Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Barriers to Foreign Direct Investment under Political Instability

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Barriers to Foreign Direct Investment under Political Instability

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Foreign direct investment (FDI), as pointed out by Kindleberger (1969), arises when the host country has an investment opportunity that it cannot exploit by itself because it lacks the means or technical know-how, or because of market incompleteness (that is, access to capital markets is re-stricted). A multinational corporation (MNC) may be able to exploit such an opportunity because it has the necessary capital, technology, and managerial skills to do so. Even though the return to foreign direct investment is potentially large in many developing countries (for example, the opening up of Eastern Europe provided advantages to multinational firms because of the low cost of labor, low levels of capital in place, and the proximity to major markets), the flow of direct investment is concentrated in just a few countries. 1 Lucas (1990) attributes this lack of FDI in countries with potentially large marginal returns to capital to the fact that many developing countries face higher political risk than industrialized ones.

A distinctive characteristic of FDI is that once an investment has been made, a foreign investor cannot prevent the government in the host country from changing the environment in which the investment decision was made. Despite attempts to establish international tribunals, contracts between multinational corporations (MNCs) and sovereign countries are almost impossible to enforce. The quality of institutions, and in particular, the degree of protection of property rights, are key in determining the expected return to foreign investors. Countries with relatively poor legal protection of assets, and a high degree of political instability, generally exhibit high rates of expropriation and this makes investment less attractive. In practice, expropriation can take different forms. A direct act of expropriation involves nationalization of foreign-owned corporations, in which the government simply takes control of the capital stock (Kobrin 1980, 1984). There are also indirect forms of expropriation that multinational corporations face. Examples include excessive taxation, capital controls, manipulation of exchange rates, and bribes and permits demanded by government officials.

In this article, wedescribe some stylized facts about expropriation episodes and other lessons learned from the empirical literature on FDI.We then summarize some of the main theories attempting to explain the effects of expropriation on investment and growth. Finally, we develop a theory that relates each type of expropriation to political instability and concentration of power.

A simple two-period political economy model is presented in which groups with access to an expropriation technology alternate in power according to an exogenous probability. The group that controls the government in the first period has the ability to obtain bribes from foreign investors who are attempting to gain access to production in the host country. This form of indirect expropriation is analogous to an investment tax, in the sense that it distorts the optimal allocation of international capital by imposing additional costs to potential investors. After investment decisions have been made (in the second period), the group in office decides how much capital should be seized or nationalized, a direct form of expropriation.

Following the literature on FDI, we will assume that any capital expropriated by the host country becomes unproductive. This stylized representation tries to characterize the empirical observation that MNCs are usually more efficient in running production than the host country. For example, Minor (1994) documents that about 35 percent of all enterprises that were expropriated between 1960 and 1979 have been privatized between 1980 and 1992, indicating public "disillusion with the typical result of expropriation, the state-owned enterprise" (see Biais and Perotti 2002 for more on recent trends on privatizations). …

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