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