Democratic Governance and Multinational Corporations:Political Regimes and Inflows of Foreign Direct Investment Nathan M.Jensen Foreign direct investment(FDI)is a key element of the global economy.FDI is an engine of employment,technological progress,productivity improvements, and ultimately economic growth.FDI provides both physical capital and employ- ment possibilities that may not be available in the host market.More importantly, FDI is a mechanism of technology transfer between countries,particularly to the less-developed nations.Because of these significant benefits,attracting FDI has become one of the integral parts of economic development strategies in many countries. Although few scholars dispute the aggregate economic benefits of FDI,critics argue that the benefits of multinational production come with substantial costs for governments and their citizens.The need to attract FDI pressures governments to provide a climate more hospitable to foreign corporations-potentially altering pat- terns of domestic economic policy,and possibly even challenging the de facto sovereignty of the nation-state and the capacity for democratic governance.De- mocracy is often seen as an inefficient institutional structure in the global economy. This article empirically assesses these predictions about the political precondi- tions for attracting FDI using both cross-sectional and panel regression analysis for 114 countries.The cross-sectional regressions estimate the effects of eco- nomic conditions,policy decisions,and democratic political institutions in the 1980s on the level of FDI inflows in the 1990s.In the panel regressions,I explore how Special thanks to Geoffrey Garrett for his extensive comments on this project and a number of other related projects on the determinants of foreign direct investment.I would also like to thank Nancy Brune,Jose Cheibub,Lilach Gilady,Witold Henisz,Charles Martin,Fiona McGillivray,Bruce Rus- sett,Andy Sobel,Jason Sorens,Thomas Konig,Leonard Wantchekon,James Vreeland,the editors of 10,and three anonymous reviewers for helpful comments and suggestions.Thanks to Nancy Brune for making her capital account liberalization data available. 1.Jessup 1999 argues that authoritarian regimes in developing countries attract more international investment.Oneal 1994 finds that authoritarian regimes provide investors with higher returns in devel- oping countries,although overall investment fows are not related to regime type. International Organization 57,Summer 2003,pp.587-616 2003 by The IO Foundation. D0:10.1017/S0020818303573040
Democratic Governance and Multinational Corporations: Political Regimes and Inflows of Foreign Direct Investment Nathan M+ Jensen Foreign direct investment ~FDI! is a key element of the global economy+ FDI is an engine of employment, technological progress, productivity improvements, and ultimately economic growth+ FDI provides both physical capital and employment possibilities that may not be available in the host market+ More importantly, FDI is a mechanism of technology transfer between countries, particularly to the less-developed nations+ Because of these significant benefits, attracting FDI has become one of the integral parts of economic development strategies in many countries+ Although few scholars dispute the aggregate economic benefits of FDI, critics argue that the benefits of multinational production come with substantial costs for governments and their citizens+ The need to attract FDI pressures governments to provide a climate more hospitable to foreign corporations—potentially altering patterns of domestic economic policy, and possibly even challenging the de facto sovereignty of the nation-state and the capacity for democratic governance+ 1 Democracy is often seen as an inefficient institutional structure in the global economy+ This article empirically assesses these predictions about the political preconditions for attracting FDI using both cross-sectional and panel regression analysis for 114 countries+ The cross-sectional regressions estimate the effects of economic conditions, policy decisions, and democratic political institutions in the 1980s on the level of FDI inflows in the 1990s+ In the panel regressions, I explore how Special thanks to Geoffrey Garrett for his extensive comments on this project and a number of other related projects on the determinants of foreign direct investment+ I would also like to thank Nancy Brune, Jose Cheibub, Lilach Gilady, Witold Henisz, Charles Martin, Fiona McGillivray, Bruce Russett, Andy Sobel, Jason Sorens, Thomas König, Leonard Wantchekon, James Vreeland, the editors of IO, and three anonymous reviewers for helpful comments and suggestions+ Thanks to Nancy Brune for making her capital account liberalization data available+ 1+ Jessup 1999 argues that authoritarian regimes in developing countries attract more international investment+ Oneal 1994 finds that authoritarian regimes provide investors with higher returns in developing countries, although overall investment flows are not related to regime type+ International Organization 57, Summer 2003, pp+ 587–616 © 2003 by The IO Foundation+ DOI: 10+10170S0020818303573040
588 International Organization changes in economic policies and political institutions affect changes in FDI in- flows in the period from 1970-97.I then use a Heckman selection model to ex- plore the robustness of the relationship between democratic governance and FDI. Lastly,I explore the causal link between democracy and FDI by empirically as- sessing the effects of democratic governance on country credibility.In this section I test the effects of democratic institutions on country sovereign debt ratings for seventy-nine countries from 1980 to 1998. My results are inconsistent with the dire predictions regarding the effects of the competition for FDI on domestic politics.Democratic political institutions are as- sociated with higher levels of FDI inflows.Democratic governments,even when controlling for other political and economic factors,attract as much as 70 percent more FDI as a percentage of GDP than their authoritarian counterparts.This result is robust under different model specifications and types of empirical tests. The remainder of this article is organized as follows.The first section presents some descriptive statistics on FDI flows.The second section examines the exist- ing work on the determinants of FDI flows and provides the theoretical links be- tween economic policy,political institutions,and FDI inflows.The third section discusses the causal links between democracy and higher levels of FDI inflows. The fourth section provides a brief overview of the empirical tests used in this analysis.The following two sections construct empirical tests of the determinants of FDI flows,examining the levels of FDI using cross-sectional data (fifth sec- tion),and changes using panel data,including a Heckman selection model (sixth section).The seventh section examines the link between democracy and credibil- ity by empirically examining the effects of democratic institutions on country sov- ereign debt ratings.The final section concludes. Multinational Corporations and Domestic Economies The focus of this work is on one of the most stable and economically important international capital flows-FDI.2 FDIs are defined as private capital flows from a parent firm to a location outside of the parent firm's home nation.These invest- ments consist of equity capital,intercompany debt,and reinvested earnings.An investment is considered FDI,as opposed to portfolio investment,if it is large enough to give the parent firm some amount of control over the management of the enterprise-usually more than 10 percent of the firm.3 FDI,unlike portfolio investments,has long time horizons and is generally not done for speculative pur- poses,but rather to serve domestic markets,exploit natural resources,or provide platforms to serve world markets through exports. 2.See Lipsey 1999 for a discussion of the stability of FDI flows relative to other investment flows. 3.These are the statistical rules used by the International Monetary Fund (IMF).See IFC 1997,9
changes in economic policies and political institutions affect changes in FDI in- flows in the period from 1970–97+ I then use a Heckman selection model to explore the robustness of the relationship between democratic governance and FDI+ Lastly, I explore the causal link between democracy and FDI by empirically assessing the effects of democratic governance on country credibility+ In this section I test the effects of democratic institutions on country sovereign debt ratings for seventy-nine countries from 1980 to 1998+ My results are inconsistent with the dire predictions regarding the effects of the competition for FDI on domestic politics+ Democratic political institutions are associated with higher levels of FDI inflows+ Democratic governments, even when controlling for other political and economic factors, attract as much as 70 percent more FDI as a percentage of GDP than their authoritarian counterparts+ This result is robust under different model specifications and types of empirical tests+ The remainder of this article is organized as follows+ The first section presents some descriptive statistics on FDI flows+ The second section examines the existing work on the determinants of FDI flows and provides the theoretical links between economic policy, political institutions, and FDI inflows+ The third section discusses the causal links between democracy and higher levels of FDI inflows+ The fourth section provides a brief overview of the empirical tests used in this analysis+ The following two sections construct empirical tests of the determinants of FDI flows, examining the levels of FDI using cross-sectional data ~fifth section!, and changes using panel data, including a Heckman selection model ~sixth section!+ The seventh section examines the link between democracy and credibility by empirically examining the effects of democratic institutions on country sovereign debt ratings+ The final section concludes+ Multinational Corporations and Domestic Economies The focus of this work is on one of the most stable and economically important international capital flows—FDI+ 2 FDIs are defined as private capital flows from a parent firm to a location outside of the parent firm’s home nation+ These investments consist of equity capital, intercompany debt, and reinvested earnings+ An investment is considered FDI, as opposed to portfolio investment, if it is large enough to give the parent firm some amount of control over the management of the enterprise—usually more than 10 percent of the firm+ 3 FDI, unlike portfolio investments, has long time horizons and is generally not done for speculative purposes, but rather to serve domestic markets, exploit natural resources, or provide platforms to serve world markets through exports+ 2+ See Lipsey 1999 for a discussion of the stability of FDI flows relative to other investment flows+ 3+ These are the statistical rules used by the International Monetary Fund ~IMF!+ See IFC 1997, 9+ 588 International Organization
The Political Economy of FDI 589 The importance of FDI to capital accumulation is large and growing.Inter- national capital flows have increasingly become dominated by flows of private capital.In 1990,44 percent of all international capital flows were private.This rose to 85 percent in 1996,with FDI being the largest single type of capital flow. FDI has outpaced international trade,growing at an average rate of 13 percent per year from 1980-97,as compared to an annual 7 percent growth rate for exports.3 In 1998 alone,FDI flows increased 25 percent.A simple snapshot of FDI as a percentage of gross domestic investment,averaged for the 1980s,is presented in Table 1.6 In the vast majority of countries,FDI accounts for a substantial amount of domestic investment. These figures obscure an even more important element of FDI flows-the role of multinational production in transferring technology.The potential for techno- logical transfer is obvious if one examines the characteristics of most multi- national firms."Multinationals tend to be important in industries and firms with four characteristics:high levels of research and development(R&D)relative to sales;a large share of professional and technical workers in their workforce;prod- ucts that are new or technically complex;and high levels of product differentia- tion and advertising.These characteristics appear in many studies,and I have never seen any of them contradicted in any study."7 Investments by these technologi- cally advanced firms translate directly into growth-promoting technical advances for the host nation.8 Although the direct effects of FDI on capital accumulation and technological transfer are economically the most important,other economic and political effects of FDI should not be overlooked.FDI is often concentrated in export sectors,gen- erating foreign exchange for the host nation.FDI is also a means of generating employment-both directly,through the foreign firm,and through the indirect ef- fects on the economy,such as domestic industries emerging to compliment the new foreign firms.9 These material benefits of FDI force governments into a competition for scarce international capital.In this article I focus specifically on the relationship between democratic governance and FDI inflows.Drawing on the vast literature on the effects of democracy in interstate relations and democratic theory,I identify a num- 4.IFC1997,14. 5.Mallampally and Sauvant 1999. 6.Data are unweighted averages from the World Development Indicators 2000.Negative values represent disinvestment by multinationals. 7.Markusen 1995,172. 8.Wang 1990;and Grossman and Helpman 1991 provide the theoretical foundation for this.Em- pirically,Luiz R.de Mello Jr.1999 uses panel data for fifteen Organization for Economic Cooperation and Development(OECD)countries and seventeen non-OECD countries from the period 1970-90 and finds that FDI does increase growth,but the growth-enhancing effects are dependent on the level of technological backwardness.For the backward countries,FDI is more productive than domestic invest- ment.A study by Barrel and Pain 1999 finds that for four industrialized European countries,a one- percentage increase in FDI increased technological progress by 0.18 percent. 9.See OECD 1995;and Markusen and Venables 1999
The importance of FDI to capital accumulation is large and growing+ International capital flows have increasingly become dominated by flows of private capital+ In 1990, 44 percent of all international capital flows were private+ This rose to 85 percent in 1996, with FDI being the largest single type of capital flow+ 4 FDI has outpaced international trade, growing at an average rate of 13 percent per year from 1980–97, as compared to an annual 7 percent growth rate for exports+ 5 In 1998 alone, FDI flows increased 25 percent+ A simple snapshot of FDI as a percentage of gross domestic investment, averaged for the 1980s, is presented in Table 1+ 6 In the vast majority of countries, FDI accounts for a substantial amount of domestic investment+ These figures obscure an even more important element of FDI flows—the role of multinational production in transferring technology+ The potential for technological transfer is obvious if one examines the characteristics of most multinational firms+ “Multinationals tend to be important in industries and firms with four characteristics: high levels of research and development ~R&D! relative to sales; a large share of professional and technical workers in their workforce; products that are new or technically complex; and high levels of product differentiation and advertising+ These characteristics appear in many studies, and I have never seen any of them contradicted in any study+”7 Investments by these technologically advanced firms translate directly into growth-promoting technical advances for the host nation+ 8 Although the direct effects of FDI on capital accumulation and technological transfer are economically the most important, other economic and political effects of FDI should not be overlooked+ FDI is often concentrated in export sectors, generating foreign exchange for the host nation+ FDI is also a means of generating employment—both directly, through the foreign firm, and through the indirect effects on the economy, such as domestic industries emerging to compliment the new foreign firms+ 9 These material benefits of FDI force governments into a competition for scarce international capital+ In this article I focus specifically on the relationship between democratic governance and FDI inflows+ Drawing on the vast literature on the effects of democracy in interstate relations and democratic theory, I identify a num- 4+ IFC 1997, 14+ 5+ Mallampally and Sauvant 1999+ 6+ Data are unweighted averages from the World Development Indicators 2000+ Negative values represent disinvestment by multinationals+ 7+ Markusen 1995, 172+ 8+ Wang 1990; and Grossman and Helpman 1991 provide the theoretical foundation for this+ Empirically, Luiz R+ de Mello Jr+ 1999 uses panel data for fifteen Organization for Economic Cooperation and Development ~OECD! countries and seventeen non-OECD countries from the period 1970–90 and finds that FDI does increase growth, but the growth-enhancing effects are dependent on the level of technological backwardness+ For the backward countries, FDI is more productive than domestic investment+ A study by Barrel and Pain 1999 finds that for four industrialized European countries, a onepercentage increase in FDI increased technological progress by 0+18 percent+ 9+ See OECD 1995; and Markusen and Venables 1999+ The Political Economy of FDI 589
590 International Organization TABLE 1.FDI as a percentage of gross domestic investment St.Kitts and Nevis 55.56 Honduras 5.92 Turkey 2.09 Singapore 41.50 Senegal 5.79 Central African Rep. 2.05 Sierra Leone 37.87 Malawi 5.75 Mozambique 2.02 Trinidad and Tobago 28.11 Greece 5.33 Chad 1.97 Fiji 25.64 Paraguay 5.33 Iceland 1.95 Jamaica 23.40 Nicaragua 5.25 Lesotho 1.93 Seychelles 22.08 France 4.91 Syria 1.87 New Zealand 21.26 Colombia 4.82 Israel 1.76 Vanuatu 19.51 Argentina 4.72 Philippines 1.60 Ecuador 17.90 Thailand 4.65 Cameroon 1.46 Dominican Republic 16.32 Bolivia 4.43 Chile 1.44 Grenada 15.43 Namibia 4.34 Gambia 1.39 Belize 14.85 Venezuela 4.28 El Salvador 1.38 Panama 14.76 Indonesia 4.26 Guinea Bissau 1.37 Portugal 13.20 Denmark 4.18 Algeria 1.32 Malaysia 13.12 Tunisia 3.77 Sri Lanka 1.17 Netherlands 13.09 Mexico 3.75 Togo 0.92 Nigeria 12.52 Norway 3.74 South Korea 0.84 Costa Rica 11.73 Guinea 3.65 Poland 0.59 United Kingdom 11.72 Kenya 3.14 Burkina Faso 0.43 Ghana 11.70 Jordan 2.97 Rwanda 0.41 Spain 11.20 Egypt 2.95 India 0.34 Australia 10.17 Brazil 2.95 Burundi 0.30 Papua New Guinea 9.84 United States 2.90 Japan 0.19 Benin 8.89 China 2.83 Bulgaria 0.08 Cyprus 8.37 Pakistan 2.69 Bangladesh 0.05 Guatemala 8.33 Sweden 2.66 Zimbabwe -0.39 Canada 8.11 Morocco 2.64 Mali -0.63 Cote d'lvoire 8.03 Mauritania 2.59 Congo -0.71 Switzerland 7.69 Gabon 2.53 Iran -1.05 Guyana 7.38 Italy 2.45 Comoros -2.03 Madagascar 6.64 Finland 2.19 Peru -2.85 Ireland 6.49 Austria 2.13 Zambia -11.54 Mauritius 6.16 Source:World Development Indicators 1998 ber of causal mechanisms by which democracy has a positive effect on FDI in- flows.Before examining the role of democracy on FDI inflows,I describe the economics of FDI. Determinants of FDI John Dunning's ownership,location,and internalization (OLI)framework is gen- erally considered the paradigmatic theory of the multinational firm's investment decisions,where multinational enterprises (MNEs)invest internationally for rea-
ber of causal mechanisms by which democracy has a positive effect on FDI in- flows+ Before examining the role of democracy on FDI inflows, I describe the economics of FDI+ Determinants of FDI John Dunning’s ownership, location, and internalization ~OLI! framework is generally considered the paradigmatic theory of the multinational firm’s investment decisions, where multinational enterprises ~MNEs! invest internationally for reaTABLE 1. FDI as a percentage of gross domestic investment St+ Kitts and Nevis 55+56 Honduras 5+92 Turkey 2+09 Singapore 41+50 Senegal 5+79 Central African Rep+ 2+05 Sierra Leone 37+87 Malawi 5+75 Mozambique 2+02 Trinidad and Tobago 28+11 Greece 5+33 Chad 1+97 Fiji 25+64 Paraguay 5+33 Iceland 1+95 Jamaica 23+40 Nicaragua 5+25 Lesotho 1+93 Seychelles 22+08 France 4+91 Syria 1+87 New Zealand 21+26 Colombia 4+82 Israel 1+76 Vanuatu 19+51 Argentina 4+72 Philippines 1+60 Ecuador 17+90 Thailand 4+65 Cameroon 1+46 Dominican Republic 16+32 Bolivia 4+43 Chile 1+44 Grenada 15+43 Namibia 4+34 Gambia 1+39 Belize 14+85 Venezuela 4+28 El Salvador 1+38 Panama 14+76 Indonesia 4+26 Guinea Bissau 1+37 Portugal 13+20 Denmark 4+18 Algeria 1+32 Malaysia 13+12 Tunisia 3+77 Sri Lanka 1+17 Netherlands 13+09 Mexico 3+75 Togo 0+92 Nigeria 12+52 Norway 3+74 South Korea 0+84 Costa Rica 11+73 Guinea 3+65 Poland 0+59 United Kingdom 11+72 Kenya 3+14 Burkina Faso 0+43 Ghana 11+70 Jordan 2+97 Rwanda 0+41 Spain 11+20 Egypt 2+95 India 0+34 Australia 10+17 Brazil 2+95 Burundi 0+30 Papua New Guinea 9+84 United States 2+90 Japan 0+19 Benin 8+89 China 2+83 Bulgaria 0+08 Cyprus 8+37 Pakistan 2+69 Bangladesh 0+05 Guatemala 8+33 Sweden 2+66 Zimbabwe 20+39 Canada 8+11 Morocco 2+64 Mali 20+63 Côte d’Ivoire 8+03 Mauritania 2+59 Congo 20+71 Switzerland 7+69 Gabon 2+53 Iran 21+05 Guyana 7+38 Italy 2+45 Comoros 22+03 Madagascar 6+64 Finland 2+19 Peru 22+85 Ireland 6+49 Austria 2+13 Zambia 211+54 Mauritius 6+16 Source: World Development Indicators 1998+ 590 International Organization
The Political Economy of FDI 591 sons of ownership,location,and internalization.0 Firms have ownership advan- tages when they have access to some asset or process that provides some advantage over existing firms in the foreign market.These can be physical,for example pat- ented products or production processes,or more intangible,such as global brand name recognition.Multinational firms invest abroad to exploit these firm-specific advantages in foreign markets and secure higher returns. Firms may also be motivated to invest abroad because of locational advan- fages.Firms often invest in production facilities in foreign markets because trans- portation costs are too high to serve these markets through exports.This could either be directly related to the physical nature of the good,as with a high bulk item or a service that needs to be provided on site,or because of policy factors such as tariff rates,import restrictions,or issues of market access that make phys- ical investment advantageous over serving the market through exports.The loca- tional advantage could also be related to the actual endowments of the host location-either the richness of its natural resources or the high quality and low cost of its labor force. The third and most complex factor is that of internalization advantages.Al- though the other two OLI factors highlight reasons why firms would move pro- duction to a foreign location,they do not give any reason as to why a firm would simply not license a foreign producer to make the item for the parent firm.A multi- national could simply provide the technology needed for the production process and the blueprints for the product to a local firm.This concept of internalization advantages captures the firm-specific motivations for a firm choosing to produce the product within the organization itself in a foreign location. Closely related to Dunning's work,other scholars have developed a number of theoretical models to explain firms'decisions to invest abroad.These models can be roughly classified as theories based on "vertical"firms,"horizontal"firms,and the"knowledge-capital model"of multinational firms.Vertical firms separate pro- duction activities by the level of capital intensity,producing different goods and services at different physical locations.2 Although these theories are important contributions to the understanding of multinationals'investment decisions,theo- ries based on vertical multinationals have failed to account for the existence of firms replicating the production of the same goods and services in different phys- ical locations. Markusen explained this pattern of replicating production by creating a model of "horizontal"firms with firm-level economies of scale that integrate hori- zontally across national borders.3 These horizontal models have been integrated, 10.Dunning 1981.For an interesting discussion on the OLI framework and recent work done in relation to it,see Markusen 1995. 11.See Markusen and Maskus 1999a and 1999b. 12.Helpman 1984. 13.Markusen 1984.For a review of recent contributions to this literature,see Markusen and Maskus 1999a
sons of ownership, location, and internalization+ 10 Firms have ownership advantages when they have access to some asset or process that provides some advantage over existing firms in the foreign market+ These can be physical, for example patented products or production processes, or more intangible, such as global brand name recognition+ Multinational firms invest abroad to exploit these firm-specific advantages in foreign markets and secure higher returns+ Firms may also be motivated to invest abroad because of locational advantages+ Firms often invest in production facilities in foreign markets because transportation costs are too high to serve these markets through exports+ This could either be directly related to the physical nature of the good, as with a high bulk item or a service that needs to be provided on site, or because of policy factors such as tariff rates, import restrictions, or issues of market access that make physical investment advantageous over serving the market through exports+ The locational advantage could also be related to the actual endowments of the host location—either the richness of its natural resources or the high quality and low cost of its labor force+ The third and most complex factor is that of internalization advantages+ Although the other two OLI factors highlight reasons why firms would move production to a foreign location, they do not give any reason as to why a firm would simply not license a foreign producer to make the item for the parent firm+ A multinational could simply provide the technology needed for the production process and the blueprints for the product to a local firm+ This concept of internalization advantages captures the firm-specific motivations for a firm choosing to produce the product within the organization itself in a foreign location+ Closely related to Dunning’s work, other scholars have developed a number of theoretical models to explain firms’ decisions to invest abroad+ These models can be roughly classified as theories based on “vertical” firms, “horizontal” firms, and the “knowledge-capital model” of multinational firms+ 11 Vertical firms separate production activities by the level of capital intensity, producing different goods and services at different physical locations+ 12 Although these theories are important contributions to the understanding of multinationals’ investment decisions, theories based on vertical multinationals have failed to account for the existence of firms replicating the production of the same goods and services in different physical locations+ Markusen explained this pattern of replicating production by creating a model of “horizontal” firms with firm-level economies of scale that integrate horizontally across national borders+ 13 These horizontal models have been integrated, 10+ Dunning 1981+ For an interesting discussion on the OLI framework and recent work done in relation to it, see Markusen 1995+ 11+ See Markusen and Maskus 1999a and 1999b+ 12+ Helpman 1984+ 13+ Markusen 1984+ For a review of recent contributions to this literature, see Markusen and Maskus 1999a+ The Political Economy of FDI 591
592 International Organization along with the existing vertical models of multinational firms,into Markusen's "knowledge-capital model."4 In this model,multinational firms can produce the same product or service in multiple locations(horizontal)or can geographically separate the firm's headquarters from the production location (vertical). Although the OLI framework and the horizontal/vertical/knowledge-capital models of multinationals all remain strong tools for understanding the motivations for MNEs'investment decisions,they still do not go far enough in answering one of the more important questions of international development:Which countries attract FDI?FDI remains a firm-level decision,but countries have differed in their abilities to attract it.The question remains,what are these country-specific factors that affect FDI inflows? In this article I argue that once a multinational has invested in a foreign market, disinvestment of physical assets is costly.Multinationals face tremendous politi- cal risks.Governments may change policy after the multinational has invested, adversely affecting the profitability of the investment.These political risks can be a major factor in a multinational's decision to invest in a foreign market. Political regimes that lower political risks will attract multinationals by decreas- ing the costs of internalizing production.In systems with lower levels of political risk,multinationals will invest via FDI.In systems with higher levels of political risk,multinationals will be wary of entering a foreign market,and either avoid the market or establish a contractual relationship with a domestic firm.Thus political regimes that have effects on political risk will affect the entry of multinational corporations into these systems.The following section discusses how democratic political institutions can lower these political risks,leading democratic political systems to attract higher levels of FDI. Democracy and FDI The debate on the relationship between political institutions and economic perfor- mance has generally been framed in terms of democracy and economic growth. Scholars such as North,and North and Weingast have stressed that ensuring prop- erty rights is a central element of economic development.5 For Olson,this leads to democracies growing at faster rates than authoritarian regimes.16 Olson argues that autocrats,being predatory,cannot credibly commit to ensuring property rights protection. Although many of the classic works in political science have argued that de- mocracy has a positive impact on economic growth,a number of dissenting con- tributions are notable.Huntington's famous work stresses that democracy leads to 14.Markusen 1997. 15.See North 1990;and North and Weingast 1989. 16.0lson1991
along with the existing vertical models of multinational firms, into Markusen’s “knowledge-capital model+”14 In this model, multinational firms can produce the same product or service in multiple locations ~horizontal! or can geographically separate the firm’s headquarters from the production location ~vertical!+ Although the OLI framework and the horizontal0vertical0knowledge-capital models of multinationals all remain strong tools for understanding the motivations for MNEs’ investment decisions, they still do not go far enough in answering one of the more important questions of international development: Which countries attract FDI? FDI remains a firm-level decision, but countries have differed in their abilities to attract it+ The question remains, what are these country-specific factors that affect FDI inflows? In this article I argue that once a multinational has invested in a foreign market, disinvestment of physical assets is costly+ Multinationals face tremendous political risks+ Governments may change policy after the multinational has invested, adversely affecting the profitability of the investment+ These political risks can be a major factor in a multinational’s decision to invest in a foreign market+ Political regimes that lower political risks will attract multinationals by decreasing the costs of internalizing production+ In systems with lower levels of political risk, multinationals will invest via FDI+ In systems with higher levels of political risk, multinationals will be wary of entering a foreign market, and either avoid the market or establish a contractual relationship with a domestic firm+ Thus political regimes that have effects on political risk will affect the entry of multinational corporations into these systems+ The following section discusses how democratic political institutions can lower these political risks, leading democratic political systems to attract higher levels of FDI+ Democracy and FDI The debate on the relationship between political institutions and economic performance has generally been framed in terms of democracy and economic growth+ Scholars such as North, and North and Weingast have stressed that ensuring property rights is a central element of economic development+ 15 For Olson, this leads to democracies growing at faster rates than authoritarian regimes+ 16 Olson argues that autocrats, being predatory, cannot credibly commit to ensuring property rights protection+ Although many of the classic works in political science have argued that democracy has a positive impact on economic growth, a number of dissenting contributions are notable+ Huntington’s famous work stresses that democracy leads to 14+ Markusen 1997+ 15+ See North 1990; and North and Weingast 1989+ 16+ Olson 1991+ 592 International Organization
The Political Economy of FDI 593 higher demands for current consumption.17 More recently,work by Przeworski and Limongi has argued that this relationship is more complex than once thought.8 In an impressive statistical analysis,Przeworski,Alvarez,Cheibub,and Limongi find that there is no difference between the growth rates of democratic and author- itarian regimes.19 These theories on the effects of democracy on macroeconomic performance are relatively divergent with the literature on multinational investors and political re- gimes.The conventional wisdom is that multinationals prefer to invest in author- itarian regimes.Authoritarian leaders can provide multinational firms with better entry deals,because of the lack of popular pressure from below,and the repres- sion of labor unions to drive down wages.This relationship leads to higher levels of FDI inflows to authoritarian countries. The second of these arguments,on the role of authoritarian regimes in provid- ing a lower-cost workforce,does have some support in the literature.20 The real question is,does this translate into higher levels of FDI inflows?Most scholars studying FDI argue that the impact of low wages has been overemphasized as a determinant of FDI,and that the wage rate is just one of many decision factors for multinational firms.21 I will argue later that the impact of lower wages is offset by the positive impact of democratic institutions for multinationals. The other argument,on the role of authoritarian regimes in bargaining with firms, has also been greatly exaggerated.Most scholars assume that the lack of con- straints for authoritarian regimes leads to a more generous situation for multination- als.As Putnam argues,the logic of a two-level game provides both constraints and leverage to political leaders.22 Although the democratic constraints imposed on leaders may limit the amount of discretion in offering deals to multinationals, this lack of discretion can also provide benefits to multinational firms. More specifically,most scholars fail to consider the possibility that the con- straints imposed on political leaders within democratic systems could translate into a beneficial situation for MNEs.I argue that these constraints lead to higher levels of policy stability and more favorable policies toward multinationals. The extensive and growing literature on the democratic peace in international relations argues that political regimes influence relationships between nation- states.This literature is helpful in understanding the potential benefits of demo- cratic governance structures for foreign investors.Beyond the obvious benefits of democratic states avoiding conflict with other democracies and winning the con- flicts in which they engage authoritarian states,multinationals may have other rea- 17.Huntington 1968. 18.Przeworski and Limongi 1993.See also Barro 1996. 19.For a review of the literature,see Przeworski and Limongi 1997;and Przeworski et al.2000. 20.Rodrik 1999. 21.Markusen 1995. 22.Putnam 1988
higher demands for current consumption+ 17 More recently, work by Przeworski and Limongi has argued that this relationship is more complex than once thought+ 18 In an impressive statistical analysis, Przeworski, Alvarez, Cheibub, and Limongi find that there is no difference between the growth rates of democratic and authoritarian regimes+ 19 These theories on the effects of democracy on macroeconomic performance are relatively divergent with the literature on multinational investors and political regimes+ The conventional wisdom is that multinationals prefer to invest in authoritarian regimes+ Authoritarian leaders can provide multinational firms with better entry deals, because of the lack of popular pressure from below, and the repression of labor unions to drive down wages+ This relationship leads to higher levels of FDI inflows to authoritarian countries+ The second of these arguments, on the role of authoritarian regimes in providing a lower-cost workforce, does have some support in the literature+ 20 The real question is, does this translate into higher levels of FDI inflows? Most scholars studying FDI argue that the impact of low wages has been overemphasized as a determinant of FDI, and that the wage rate is just one of many decision factors for multinational firms+ 21 I will argue later that the impact of lower wages is offset by the positive impact of democratic institutions for multinationals+ The other argument, on the role of authoritarian regimes in bargaining with firms, has also been greatly exaggerated+ Most scholars assume that the lack of constraints for authoritarian regimes leads to a more generous situation for multinationals+ As Putnam argues, the logic of a two-level game provides both constraints and leverage to political leaders+ 22 Although the democratic constraints imposed on leaders may limit the amount of discretion in offering deals to multinationals, this lack of discretion can also provide benefits to multinational firms+ More specifically, most scholars fail to consider the possibility that the constraints imposed on political leaders within democratic systems could translate into a beneficial situation for MNEs+ I argue that these constraints lead to higher levels of policy stability and more favorable policies toward multinationals+ The extensive and growing literature on the democratic peace in international relations argues that political regimes influence relationships between nationstates+ This literature is helpful in understanding the potential benefits of democratic governance structures for foreign investors+ Beyond the obvious benefits of democratic states avoiding conflict with other democracies and winning the con- flicts in which they engage authoritarian states, multinationals may have other rea- 17+ Huntington 1968+ 18+ Przeworski and Limongi 1993+ See also Barro 1996+ 19+ For a review of the literature, see Przeworski and Limongi 1997; and Przeworski et al+ 2000+ 20+ Rodrik 1999+ 21+ Markusen 1995+ 22+ Putnam 1988+ The Political Economy of FDI 593
594 International Organization sons to prefer investing in democracies.23 If democratic political institutions allow higher levels of cooperation between states,they may also allow for higher levels of cooperation between states and multinational corporations.In this article I high- light two mechanisms through which democratic institutions could attract higher levels of FDI inflows. The main advantage of democratic institutions to multinational investors is cred- ibility.FDI,while mobile ex ante,is relatively illiquid ex post.24 Once foreign capital is invested in a country,the firm is subject to policy change or reversal by the central government.Once multinational investments have been made,there are considerable political risks in the investment. These political risks come in a number of forms.The most obvious political risks,nationalization and expropriation,involve the loss of ownership by multi- nationals of their investments-but are now relatively uncommon.Even with the decreasing incidences of nationalization,multinationals still face considerable po- litical risks in terms of the expropriation of revenue streams.25 Governments can renegotiate tax rates,depreciations schedules,tariff rates,and a host of other pol- icies that directly affect multinational operations.Other indirect factors,such as the imposing of capital controls,devaluations,or other macroeconomic decisions not targeted specifically at multinational firms,but affecting the profitability of the investment,are also important.Multinational corporations are attracted to gov- ernments that can help minimize these political risks. Democratic institutions can be a mechanism by which to decrease these politi- cal risks.Democratic governments have been found to be more credible in making agreements in the international arena.26 Explanations for this range from the insti- tutional checks and balances within democratic systems to the "audience costs"gen- erated by elected leaders.Logically following from this large literature,democratic governments may also be more credible in their direct dealings with multinationals. One specific mechanism that leads democratic governments to higher levels of credibility is based on the number of veto players in a democratic political sys- tem.George Tsebelis argues that the existence of these veto players can increase policy stability.These veto players can include chambers of the legislature,a su- preme court,separation of the executive and legislative branches of government, or federal actors.27 Henisz argues that foreign firms change their entrance strat- egies into domestic markets conditional on the number of veto players.28 Demo- cratic governments have these institutional constraints in place,which may help 23.Bruce Russett pioneered a large part of the literature on the democratic peace.See Russett and Oneal 2001 for a review of the literature and a number of relevant empirical tests.Perhaps most rele- vant for this study,Russett and Oneal 2001,chap.6 find that democracies are more likely to trade with other democracies. 24.Vernon 1971 25.This is often referred to as"creeping expropriation." 26.See Cowhey 1993;Fearon 1994;Gaubatz 1996;McGillivray and Smith 1998;and Leeds 1999. 27.Tsebelis 1995. 28.Henisz 2000
sons to prefer investing in democracies+ 23 If democratic political institutions allow higher levels of cooperation between states, they may also allow for higher levels of cooperation between states and multinational corporations+ In this article I highlight two mechanisms through which democratic institutions could attract higher levels of FDI inflows+ The main advantage of democratic institutions to multinational investors is credibility+ FDI, while mobile ex ante, is relatively illiquid ex post+ 24 Once foreign capital is invested in a country, the firm is subject to policy change or reversal by the central government+ Once multinational investments have been made, there are considerable political risks in the investment+ These political risks come in a number of forms+ The most obvious political risks, nationalization and expropriation, involve the loss of ownership by multinationals of their investments—but are now relatively uncommon+ Even with the decreasing incidences of nationalization, multinationals still face considerable political risks in terms of the expropriation of revenue streams+ 25 Governments can renegotiate tax rates, depreciations schedules, tariff rates, and a host of other policies that directly affect multinational operations+ Other indirect factors, such as the imposing of capital controls, devaluations, or other macroeconomic decisions not targeted specifically at multinational firms, but affecting the profitability of the investment, are also important+ Multinational corporations are attracted to governments that can help minimize these political risks+ Democratic institutions can be a mechanism by which to decrease these political risks+ Democratic governments have been found to be more credible in making agreements in the international arena+ 26 Explanations for this range from the institutional checks and balances within democratic systems to the “audience costs” generated by elected leaders+ Logically following from this large literature, democratic governments may also be more credible in their direct dealings with multinationals+ One specific mechanism that leads democratic governments to higher levels of credibility is based on the number of veto players in a democratic political system+ George Tsebelis argues that the existence of these veto players can increase policy stability+ These veto players can include chambers of the legislature, a supreme court, separation of the executive and legislative branches of government, or federal actors+ 27 Henisz argues that foreign firms change their entrance strategies into domestic markets conditional on the number of veto players+ 28 Democratic governments have these institutional constraints in place, which may help 23+ Bruce Russett pioneered a large part of the literature on the democratic peace+ See Russett and Oneal 2001 for a review of the literature and a number of relevant empirical tests+ Perhaps most relevant for this study, Russett and Oneal 2001, chap+ 6 find that democracies are more likely to trade with other democracies+ 24+ Vernon 1971+ 25+ This is often referred to as “creeping expropriation+” 26+ See Cowhey 1993; Fearon 1994; Gaubatz 1996; McGillivray and Smith 1998; and Leeds 1999+ 27+ Tsebelis 1995+ 28+ Henisz 2000+ 594 International Organization
The Political Economy of FDI 595 ensure their credibility by making the possibility of policy reversal more difficult. Multinationals that enter foreign markets can be reasonably confident that the gov- ernment policies in place when the firm entered the country will continue over time. A second potential reason for the credibility of democratic systems,more strongly supported than the veto player argument,can be found in the audience cost liter- ature.While the veto players in a political system generate higher levels of policy stability,an even more important component of credibility is a government's com- mitment to market friendly policies in the future.International relations theories find that democratic leaders are held accountable for their actions,including re- neging on a promise or threat.These audience costs can also be important for multinational investors.If governments make agreements with multinational firms and renege on the contracts after the investment has been made,democratic lead- ers may suffer electoral costs.The potential for these electoral backlashes may constrain democratic leaders. In a recent article,McGillivray and Smith argue that political leaders play an "Agent Specific Grimm Trigger Strategy,"in which political leaders in one coun- try refuse to cooperate with other political leaders that have"defected"in the past.9 Multinationals can also play this strategy with governments that institute legisla- tion or reverse policy in ways that negatively affect multinational corporations. Essentially,firms can hold individual leaders politically accountable for policy, and refuse to cooperate (invest)in the future.In democracies,citizens have the incentive and the opportunity to replace leaders with tarnished reputations through electoral mechanisms.Thus the leadership turnover in democratic systems (or the potential for leadership turnover)can be associated with more market-friendly pol- icies for multinationals. This argument on the role of leadership turnover in ensuring more market- friendly policies obviously ignores the potential political benefits of expropriation for leaders.In both democratic and authoritarian countries,there may be some immediate benefits to "expropriation."30 Political leaders may use the assets or income streams from policy changes to essentially "buy off"key support groups. My argument is that this holds for both authoritarian and democratic systems.In both types of regime,political leaders have a key support group,the"selectorate," that must be appeased for political survival.31 There is little reason to believe that democratic regimes are more likely to expropriate than authoritarian regimes. This complex interplay between individual political leaders and international capital markets permeates domestic politics in many countries.The relationship 29.McGillivray and Smith 2000. 30.For an interesting discussion of expropriation,see Thomas and Worrall 1994. 31.See Bueno de Mesquita et al.1999.The most logical extension of their theory would be that expropriation would be more likely in systems with smaller selectorates (authoritarian regimes).In systems with large selectorates (democracies)political leaders would have to spread the benefits of expropriation over a larger percentage of the citizenry,a making expropriation a less viable option
ensure their credibility by making the possibility of policy reversal more difficult+ Multinationals that enter foreign markets can be reasonably confident that the government policies in place when the firm entered the country will continue over time+ A second potential reason for the credibility of democratic systems, more strongly supported than the veto player argument, can be found in the audience cost literature+ While the veto players in a political system generate higher levels of policy stability, an even more important component of credibility is a government’s commitment to market friendly policies in the future+ International relations theories find that democratic leaders are held accountable for their actions, including reneging on a promise or threat+ These audience costs can also be important for multinational investors+ If governments make agreements with multinational firms and renege on the contracts after the investment has been made, democratic leaders may suffer electoral costs+ The potential for these electoral backlashes may constrain democratic leaders+ In a recent article, McGillivray and Smith argue that political leaders play an “Agent Specific Grimm Trigger Strategy,” in which political leaders in one country refuse to cooperate with other political leaders that have “defected” in the past+ 29 Multinationals can also play this strategy with governments that institute legislation or reverse policy in ways that negatively affect multinational corporations+ Essentially, firms can hold individual leaders politically accountable for policy, and refuse to cooperate ~invest! in the future+ In democracies, citizens have the incentive and the opportunity to replace leaders with tarnished reputations through electoral mechanisms+ Thus the leadership turnover in democratic systems ~or the potential for leadership turnover! can be associated with more market-friendly policies for multinationals+ This argument on the role of leadership turnover in ensuring more marketfriendly policies obviously ignores the potential political benefits of expropriation for leaders+ In both democratic and authoritarian countries, there may be some immediate benefits to “expropriation+”30 Political leaders may use the assets or income streams from policy changes to essentially “buy off” key support groups+ My argument is that this holds for both authoritarian and democratic systems+ In both types of regime, political leaders have a key support group, the “selectorate,” that must be appeased for political survival+ 31 There is little reason to believe that democratic regimes are more likely to expropriate than authoritarian regimes+ This complex interplay between individual political leaders and international capital markets permeates domestic politics in many countries+ The relationship 29+ McGillivray and Smith 2000+ 30+ For an interesting discussion of expropriation, see Thomas and Worrall 1994+ 31+ See Bueno de Mesquita et al+ 1999+ The most logical extension of their theory would be that expropriation would be more likely in systems with smaller selectorates ~authoritarian regimes!+ In systems with large selectorates ~democracies! political leaders would have to spread the benefits of expropriation over a larger percentage of the citizenry, a making expropriation a less viable option+ The Political Economy of FDI 595
596 International Organization between Brazilian presidential candidate Luiz Inacio da Silva and the Brazilian stock and bond markets is just one of many illustrative examples.After the an- nouncement that da Silva and his left-wing Workers'Party had overtaken Presi- dent Cardoso for the lead in the 2002 presidential elections,stock and bond markets tumbled.Cardoso stressed that voting da Silva into power would ruin Brazil's im- age in the eyes of the international financial community.To calm international markets,da Silva made pledges to the international community on his future pol- icies,making assurances that his policies would be market-friendly.This is just one of many examples of the effects of international capital markets both on do- mestic politics and on individual politicians'electoral fortunes.The big question is if elections,or democratic institutions generally,constrain political leaders. This complex relationship,given the potential costs and benefits of democratic institutions to multinationals,calls for a serious empirical study to discover the aggregate relationship between political regimes and domestic governments.Un- fortunately,few empirical studies have examined the relationship between demo- cratic political institutions and FDI flows.The empirical work that directly explores this issue,while thin,finds either that FDI flows are not responsive to political regimes or that democratic political institutions are associated with lower levels of FDI inflows.32 These studies suffer from serious empirical flaws that I examine more closely in the empirical section of this article. The next section of this article first examines if there is a general positive rela- tionship between democratic governments and higher levels of FDI inflows.The seventh section comes back to the issue of credibility and examines the effects of democratic institutions on country sovereign debt ratings.My empirical results show that democratic systems are associated with higher country credit ratings. Empirical Tests-Overview In this article I explore the relationship between FDI and democracy in four sets of empirical tests.The first set of tests estimates the effects of democratic institu- tions on FDI inflows in a cross-section of countries in the 1990s.These tests ex- amine the general relationship and the robustness of the findings on the effects of democracy on FDI inflows.The second set tests the relationship by using a time- series cross-sectional analysis of more than 100 countries for almost thirty years.33 The third set of empirical tests employs a Heckman selection model to further examine the robustness of the relationship.The final set examines the causal mech- anism linking democracy and FDI by examining the effects of democratic institu- 32.See Oneal 1994;Alesina and Dollar 1998;and Jessup 1999. 33.For presentational reasons I only include the fixed-effects results.All results are the same in both the random and fixed-effects regressions unless noted
between Brazilian presidential candidate Luiz Inácio da Silva and the Brazilian stock and bond markets is just one of many illustrative examples+ After the announcement that da Silva and his left-wing Workers’ Party had overtaken President Cardoso for the lead in the 2002 presidential elections, stock and bond markets tumbled+ Cardoso stressed that voting da Silva into power would ruin Brazil’s image in the eyes of the international financial community+ To calm international markets, da Silva made pledges to the international community on his future policies, making assurances that his policies would be market-friendly+ This is just one of many examples of the effects of international capital markets both on domestic politics and on individual politicians’ electoral fortunes+ The big question is if elections, or democratic institutions generally, constrain political leaders+ This complex relationship, given the potential costs and benefits of democratic institutions to multinationals, calls for a serious empirical study to discover the aggregate relationship between political regimes and domestic governments+ Unfortunately, few empirical studies have examined the relationship between democratic political institutions and FDI flows+ The empirical work that directly explores this issue, while thin, finds either that FDI flows are not responsive to political regimes or that democratic political institutions are associated with lower levels of FDI inflows+ 32 These studies suffer from serious empirical flaws that I examine more closely in the empirical section of this article+ The next section of this article first examines if there is a general positive relationship between democratic governments and higher levels of FDI inflows+ The seventh section comes back to the issue of credibility and examines the effects of democratic institutions on country sovereign debt ratings+ My empirical results show that democratic systems are associated with higher country credit ratings+ Empirical Tests—Overview In this article I explore the relationship between FDI and democracy in four sets of empirical tests+ The first set of tests estimates the effects of democratic institutions on FDI inflows in a cross-section of countries in the 1990s+ These tests examine the general relationship and the robustness of the findings on the effects of democracy on FDI inflows+ The second set tests the relationship by using a timeseries cross-sectional analysis of more than 100 countries for almost thirty years+ 33 The third set of empirical tests employs a Heckman selection model to further examine the robustness of the relationship+ The final set examines the causal mechanism linking democracy and FDI by examining the effects of democratic institu- 32+ See Oneal 1994; Alesina and Dollar 1998; and Jessup 1999+ 33+ For presentational reasons I only include the fixed-effects results+ All results are the same in both the random and fixed-effects regressions unless noted+ 596 International Organization
