Reversal of Fortunes:Democratic Institutions and Foreign Direct Investment STOR Inflows to Developing Countries Quan Li:Adam Resnick International Organization,Vol.57,No.1.(Winter,2003),pp.175-211. Stable URL: http://links.istor.org/sici?sici=0020-8183%28200324%2957%3A1%3C175%3AROFDIA%3E2.0.CO%3B2-W International Organization is currently published by Cambridge University Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use,available at http://www.istor org/about/terms.html.JSTOR's Terms and Conditions of Use provides,in part,that unless you have obtained prior permission,you may not download an entire issue of a journal or multiple copies of articles,and you may use content in the JSTOR archive only for your personal,non-commercial use. Please contact the publisher regarding any further use of this work.Publisher contact information may be obtained at http://www.istor.org/iournals/cup.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world.The Archive is supported by libraries,scholarly societies,publishers, and foundations.It is an initiative of JSTOR,a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology.For more information regarding JSTOR,please contact support@jstor.org. http://www.jstor.org Sat Feb910:45:352008
Reversal of Fortunes: Democratic Institutions and Foreign Direct Investment Inflows to Developing Countries Quan Li; Adam Resnick International Organization, Vol. 57, No. 1. (Winter, 2003), pp. 175-211. Stable URL: http://links.jstor.org/sici?sici=0020-8183%28200324%2957%3A1%3C175%3AROFDIA%3E2.0.CO%3B2-W International Organization is currently published by Cambridge University Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/cup.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Sat Feb 9 10:45:35 2008
Reversal of Fortunes: Democratic Institutions and Foreign Direct Investment Inflows to Developing Countries Quan Li and Adam Resnick Increasing economic globalization and the diffusion of political democracy are arguably the two most important characteristics of contemporary international po- litical economy.As a salient dimension of globalization,foreign direct investment (FDI)inflows have grown faster than world income since the 1960s,multinational enterprises(MNEs)now account for about 70 percent of world trade,and the sales of their foreign affiliates have exceeded total global exports.Foreign production capital has dispersed to almost all developing countries since the 1980s,and the number of foreign affiliates located in developing economies has reached 129,771, compared with 93,628 in the developed world.2 Paralleling this economic struc- tural change is the spread of liberal or representative democracy.A growing number of less-developed countries (LDCs)have experienced increased political participation,open competition for elected office,and expanding civil society.The proportion of democratic and partially democratic countries rose from about 31 percent in 1975 to about 73 percent in 1995.3 The flood of FDI and the diffusion of democratic governance have come to an inevitable encounter.While the effect of FDI on democracy has long attracted both scholarly attention and public interest,*the effect of democracy on FDI is surpris- ingly understudied and poorly understood.Explaining the effect of democratic in- stitutions on FDI,however,has clear significance for both theory and policy.Many We thank Steve Chan,Jim Eisenstein,Erik Gartzke,John Oneal,Andrew Sobel,Holloway Sparks, Peter Gourevitch,David Lake,Lisa Martin,and two anonymous referees for their helpful comments and suggestions.We thank Monica Lombana for research assistance.An earlier version of this article was presented at the ISA Annual Meeting,2001,Chicago.Replication data are available from the authors upon request. 1.Held et al.1999. 2.Ibid.,245. 3.Ibid,47. 4.Some examples of empirical examinations include Bornschier,Chase-Dunn,and Rubinson 1978; Jackman 1982;de Soysa and Oneal 1999;Li and Reuveny forthcoming;and Quinn 2000. International Organization 57,Winter 2003,pp.175-211 2003 by The IO Foundation. D0L:10.1017/S0020818303571077
Reversal of Fortunes: Democratic Institutions and Foreign Direct Investment Inflows to Developing Countries Quan Li and Adam Resnick Increasing economic globalization and the diffusion of political democracy are arguably the two most important characteristics of contemporary international political economy. As a salient dimension of globalization, foreign direct investment (FDI) inflows have grown faster than world income since the 1960s, multinational enterprises (MNEs) now account for about 70 percent of world trade, and the sales of their foreign affiliates have exceeded total global exports.' Foreign production capital has dispersed to almost all developing countries since the 1980s, and the number of foreign affiliates located in developing economies has reached 129,77 1, compared with 93,628 in the developed world.' Paralleling this economic structural change is the spread of liberal or representative democracy. A growing number of less-developed countries (LDCs) have experienced increased political participation, open competition for elected office, and expanding civil society. The proportion of democratic and partially democratic countries rose from about 3 1 percent in 1975 to about 73 percent in 1995." The flood of FDI and the diffusion of democratic governance have come to an inevitable encounter. While the effect of FDI on democracy has long attracted both scholarly attention and public interest,"he effect of democracy on FDI is surprisingly understudied and poorly understood. Explaining the effect of democratic institutions on FDI, however, has clear significance for both theory and policy. Many We thank Steve Chan, Jim Eisenstein, Erik Gartzke, John Oneal, Andrew Sobel, Hollouay Sparks, Peter Gourevitch, David Lake, Lisa Martin, and two anonymous referee, for their helpl'ul comment\ and suggestions. We thank Monica Lonibana for research assistance. An earlier ver\ion of this article was presented at the ISA Annual Meeting, 2001, Chicago. Replication data are available from the authors upon request. 1. Held et al. 1999. 2. Tbid., 245. 3. Ibid., 47. 4. Some examples of empirical examinations include Bornschier, Chase-Dunn, and Ruhinson 1978; Jackman 1982; de Soysa and Oneal 1999; Li and Reuveny forthcoming; and Quinn 2000. International Organiiariot~ 57, Winter 2003, pp. 175-21 1 O 2003 by The 10 Foundation. DOT: 10.1017/S00208 18303571077
176 International Organization countries that are democratizing also happen to be developing economies pursu- ing foreign capital.If democratic governance hurts a country's attractiveness to foreign investors,the developing country faces a trade-off between competing for limited FDI and democratization.If,on the other hand,deepening democratic gov- ernance enhances a country's ability to attract FDI,then democratization helps to deliver the economic benefits from foreign capital.The stakes for leaders in the LDCs are high given the potential consequences.Theoretically,the lack of an ad- equate explanation for the effect of democracy on FDI suggests an important gap in how scholars explain interactions between economic globalization and political democracy.In this article,we set out to fill this gap by focusing on the causality from democratic institutions to FDI inflows.More specifically,does increased de- mocracy lead to more FDI inflows to LDCs? Previous theoretical work,while providing a broad framework for our question, suggests conflicting answers.Olson argues that in well-established democracies, independent judiciaries and electoral challenges help to guarantee property rights, ensuring that investments are secure for the long haul.s Investors favor such re- gimes because their assets are shielded from predatory banditry by dictators.Fol- lowing this argument,one concludes that higher levels of democracy should be associated with more FDI inflows.O'Donnell presents a contrasting view,arguing that investors and autocrats often share a cozy relationship.6 Because of political leaders'interest in the economic benefits of FDI,the autocrats shield foreign cap- ital from popular pressure for higher wages,stronger labor protection,or less capital- friendly taxation.Olson and O'Donnell each suggest plausible yet contradictory answers to the democracy-FDI relationship.Olson tells us that property rights make stable democracies fertile territory for investment;O'Donnell illustrates how investor-state collusion favors foreign capital in highly autocratic countries. Other scholars offer similarly contrasting arguments.Because democracy re- ceives broad domestic support,avoids irregular political changes,and institution- alizes income redistribution,democratic developing countries have fewer property rights violations and more private investment.'In contrast,Haggard argues that authoritarian rule may be attractive to investors in countries with traditions of "strong pressure from labor or the left to their economic viability or basic prop- erty rights."Autocrats,in some contexts,may also protect property rights rather than practicing banditry,even though they can be quite effective at banditry.In addition,authoritarian regimes"give political elites autonomy from distributionist pressures,"allowing a broader range of economic policy options.An alliance of the state,local,and multinational capital is likely in autocratic countries where their leaders prefer repression to increased pluralism out of fear of diluted control.10 5.01s0n1993. 6.O'Donnell 1978 and 1988. 7.Feng 2001;Pastor and Hilt 1993;and Pastor and Sung 1995. 8.Haggard1990,258. 9.bid,262. 10.Evans1979,49
176 International Organization countries that are democratizing also happen to be developing economies pursuing foreign capital. If democratic governance hurts a country's attractiveness to foreign investors, the developing country faces a trade-off between competing for limited FDI and democratization. If, on the other hand, deepening democratic governance enhances a country's ability to attract FDI, then democratization helps to deliver the economic benefits from foreign capital. The stakes for leaders in the LDCs are high given the potential consequences. Theoretically, the lack of an adequate explanation for the effect of democracy on FDI suggests an important gap in how scholars explain interactions between economic globalization and political democracy. In this article, we set out to fill this gap by focusing on the causality from democratic institutions to FDI inflows. More specifically, does increased democracy lead to more FDI inflows to LDCs? Previous theoretical work, while providing a broad framework for our question, suggests conflicting answers. Olson argues that in well-established democracies, independent judiciaries and electoral challenges help to guarantee property rights, ensuring that investments are secure for the long haul.5 Investors favor such regimes because their assets are shielded from predatory banditry by dictators. Following this argument, one concludes that higher levels of democracy should be associated with more FDI inflows. O'Donnell presents a contrasting view, arguing that investors and autocrats often share a cozy relati~nship.~ Because of political leaders' interest in the economic benefits of FDI, the autocrats shield foreign capital from popular pressure for higher wages, stronger labor protection, or less capitalfriendly taxation. Olson and O'Donnell each suggest plausible yet contradictory answers to the democracy-FDI relationship. Olson tells us that property rights make stable democracies fertile territory for investment; O'Donnell illustrates how investor-state collusion favors foreign capital in highly autocratic countries. Other scholars offer similarly contrasting arguments. Because democracy receives broad domestic support, avoids irregular political changes, and institutionalizes income redistribution, democratic developing countries have fewer property rights violations and more private investment.' In contrast, Haggard argues that authoritarian rule may be attractive to investors in countries with traditions of "strong pressure from labor or the left to their economic viability or basic property rights." ' Autocrats, in some contexts, may also protect property rights rather than practicing banditry, even though they can be quite effective at banditry. In addition, authoritarian regimes "give political elites autonomy from distributionist pressures," allowing a broader range of economic policy option^.^ An alliance of the state, local, and multinational capital is likely in autocratic countries where their leaders prefer repression to increased pluralism out of fear of diluted control.1° 5. Olson 1993. 6. O'Donnell 1978 and 1988. 7. Feng 2001: Pastor and H~lt 1993: and Pastor and Sung 1995. 8. Haggard 1990, 258. 9. Ib~d., 262. 10. Evans 1979, 49
Democratic Institutions and Investment Inflows 177 While Olson,O'Donnell and others offer useful insights about the expected ef- fect of democratic institutions on FDI inflows to the developing countries,they disagree on the direction of the effect.In this article,we offer a theoretical syn- thesis and extension.Basing our theory on the logic of why firms invest abroad, we argue that democratic institutions have conflicting effects on FDI infows.On one hand,democratic institutions hinder FDI inflows through three avenues.First, democratic constraints over elected politicians tend to weaken the oligopolistic or monopolistic positions of MNEs.Second,these constraints further prevent host governments from offering generous financial and fiscal incentives to foreign in- vestors.Third,broad access to elected officials and wide political participation offer institutionalized avenues through which indigenous businesses can seek pro- tection.In each case,the increased pluralism ensured by democratic institutions generates policy outcomes that reduce the MNE's degree of freedom in the host developing country.On the other hand,democratic institutions promote FDI in- flows by strengthening property rights protection.The representation of the inter- ests of common citizens in the legislature prevents the state from predatory rent seeking.Constraints over elected politicians further guarantee contract enforce- ment for businesses.These effects generate credible property rights protection, reducing risks for foreign investors and encouraging foreign investment.Hence, the net effect of democratic institutions on FDI inflows to the developing coun- tries is contingent on the relative strength of these two competing forces. Existing empirical work rarely explores the effect of democracy on FDI.Oneal stands out as the first quantitative study of how regime characteristics affect FDI.2 He examines whether foreign firms invest more and collect more profit in author- itarian countries than in democracies.He finds that the relationship between re- gime type and FDI flows is not statistically significant,and that returns on investment are best in developed democracies but greater in authoritarian coun- tries among LDCs.While Oneal addresses democracy-FDI connections,he does not consider the competing effects of democracy.In addition,he focuses on FDI from the United States to LDCs dyadically and covers a different time frame.13 11.Looking at a different dependent variable (borrowing in the international capital market),Sobel also examines the effects of property rights institutions(the regulatory state)and democracy (the par- ticipatory state).He finds that the regulatory state affects international borrowing significantly while the participatory state affects such borrowing subtly.Borrowers from more democratic developing coun- tries can borrow more than their less democratic peers,but this relationship does not hold where the regulatory state is weak and corrupt.While our arguments are similar,FDI and international borrow- ing are different phenomena,driven by different causal logics.Sobel 1999. 12.0neal1994. 13.Several authors consider the effects of other political factors on FDI.Chan and Mason find that country size,level of industrialization,alignment with the United States,and strength of central gov- ernment increase FDI inflows.Jun and Singh find that industrial disputes reduce FDI.Enders and San- dler find that terrorism reduces FDI in Spain and Greece from 1968 to 1991.Crenshaw finds that growth and over-urbanization are associated with increased FDI penetration,arguing that the level of FDI can be explained without reference to political factors.Schneider and Frey find that political in- stability decreases FDI flows but other political factors,including government ideology,are insignifi- cant.Chan and Mason 1992;Jun and Singh 1996;Enders and Sandler 1996;Crenshaw 1991;and Schneider and Frey 1985
Democratic Institutions and Investment Inflows 177 While Olson, O'Donnell and others offer useful insights about the expected effect of democratic institutions on FDI inflows to the developing countries, they disagree on the direction of the effect. In this article, we offer a theoretical synthesis and extension. Basing our theory on the logic of why firms invest abroad, we argue that democratic institutions have conflicting effects on FDI inflows. On one hand, democratic institutions hinder FDI inflows through three avenues. First, democratic constraints over elected politicians tend to weaken the oligopolistic or monopolistic positions of MNEs. Second, these constraints further prevent host governments from offering generous financial and fiscal incentives to foreign investors. Third, broad access to elected officials and wide political participation offer institutionalized avenues through which indigenous businesses can seek protection. In each case, the increased pluralism ensured by democratic institutions generates policy outcomes that reduce the MNE's degree of freedom in the host developing country. On the other hand, democratic institutions promote FDI inflows by strengthening property rights protection. The representation of the interests of common citizens in the legislature prevents the state from predatory rent seeking. Constraints over elected politicians further guarantee contract enforcement for businesses. These effects generate credible property rights protection, reducing risks for foreign investors and encouraging foreign investment. Hence, the net effect of democratic institutions on FDI inflows to the developing countries is contingent on the relative strength of these two competing forces." Existing empirical work rarely explores the effect of democracy on FDI. Oneal stands out as the first quantitative study of how regime characteristics affect FDI.I2 He examines whether foreign firms invest more and collect more profit in authoritarian countries than in democracies. He finds that the relationship between regime type and FDI flows is not statistically significant, and that returns on investment are best in developed democracies but greater in authoritarian countries among LDCs. While Oneal addresses democracy-FDI connections, he does not consider the competing effects of democracy. In addition, he focuses on FDI from the United States to LDCs dyadically and covers a different time frame." 11. Looking at a different dependent variable (borrowing in the international capital market), Sobel also examines the effects of property rights institutions (the regulatory state) and democracy (the participatory state). He finds that the regulatory state affects international borrowing significantly while the participatory state affects such borrowing subtly. Borrowers from more democratic developing countries can borrow more than their less democratic peers, but this relationship does not hold where the regulatory state is weak and corrupt. While our arguments are similar, FDI and international borrowing are different phenomena, driven by different causal logics. Sobel 1999. 12. Oneal 1994. 13. Several authors consider the effects of other political factors on FDI. Chan and Mason find that country size, level of industrialization, alignment with the United States, and strength of central government increase FDI inflows. Jun and Singh find that industrial disputes reduce FDI. Enders and Sandler find that terrorism reduces FDI in Spain and Greece from 1968 to 1991. Crenshaw finds that growth and over-urbanization are associated with increased FDI penetration, arguing that the level of FDI can be explained without reference to political factors. Schneider and Frey find that political instability decreases FDI flows but other political factors, including government ideology, are insignificant. Chan and Mason 1992; Jun and Singh 1996; Enders and Sandler 1996; Crenshaw 1991; and Schneider and Frey 1985
178 International Organization Resnick analyzes how democratic transition affects FDI,though he does not con- sider the role of property rights independent of democratic institutions.He finds that transition to democracy has a statistically significant negative effect on FDI.14 Our theory identifies the causal avenues through which democratic institutions promote or hinder FDI inflows.We assess quantitatively both the positive and neg- ative effects of democratic institutions on FDI inflows with empirical tests cover- ing fifty-three developing countries from 1982 to 1995.We find that both property rights protection and democracy-related property rights protection encourage FDI inflows while democratic institutions improve private property rights protection. After controlling for the positive effect of democracy via property rights protec- tion,democratic institutions reduce FDI inflows.These results support our theo- retical claims and are robust against alternative model specifications,statistical estimators,and variable measurements. The article proceeds as follows.We first elaborate our theory on the effects of democratic institutions on FDI inflows.Next,we discuss the research design and the results of our empirical analyses.We conclude with a discussion of implica- tions of our findings. A Theory on How Democratic Institutions Affect FDI Inflows Our theory on the effects of democratic institutions on FDI inflows is based on the logic of why firms invest abroad.As shown below,the level of FDI inflows hinges on the interactions between MNEs and host countries.By affecting these inter- actions,democratic institutions encourage or deter foreign direct investors. Why Do Firms Invest Abroad? As widely accepted,FDI implies that a multinational enterprise organizes produc- tion of goods and services in more than one country,involving the transfer of assets or intermediate products within the investing enterprise and without any change in ownership.It involves additional costs of setting up and operating fac- tories in foreign lands.Given the disadvantages of operating overseas,why do some firms locate their production abroad instead of at home?Why do they own foreign production facilities instead of serving the intended market with such al- ternative means as trade or licensing?Why do they invest in one country instead of another?The logic of international production behind these questions holds the answer to how political institutions affect FDI inflows to the developing coun- tries.Our discussion draws heavily from John Dunning's eclectic paradigm of in- ternational production,15 which encompasses various competing explanations, 14.Resnick 2001. 15.Dunning 1988 and 1993
178 International Organization Resnick analyzes how democratic transition affects FDI, though he does not consider the role of property rights independent of democratic institutions. He finds that transition to democracy has a statistically significant negative effect on FDI.I4 Our theory identifies the causal avenues through which democratic institutions promote or hinder FDI inflows. We assess quantitatively both the positive and negative effects of democratic institutions on FDI inflows with empirical tests covering fifty-three developing countries from 1982 to 1995.We find that both property rights protection and democracy-related property rights protection encourage FDI inflows while democratic institutions improve private property rights protection. After controlling for the positive effect of democracy via property rights protection, democratic institutions reduce FDI inflows. These results support our theoretical claims and are robust against alternative model specifications, statistical estimators, and variable measurements. The article proceeds as follows. We first elaborate our theory on the effects of democratic institutions on FDI inflows. Next, we discuss the research design and the results of our empirical analyses. We conclude with a discussion of implications of our findings. A Theory on How Democratic Institutions Affect FDI Inflows Our theory on the effects of democratic institutions on FDI inflows is based on the logic of why firms invest abroad. As shown below, the level of FDI inflows hinges on the interactions between MNEs and host countries. By affecting these interactions, democratic institutions encourage or deter foreign direct investors. Why Do Firms Invest Abroad? As widely accepted, FDI implies that a multinational enterprise organizes production of goods and services in more than one country, involving the transfer of assets or intermediate products within the investing enterprise and without any change in ownership. It involves additional costs of setting up and operating factories in foreign lands. Given the disadvantages of operating overseas, why do some firms locate their production abroad instead of at home? Why do they own foreign production facilities instead of serving the intended market with such alternative means as trade or licensing? Why do they invest in one country instead of another? The logic of international production behind these questions holds the answer to how political institutions affect FDI inflows to the developing countries. Our discussion draws heavily from John Dunning's eclectic paradigm of international production,15 which encompasses various competing explanations, 14. Resnick 2001. 15. Dunning 1988 and 1993
Democratic Institutions and Investment Inflows 179 including those based on the industrial organization approach,transaction cost economics,7 and trade and location theory.8 Dunning explains that international production is motivated by three sets of ad- vantages perceived by firms.9 The first set is a firm's ownership-specific advan- tages.These include its ownership of intangible assets and common governance of cross-border production.Some examples of intangible assets are product inno- vations,management practices,marketing techniques,and brand names.Diversi- fication across borders allows a firm to exploit economies of scale and to develop monopoly power based on its size and established position.The foreign investor's ownership-specific advantages are sensitive to property rights protection in the host country.In other words,an MNE's success is tied to the security of its intel- lectual and physical property in multiple countries. The second set of advantages concerns the firm's internalization advantages deriving from its hierarchical control of cross-border production.Internalization refers to a firm's direct control over its value-added activities in multiple coun- tries,as opposed to outsourcing,trade,or licensing.The size of a firm's internal- ization advantages correlates with the degree of transnational market failure.For example,where the risks of opportunism by foreign buyers and sellers are high, such as disrupting supplies and violating property rights in primary product and high technology industries,the firm has an incentive to claim hierarchical control of cross-border production.20 Where economic rents from exploiting oligopolistic or monopolistic market structures or large-scale production are high,the firm is also likely to exert hierarchical control of transnational production.The greater the internalization advantages,the more likely a firm is to pursue international production-hierarchical control of its assets,instead of trading or leasing.The exploitation of these advantages is affected by the antitrust or competition- oriented regulation in the host country. The third set of advantages refers to the location-specific advantages per- ceived by firms or the characteristics of host countries in terms of their economic environment or government policies.They may include scarce natural resources, abundant labor,high economic development,or favorable macroeconomic,mi- croeconomic,and FDI-specific government policies.For instance,oil companies have to produce overseas where required resources are available.Export-processing firms typically shift production based on labor cost.Firms also consider govern- ment policies on tariffs,domestic corporate taxation,investment or tax regula- tion of foreign firms,profit repatriation or transfer pricing,royalties on extracted 16.For example,Hymer 1976;and Caves 1971. 17.For example,Rugman 1981;and Teece 1981. 18.Vernon 1966.See also Dunning 1988 and 1993;and Caves 1996 for reviews of the literature on international production. 19.Dunning 1988 and 1993. 20.For example,metals firms are often MNEs.They centralize the management of different steps of production(mining,smelting,and milling)to avoid the risk of being held hostage by a supplier to whom they have outsourced an aspect of production
Democratic Institutions and Investment Inflows 179 including those based on the industrial organization approach,16 transaction cost economics," and trade and location theory." Dunning explains that international production is motivated by three sets of advantages perceived by firms." The first set is a firm's ownership-specific advantages. These include its ownership of intangible assets and common governance of cross-border production. Some examples of intangible assets are product innovations, management practices, marketing techniques, and brand names. Diversification across borders allows a firm to exploit economies of scale and to develop monopoly power based on its size and established position. The foreign investor's ownership-specific advantages are sensitive to property rights protection in the host country. In other words, an MNE's success is tied to the security of its intellectual and physical property in multiple countries. The second set of advantages concerns the firm's internalization advantages deriving from its hierarchical control of cross-border production. Internalization refers to a firm's direct control over its value-added activities in multiple countries, as opposed to outsourcing, trade, or licensing. The size of a firm's internalization advantages correlates with the degree of transnational market failure. For example, where the risks of opportunism by foreign buyers and sellers are high, such as disrupting supplies and violating property rights in primary product and high technology industries, the firm has an incentive to claim hierarchical control of cross-border production.20 Where economic rents from exploiting oligopolictic or monopolistic market structures or large-scale production are high, the firm is also likely to exert hierarchical control of transnational production. The greater the internalization advantages, the more likely a firm is to pursue international production-hierarchical control of its assets, instead of trading or leasing. The exploitation of these advantages is affected by the antitrust or competitionoriented regulation in the host country. The third set of advantages refers to the location-specific advantages perceived by firms or the characteristics of host countries in terms of their economic environment or government policies. They may include scarce natural resources, abundant labor, high economic development, or favorable macroeconomic, microeconomic, and FDI-specific government policies. For instance, oil companies have to produce overseas where required resources are available. Export-processing firms typically shift production based on labor cost. Firms also consider government policies on tariffs, domestic corporate taxation, investment or tax regulation of foreign firms, profit repatriation or transfer pricing, royalties on extracted 16. For example, Hymer 1976; and Caves 197 1. 17. For example, Rugman 1981; and Teece 1981. 18. Vernon 1966. See also Dunning 1988 and 1993; and Caves 1996 for reviews of the literature on international production. 19. Dunning 1988 and 1993. 20. For example, metals firms are often MNEs. They centralize the management of different steps of production (mining, smelting, and milling) to avoid the risk of being held hostage by a supplier to whom they have outsourced an aspect of production
180 International Organization natural resources,antitrust regulation,technology transfer requirements,intellec- tual property protections,and labor market regulation. In the context of our analysis,the connection between politics and FDI inflows hinges on the interaction between host governments and MNEs.Firms select in- vestment sites based on how well their ownership-specific and internalization ad- vantages mesh with location-specific benefits.21 Host government policies create location-specific conditions that affect how well a firm can exploit its advantages. The logic of international production discussed above suggests the following im- plications that set the stage for our analysis of the effects of democratic institu- tions on FDI infows.First,the MNE's ownership-specific and internalization advantages often result from,and are further enhanced by,the oligopolistic or mo- nopolistic market structures.Host government regulatory policies can limit the use of these advantages,particularly through the application of antitrust and other competition-oriented legislation.Second,endowed with the ownership-specific and internalization advantages,the MNE is more competitive than,and often displaces, indigenous firms in the host country.The host government may adopt industrial pol- icy that either protects indigenous businesses from the MNE or favors the MNE. Third,expecting FDI to bring about managerial skills and production technology beneficial to economic growth,the host government may offer foreign investors fi- nancial and fiscal incentives.Such incentives not only affect the choice of FDI lo- cation,but also strengthen the competitiveness of foreign investors.Finally,the MNE must rely on the host government for protection of its property rights in pro- prietary assets,without which its ownership-specific advantages would disappear. These implications depict a contrast between a good and a bad investment cli- mate for MNEs.A good climate is one in which the location-specific advantages existing in the host country facilitate the MNE's exploitation of its ownership- specific and internalization advantages.For example,the host government pro- vides favorable regulation,preferential treatment for MNEs,and sound property rights protection.Conversely,a bad investment climate is one where the condi- tions in the host country hinder the MNE from exploiting its ownership-specific and internalization advantages.Firms that enjoy monopolistic or oligopolistic po- sitions may shy away from host countries with strong antitrust regulation.MNEs may also balk at weak property rights protection and strong preferences of the host government for domestic firms.Domestic political institutions,because they define the policymaking environment,have significant effects on the quality of the investment climate. Suppressive Effect of Democratic Institutions on FDI Inflows The nature of domestic political institutions is defined largely by the relative strength of democratic versus autocratic characteristics of a country's political system.Gen- erally speaking,it depends on the degree to which citizens are able to choose how 21.Dunning1993,548-51
180 International Organization natural resources, antitrust regulation, technology transfer requirements, intellectual property protections, and labor market regulation. In the context of our analysis, the connection between politics and FDI inflows hinges on the interaction between host governments and MNEs. Firms select investment sites based on how well their ownership-specific and internalization advantages mesh with location-specific benefih2' Host government policies create location-specific conditions that affect how well a firm can exploit its advantages. The logic of international production discussed above suggests the following implications that set the stage for our analysis of the effects of democratic institutions on FDI inflows. First, the MNE's ownership-specific and internalization advantages often result from, and are further enhanced by, the oligopolistic or monopolistic market structures. Host government regulatory policies can limit the use of these advantages, particularly through the application of antitrust and other competition-oriented legislation. Second, endowed with the ownership-specific and internalization advantages, the MNE is more competitive than, and often displaces, indigenous firms in the host country. The host government may adopt industrial policy that either protects indigenous businesses from the MNE or favors the MNE. Third, expecting FDI to bring about managerial skills and production technology beneficial to economic growth, the host government may offer foreign investors financial and fiscal incentives. Such incentives not only affect the choice of FDI location, but also strengthen the competitiveness of foreign investors. Finally, the MNE must rely on the host government for protection of its property rights in proprietary assets, without which its ownership-specific advantages would disappear. These implications depict a contrast between a good and a bad investment climate for MNEs. A good climate is one in which the location-specific advantages existing in the host country facilitate the MNE's exploitation of its ownershipspecific and internalization advantages. For example, the host government provides favorable regulation, preferential treatment for MNEs, and sound property rights protection. Conversely, a bad investment climate is one where the conditions in the host country hinder the MNE from exploiting its ownership-specific and internalization advantages. Firms that enjoy monopolistic or oligopolistic positions may shy away from host countries with strong antitrust regulation. MNEs may also balk at weak property rights protection and strong preferences of the host government for domestic firms. Domestic political institutions, because they define the policymaking environment, have significant effects on the quality of the investment climate. Suppressive Effect of Democratic Institutions on FDI Inflows The nature of domestic political institutions is defined largely by the relative strength of democratic versus autocratic characteristics of a country's political system. Generally speaking, it depends on the degree to which citizens are able to choose how 21. Dunning 1993, 548-5 1
Democratic Institutions and Investment Inflows 181 and by whom they are governed.Democratic institutions under a representative de- mocracy or"polyarchy"22 typically include free and fair elections of the executive and legislative offices,the right of citizens to vote and compete for public office, and institutional guarantees for the freedom of association and expression such as an independent judiciary and the absence of censorship.23 These institutions sup- ply"regular constitutional opportunities for changing the governing officials,and a social mechanism that permits the largest possible part of the population to in- fluence major contenders for political office."24 Under democratic institutions,pol- iticians have incentives to develop public policies reflecting the popular sentiment.25 Representative democracy also allows various interests to be represented in the leg- islature,thereby constraining executive power.In addition,the stronger a country's democratic characteristics,the more likely its social interests are to get organized and participate in political competition.Even in fledgling democracies,the state is subject to a broad spectrum of political interests as it attempts to broker compliance with democratic rules,offering relevant political actors welfare improvements to induce their consent.26 Hence,democratic political processes are characterized by the influence of diverse opinions over electoral and public policymaking outcomes. In contrast,autocratic characteristics derive from "limited pluralism"as op- posed to "almost unlimited pluralism"under a representative democracy.27 They may include government co-optation of civil society leadership or legal limitation of pluralism,a single leader or small ruling clique,and weak political mobiliza- tion.Regardless of the methods rulers use to enhance their legitimacy,autocratic politics is biased in favor of narrow elite control over public policy. Countries exhibit heterogeneity in how and to what extent they conform to dem- ocratic or autocratic properties.28 Despite such cross-sectional and temporal het- erogeneity,regime characteristics within the democratic or autocratic category tend to correlate with and reinforce each other.For example,free elections are sustain- able only if leaders are constrained through some mechanism by the citizenry; free election can effectively reflect the will of the people only if citizens partici- pate actively in political competition.To a great extent,the relative strength of democratic and autocratic characteristics defines the nature of political institu- tions.The manner in which these competing democratic and autocratic character- istics are manifested in democratic institutions has implications for foreign direct 22.Though not the focus of our analysis,other variants of democracy include democracy based on a one-party model or direct or participatory democracy,where citizens are directly involved in policy- making.Held 1993,15. 23.Dahl1971and1998. 24.Lipset1960,27. 25.Politicians converge to the median voter's preference in a majoritarian system and to the ideal point of the median voter of popularly elected legislators in a proportional representation system.Hu- ber and Powell 1994. 26.Przeworski 1991,32 27.Linz2000. 28.The development of democracy is not a linear,monotonic process,but is punctuated by rever- sals and sudden changes.Casper 1995
Democratic Institutions and Investment Inflows 181 and by whom they are governed. Democratic institutions under a representative democracy or "polyarchy" 22 typically include free and fair elections of the executive and legislative offices, the right of citizens to vote and compete for public office, and institutional guarantees for the freedom of association and expression such as an independent judiciary and the absence of censorship.23 These institutions supply "regular constitutional opportunities for changing the governing officials, and a social mechanism that permits the largest possible part of the population to influence major contenders for political office." 2%nder democratic institutions, politicians have incentives to develop public policies reflecting the popular sentiment.25 Representative democracy also allows various interests to be represented in the legislature, thereby constraining executive power. In addition, the stronger a country's democratic characteristics, the more likely its social interests are to get organized and participate in political competition. Even in fledgling democracies, the state is subject to a broad spectrum of political interests as it attempts to broker compliance with democratic rules, offering relevant political actors welfare improvements to induce their consent.26 Hence, democratic political processes are characterized by the influence of diverse opinions over electoral and public policymaking outcomes. In contrast, autocratic characteristics derive from "limited pluralism" as opposed to "almost unlimited pluralism" under a representative democracy.27 They may include government co-optation of civil society leadership or legal limitation of pluralism, a single leader or small ruling clique, and weak political mobilization. Regardless of the methods rulers use to enhance their legitimacy, autocratic politics is biased in favor of narrow elite control over public policy. Countries exhibit heterogeneity in how and to what extent they conform to democratic or autocratic proper tie^.^^ Despite such cross-sectional and temporal heterogeneity, regime characteristics within-the democratic or autocratic category tend to correlate with and reinforce each other. For example, free elections are sustainable only if leaders are constrained through some mechanism by the citizenry; free election can effectively reflect the will of the people only if citizens participate actively in political competition. To a great extent, the relative strength of democratic and autocratic characteristics defines the nature of political institutions. The manner in which these competing democratic and autocratic characteristics are manifested in democratic institutions has implications for foreign direct 22. Though not the focus of our analysis, other variants of democracy include democracy based on a one-party model or direct or participatory democracy, where citizens are directly involved in policymaking. Held 1993, 15. 23. Dahl 1971 and 1998. 24. Lipset 1960, 27. 25. Politicians converge to the median voter's preference in a majoritarian system and to the ideal point of the median voter of popularly elected legislators in a proportional representation system. Huber and Powell 1994. 26. Przeworski 1991, 32. 27. Linz 2000. 28. The development of democracy is not a linear, monotonic process, but is punctuated by reversals and sudden changes. Casper 1995
182 International Organization investors.Below we suggest three mechanisms through which these institutions hinder FDI inflows. Effect on MNE exploitation of monopolistic or oligopolistic position.Dem- ocratic institutions in host countries attenuate many MNEs'ability to exploit and enhance their monopolistic or oligopolistic positions.As discussed earlier,firms invest abroad to take advantage of their ownership-specific and internalization ad- vantages,advantages that often result from,and further result in,oligopolistic or monopolistic market structures.29 Such large MNEs constitute the bulk of FDI,30 possess enormous market power,and have significantly shaped trade patterns and the location of economic activities in the global economy.31 In the host countries, such MNEs seek to create and strengthen their oligopolistic or monopolistic posi- tions that result in higher returns.The associated imperfect market structures,how- ever,lead to less optimal allocation of resources in the host economy than perfection competition.While MNEs consider the pursuit of monopolistic or oligopolistic positions a legitimate corporate strategy for greater returns,their desire to create, maintain and increase their monopoly or oligopoly positions sets them at odds with host country governments,particularly democratic ones.32 In more democratic host governments,elected politicians presumably encour- age and manage inward investment to improve national economic performance, benefit their electoral constituencies,and increase their odds of being reelected. That many MNEs may decrease market competition motivates elected politicians to limit the monopoly or oligopoly positions of the relevant MNEs through public policy.In reaction,the MNEs may seek to bribe and collude with the host govern- ment to influence domestic politics of the host country.33 However,freedom of expression and open media bring about relatively better monitoring of elected pol- iticians and allow the opponents of FDI to access the public policymaking process relatively more easily.Hence,democratic characteristics of the host country col- lectively constrain the pursuit by many MNEs of monopoly or oligopoly. Conversely,more autocratic host governments are less likely to clash and more likely to collude with the oligopoly or monopoly-seeking MNEs.By definition, the size of the winning coalition for autocratic leaders is smaller than for demo- cratic leaders because autocratic rulers depend less on broad popular support to stay in power.While such rulers are happy if FDI improves national economic 29.Dunning 1993;and Stopford and Strange 1991,74. 30.Graham 1996. 31.For example,the hundred largest MNEs control about 20 percent of global foreign assets,em- ploy about 6 million workers and account for about 30 percent of total world sales of all MNEs.Con- temporary MNEs further strengthen themselves vis-a-vis the state by collaborating with each other through mergers,acquisitions,and strategic alliances.The number of strategic alliances-cooperative ventures between firms of different countries to undertake research and development-rose from 280 in 1991 to 430 in 1993.United Nations Conference on Trade and Development 1997,8,14. 32.Our argument is consistent with the evidence at the aggregate level in Oneal and Oneal that efforts to pursue supernormal profits by British and American MNEs appear thwarted in the develop- ing regions.Oneal and Oneal 1988. 33.Bergsten,Horst,and Moran 1978;and Tarzi 1991
182 International Organization investors. Below we suggest three mechanisms through which these institutions hinder FDI inflows. Effect on MNE exploitation of monopolistic or oligopolistic position. Democratic institutions in host countries attenuate many MNEs' ability to exploit and enhance their monopolistic or oligopolistic positions. As discussed earlier, firms invest abroad to take advantage of their ownership-specific and internalization advantages, advantages that often result from, and further result in, oligopolistic or monopolistic market structure^.'^ Such large MNEs constitute the bulk of FDI,30 possess enormous market power, and have significantly shaped trade patterns and the location of economic activities in the global e~onorny.~' Inthe host countries, such MNEs seek to create and strengthen their oligopolistic or monopolistic positions that result in higher returns. The associated imperfect market structures, however, lead to less optimal allocation of resources in the host economy than perfection competition. While MNEs consider the pursuit of monopolistic or oligopolistic positions a legitimate corporate strategy for greater returns, their desire to create, maintain and increase their monopoly or oligopoly positions sets them at odds with host country governments, particularly democratic ones.32 In more democratic host governments, elected politicians presumably encourage and manage inward investment to improve national economic performance, benefit their electoral constituencies, and increase their odds of being reelected. That many MNEs may decrease market competition motivates elected politicians to limit the monopoly or oligopoly positions of the relevant MNEs through public policy. In reaction, the MNEs may seek to bribe and collude with the host government to influence domestic politics of the host country." However, freedom of expression and open media bring about relatively better monitoring of elected politicians and allow the opponents of FDI to access the public policymaking process relatively more easily. Hence, democratic characteristics of the host country collectively constrain the pursuit by many MNEs of monopoly or oligopoly. Conversely, more autocratic host governments are less likely to clash and more likely to collude with the oligopoly or monopoly-seeking MNEs. By definition, the size of the winning coalition for autocratic leaders is smaller than for democratic leaders because autocratic rulers depend less on broad popular support to stay in power. While such rulers are happy if FDI improves national economic 29. Dunning 1993; and Stopford and Strange 1991, 74. 30. Graham 1996. 31. For example, the hundred largest MNEs control about 20 percent of global foreign assets, employ about 6 million workers and account for about 30 percent of total world sales of all MNEs. Contemporary MNEs further strengthen themselves vis-a-vis the state by collaborating with each other through mergers, acquisitions, and strategic alliances. The number of strategic alliances-cooperative ventures between firms of different countries to undertake research and development-rose from 280 in 1991 to 430 in 1993. United Nations Conference on Trade and Development 1997, 8, 14. 32. Our argument is consistent with the evidence at the aggregate level in Oneal and Oneal that efforts to pursue supernormal profits by British and American MNEs appear thwarted in the developing regions. Oneal and Oneal 1988. 33. Bergsten, Horst, and Moran 1978; and Tarzi 1991
Democratic Institutions and Investment Inflows 183 performance,their primary focus is to generate more revenues for the ruling clique.34 As long as they obtain increased revenues and benefits from foreign cap- ital,these rulers would tolerate the imperfect competition and concentrated mar- ket power of oligopolistic or monopolistic foreign firms.Narrow elite control further allows rulers to subdue dissenting voices within or outside of the regime.As a result,the weaker the host country's democratic institutions,the less likely the host government is to limit the monopoly or oligopoly position of the MNEs. Effect on host country industrial policy.Industrial policy is another arena in which democratic institutions in the host country degrade conditions for MNEs.Be- cause of their ownership-specific and internalization advantages and exposure to international competition,MNEs are typically more competitive than indigenous firms in the developing host country.While inward investment raises competition in the host country and may improve the allocation of resources,foreign firms typ- ically displace local businesses and even compete for loans in the host country.35 Just as with trade,the growing presence of more-competitive foreign firms often turns less-competitive local firms into losers.Local business owners and the un- employed,suffering concentrated losses,are likely to get organized and lobby for protective industrial policy from the government.While MNEs also bring about new jobs and resources,such benefits do not directly go to the displaced capital and workers. Grievances are likely to be more pronounced in developing countries,where social welfare systems are not well developed and provide limited compensation for displacement.36Where democratic institutions are strong,the opponents of FDI have multiple avenues to influence public policymaking.Domestic interests that lose out to the MNEs can resort to elections,campaign finance,interest groups, public protests,and media exposure.Under such pressures,the host government is compelled to cushion the blow to domestic losers by subsidizing less competi- tive indigenous firms,imposing more restrictive entry conditions on MNEs such as joint ownership,limiting the sectors open to foreign capital,or demanding solely foreign financing of initial investments.It also could pose more restrictive operat- ing requirements in terms of local purchases of capital goods and raw materials, local employment,the proportion of output to be exported,and the use of technol- ogy.37 These policies reduce the MNE's degree of control over its overseas pro- duction and weaken its competitiveness. 34.01s0n1993 35.Graham and Krugman 1995;and Stopford and Strange 1991. 36.Such societal opposition is discounted and indeterminate if local firms are concerned about for- eign retaliation or their own investment entry into foreign countries,as Jonathan Crystal shows to be the case with U.S.firms.In the developing world,however,local firms are not likely to have these con- cerns and thus are more likely to organize to pursue protection from the host government.Crystal 1998. 37.See Dunning 1993,559-60 for a review of the host government policies that affect inward investment.Although the latitude available for such policies has diminished in the context of the World Trade Organization(WTO)and other international agreements,an international regime on foreign in- ward investment is still lacking,and host countries have exhibited great creativity in maintaining ben- efits for domestic producers
Democratic Institutions and Investment Inflows 183 performance, their primary focus is to generate more revenues for the ruling clique.34 As long as they obtain increased revenues and benefits from foreign capital, these rulers would tolerate the imperfect competition and concentrated market power of oligopolistic or monopolistic foreign firms. Narrow elite control further allows rulers to subdue dissenting voices within or outside of the regime. As a result, the weaker the host country's democratic institutions, the less likely the host government is to limit the monopoly or oligopoly position of the MNEs. Effect on host country industrial policy. Industrial policy is another arena in which democratic institutions in the host country degrade conditions for MNEs. Because of their ownership-specific and internalization advantages and exposure to international competition, MNEs are typically more competitive than indigenous firms in the developing host country. While inward investment raises competition in the host country and may improve the allocation of resources, foreign firms typically displace local businesses and even compete for loans in the host country." Just as with trade, the growing presence of more-competitive foreign firms often turns less-competitive local firms into losers. Local business owners and the unemployed, suffering concentrated losses, are likely to get organized and lobby for protective industrial policy from the government. While MNEs also bring about new jobs and resources, such benefits do not directly go to the displaced capital and workers. Grievances are likely to be more pronounced in developing countries, where social welfare systems are not well developed and provide limited compensation for di~placement.~~ Where democratic institutions are strong, the opponents of FDI have multiple avenues to influence public policymaking. Domestic interests that lose out to the MNEs can resort to elections, campaign finance, interest groups, public protests, and media exposure. Under such pressures, the host government is compelled to cushion the blow to domestic losers by subsidizing less competitive indigenous firms, imposing more restrictive entry conditions on MNEs such as joint ownership, limiting the sectors open to foreign capital, or demanding solely foreign financing of initial investments. It also could pose more restrictive operating requirements in terms of local purchases of capital goods and raw materials, local employment, the proportion of output to be exported, and the use of technol- ~gy.~~ These policies reduce the MNE's degree of control over its overseas production and weaken its competitiveness. 34. Olson 1993. 35. Graham and Krugman 1995; and Stopford and Strange 1991. 36. Such societal opposition is discounted and indeterminate if local firms are concerned about foreign retaliation or their own investment entry into foreign countries, as Jonathan Crystal shows to be the case with U.S. firms. In the developing world, however, local firms are not likely to have these concerns and thus are more likely to organize to pursue protection from the host government. Crystal 1998. 37. See Dunning 1993, 559-60 for a review of the host government policies that affect inward investment. Although the latitude available for such policies has diminished in the context of the World Trade Organization (WTO) and other international agreements, an international regime on foreign inward investment is still lacking, and host countries have exhibited great creativity in maintaining benefits for domestic producers
