse effects. This study demonstrates a continued utility of democratic institutions and public policies towards promoting social cohesion, especially when the host states are engaged in military action in Muslim countries.     

Campaigning for Capital: Fair Elections and Foreign Investment in Comparative Perspective

This article makes several contributions to the literature on political risk and the determinants of capital inflows. First, I clarify the relationship between capital flows and democracy’s constituent parts in a way that takes arguments beyond aggregate democracy indicators and static political institutional structures. Specifically, I argue that fair elections signal government respect for democracy and the rule of law in a highly visible manner investors can access. I show how investors therefore use the fairness of elections as a way to assess political risk and to inform their investment strategies. However, the type of investment and the kinds of evidence of electoral misbehavior condition elections’ influence on capital flows. I also disaggregate capital flows into foreign direct investment (FDI) and portfolio investment. I argue that the logic of investing is different in the short term (portfolio) versus the long term (FDI). When it comes to political risk, I provide evidence that portfolio investment is much more sensitive to risk factors than FDI because of the relative ease with which portfolio investors can extricate themselves from an increasingly risky market and seek safer returns elsewhere compared to direct investors.     

The Catalytic Effect of IMF Lending: Evidence from Sectoral FDI Data

Our study contributes to the search for the elusive catalytic effect of International Monetary Fund (IMF) lending on inflows of foreign direct investment (FDI). Recent scholarship has found that the catalytic effect is conditional on political regime and program stringency. We contribute to this literature by developing and testing a theory which describes how the catalytic effect also varies by economic sector. This is a departure from existing studies, which have tended to focus on aggregate FDI flows after crises. Our findings corroborate previous research, which finds that in general IMF lending has a substantial and negative effect on FDI. However, we find that the negative effect is concentrated in sectors that are highly dependent on external capital and have low sunk costs in the host country. Our findings are robust to several alternative explanations common in IMF literature, namely the importance of IMF program design and the ability of governments to make credible commitments to reform. Substantively, our findings suggest that investors are more likely to use IMF lending as an escape hatch in countries where FDI is dependent on external capital and has low sunk costs.     

Why Should I Believe You? The Costs and Consequences of Bilateral Investment Treaties

Bilateral Investment Treaties (BITs) are the primary legal mechanism protecting foreign direct investment (FDI) around the world. BITs are thought to encourage FDI by establishing a broad set of investor's rights and by allowing investors to sue a host state in an international tribunal if these rights are violated. Perhaps surprisingly, the empirical literature connecting BITs to FDI flows has produced conflicting results. Some papers have found that BITs attract FDI, while others have found no relationship or even that BITs repel FDI. I suggest in this paper that these results stem from statistical models that do not fully capture the causal mechanisms that link BITs to FDI. Extant literature has often suggested that BITs may encourage investment from both protected and unprotected investors, yet the literature has not allowed for a full evaluation of this claim. This paper explores the theoretical underpinnings and empirical implications of an institution that works in these direct and indirect ways, and offers a statistical test that is capable of distinguishing between the two. The results indicate that: (1) BITs attract significant amounts of investment; (2) BITs attract this investment from protected and unprotected investors; and (3) these results are obscured by endogeneity unless corrected for in the statistical model.     

Credibility and Flexibility: Political Institutions,Governance, and Foreign Direct Investment

This article argues that the relationship between political institutions and foreign direct investment is both nonlinear and conditional upon status quo policies. The empirical analysis demonstrates an inverted U-shaped relationship between political institutions and foreign direct investment in developing countries, with four veto players being the most attractive institutional arrangement. Countries with too few or too many veto players are not favored because of either high policy uncertainty or high policy rigidity. In addition, the benefits and costs of credibility and flexibility vary in good times and hard times. The benefits of maintaining status quo tend to outweigh the costs in countries with good initial regulatory environment. The costs of maintaining status quo tend to outweigh the benefits when countries are more vulnerable to exogenous shocks.     

Variation in Bilateral Investment Treaty Provisions and Foreign Direct Investment Flows to China, 1997–2011

This article examines the differentisal effects of specific provisions included in China’s bilateral investment treaties (BITs) in inducing foreign direct investment (FDI). Empirical analysis yields some evidence suggesting that while the signing of a BIT does not necessarily boost FDI, the entry into force of a BIT does exert a strong effect on investment flows. More importantly, we find substantial evidence that BITs with stronger investment protection provisions such as absolute and relative standards of treatment and dispute settlement procedures are more likely to induce greater FDI flows. These results suggest that the variation in the institutional design of bilateral investment treaties strongly influences FDI flows by shaping foreign investors’ expectations of their asset security and the overall stability of the host country investment environment.