Foreign Direct Investment, Financial Development and Political Risks

By Dutta, Nabamita; Roy, Sanjukta | The Journal of Developing Areas, Spring 2011 | Go to article overview

Foreign Direct Investment, Financial Development and Political Risks


Dutta, Nabamita, Roy, Sanjukta, The Journal of Developing Areas


ABSTRACT

Financial development is definitely a determinant of the extent of foreign direct investment (FDI) inflow into an economy. Yet, the contribution of financial development (FD) can be dependent on the political situation of the recipient nation. Higher political stability aids financial institutions to reap the benefits of FDI efficiently. Our paper empirically investigates the role of political risk in the association of FDI and FD. Using a panel of 97 countries, we show the relationship to be strictly non-linear. The impact of FD on FDI becomes negative beyond a threshold level of FD. However, we do find political risk factors to be affecting the relationship by altering the threshold level of financial development.

JEL Classifications: C23; F23; O16

Keywords: Foreign Direct Investment, Financial Development, Political Risks.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Financial Development is an integral component of the growth process of an economy. According to Beck, Demirguc-Kunt and Levine (2000), financial development indicators measure the size, activity and efficiency of financial intermediaries and markets. The indispensable role of financial system has been accepted by economists like Schumpeter (1934), Hick (1969) and McKinnon (1973). In Schumpeter's words, "The banker... is not so much primarily a middleman in the commodity "purchasing power? as a producer of this commodity...He stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development, though only when no central authority directs the social process. He makes possible the carrying out of new combinations, authorizes people, in the name of society as it were, to form them. He is the ephor [overseer] of the exchange economy."(Schumpeter, 1934, p174). King and Levine (1993a, 1993b, 1993c) and Levine (1997) re-established the importance of efficient financial markets during recent times. Apart from having a first order impact on growth, financial development also affect other aspects of economic development. Financial development can make foreign aid work better for aid recipient countries (Nkusu and Sayek, 2004). Further, Beck (2002) has proved that countries with an effective financial sector have a comparative advantage in manufacturing industries. An agreed view of the functions of financial development identify the following functions - channelizing resources efficiently, mobilizing savings, reducing information asymmetry problem, facilitating trading, hedging, pooling and diversification of risk, aiding the exchange of goods and services and monitoring managers by exerting corporate control.

We revisit the links between financial development and foreign direct investment (FDI). Previous literature has already explored the connection in the context of growth (Hermes and Lensink, 2003). Another strand of literature has attributed the uneven distribution of financial development to the political stability of the respective nations (Roe and Siegel, 2007). They argue that political stability is crucial for a nation since it helps build institutions such as investor protection which, in turn, aids the financial sector. Hess (2004) argues that firms are willing to invest in nations which experience political stability. Yet, no literature has explored the interlinkage among political risks, FDI and FD. The main contribution of the paper is to investigate the role political stability plays in enhancing the relationship shared by FDI and FD.

Is it sufficient for a country to have competent financial markets to lure foreign capital? We argue that a stable political scenario is critical to attract FDI even in the presence of an efficient financial sector. Using a panel of 97 countries over a period of 20 years, the results establish a non-linear association between financial development and FDI inflows. Financial Development leads to greater FDI inflows up to a certain level of financial development. …

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