American Political Science Review Vol.104.No.3 August 2010 doi:10.1017/S0003055410000201 Familiarity Breeds Investment: Diaspora Networks and International Investment DAVID LEBLANG University of Virginia That explains cross-national patterns of international portfolio and foreign direct investment (FDI)?While existing explanations focus on the credibility of a policy maker's commitment,we emphasize the role of diaspora networks.We hypothesize that diaspora networks-connections between migrants residing in investing countries and their home country-influence global investment by reducing transaction and information costs.This hypothesis is tested using dyadic cross-sectional data for both portfolio and FDI.The findings indicate that even after controlling for a multitude of factors, disapora networks have both a substantively significant effect and a statistically significant effect on cross-border investment. igration is an increasingly important facet and Prskawetz 1998).There is growing evidence that of the global political economy.Like flows emigres do benefit their homeland:return migration of commodities and capital,flows of labor constitutes a flow of knowledge of skills.and remit- have increased dramatically in recent years.The United tances provide enormous flows of capital. Nations'(UN's)Population Division put the share of In this article,we add another layer to the liter- the world's population residing outside their nation of ature on global migration by arguing that diaspora birth at almost 200 million people-or approximately networks-cultural and/or familial linkages between 3%of the world's population-in 2007.That number migrant communities in the investing country and the continues to grow:the Organisation for Economic Co- migrant's country of origin-play a pivotal role in operation and Development (OECD;2006)estimates the global allocation of capital.We provide some of that the number of legal immigrants entering OECD the first quantitative evidence that diaspora networks countries stands at about 3 million annually.Just as act as a conduit for both portfolio and foreign di- with flows of commodities and capital,scholars have rect investment (FDI)across country pairs.A focus devoted enormous energies to the exploration of the on diasporas-an explicitly cross-border phenomena- consequences of immigration.We know that migration also provides a fresh perspective on the factors influ- is associated with a rise in support for extreme right encing international investment.The existing literature wing parties and that it has mixed effects on social on investment is primarily monadic,emphasizing the spending and on wages in the destination country (e.g., importance of credible commitments and institutional Borjas 1999;Borjas,Freeman,and Katz 1996;Knigge quality in the countries that seek global capital(e.g., 1998). Alfaro,Kelemli-Ozcan,and Volosovych 2006;Buthe Less is known,however,about the consequences of and Milner 2008:Jensen 2003). migration for the migrant's country of origin.Some We do not question the importance of credible com- scholars argue that migration results in a"brain drain," mitments.However,focusing on institutional design whereby educated and skilled members of a country only gets us part of the way toward understanding pat- leave in search of better wages.Others argue that this terns of international investment.Because diasporas brain drain is offset because the prospect of leaving provide connections between home and host countries. provides an incentive for those left behind to invest these networks facilitate cross-border investment in in their own human capital(e.g.,Stark,Helmenstein, numerous ways.Broadly speaking,migrant networks foster a greater degree of familiarity between home and host countries than may occur in their absence.Just as David Leblang is J.Wilson Newman Professor of Governance. Department of Politics,University of Virginia,P.O.Box 400787, migrants may have a taste for commodities produced Charlottesville,VA 22904 (leblang@virginia.edu). in their home country,they may also have a preference This article originally circulated under the title "Diaspora Bonds for home country investments-leading them to invest and Cross-Border Capital."I am grateful to Zane Kelly and Jessica money in their country of origin.Diaspora networks Teets for outstanding research assistance.Lee Alston,Ben Ansell, Andy Baker.Bernd Beber.William Bernhard.David Brown,Tim can also help decrease asymmetries of information Buithe,Steve Chan,Rafaela Dancygier,Jennifer Fitzgerald,John that,from the perspective of the theory of portfolio Freeman,Daniel Gingerich,Jude Hays,Nathan Jensen,Joseph investment.can result in a less than optimal portfo- Jupille,Moonhawk Kim.Robert McKnown.Sonal Pandya.Tom lio.The reduction in information asymmetries works Pepinsky,Andy Rose,Idean Salehyan,Kathryn Sikkink.David Singer,Andy Sobel,Enrico Spolaore,Michael Tomz,Romain through two channels.First,migrant communities in Wacziarg,and Jennifer Wolak provided helpful comments and/or destination countries can provide investors with infor- generously shared their data.I am also grateful to Roger,Keith,Pete, mation about their homeland-information regarding and John for helping me get through extensive revisions.Replication the tastes of consumers in their country of origin- materials are available at http://journals.cambridge.org/psr2010008 that can influence the decision of investors to invest The research was funded in part by a developmental grant from the National Institute of Child Health and Human Development there.Second,diaspora networks can have an indirect (NICHD)-funded University of Colorado Population Center(grant effect on investment because they may have knowl- R1HD51146). edge about investment opportunities,information 584
American Political Science Review Vol. 104, No. 3 August 2010 doi:10.1017/S0003055410000201 Familiarity Breeds Investment: Diaspora Networks and International Investment DAVID LEBLANG University of Virginia What explains cross-national patterns of international portfolio and foreign direct investment (FDI)? While existing explanations focus on the credibility of a policy maker’s commitment, we emphasize the role of diaspora networks. We hypothesize that diaspora networks—connections between migrants residing in investing countries and their home country—influence global investment by reducing transaction and information costs. This hypothesis is tested using dyadic cross-sectional data for both portfolio and FDI. The findings indicate that even after controlling for a multitude of factors, disapora networks have both a substantively significant effect and a statistically significant effect on cross-border investment. Migration is an increasingly important facet of the global political economy. Like flows of commodities and capital, flows of labor have increased dramatically in recent years. The United Nations’ (UN’s) Population Division put the share of the world’s population residing outside their nation of birth at almost 200 million people—or approximately 3% of the world’s population—in 2007. That number continues to grow: the Organisation for Economic Cooperation and Development (OECD; 2006) estimates that the number of legal immigrants entering OECD countries stands at about 3 million annually. Just as with flows of commodities and capital, scholars have devoted enormous energies to the exploration of the consequences of immigration. We know that migration is associated with a rise in support for extreme right wing parties and that it has mixed effects on social spending and on wages in the destination country (e.g., Borjas 1999; Borjas, Freeman, and Katz 1996; Knigge 1998). Less is known, however, about the consequences of migration for the migrant’s country of origin. Some scholars argue that migration results in a “brain drain,” whereby educated and skilled members of a country leave in search of better wages. Others argue that this brain drain is offset because the prospect of leaving provides an incentive for those left behind to invest in their own human capital (e.g., Stark, Helmenstein, David Leblang is J. Wilson Newman Professor of Governance, Department of Politics, University of Virginia, P.O. Box 400787, Charlottesville, VA 22904 (leblang@virginia.edu). This article originally circulated under the title “Diaspora Bonds and Cross-Border Capital.” I am grateful to Zane Kelly and Jessica Teets for outstanding research assistance. Lee Alston, Ben Ansell, Andy Baker, Bernd Beber, William Bernhard, David Brown, Tim Buthe, Steve Chan, Rafaela Dancygier, Jennifer Fitzgerald, John ¨ Freeman, Daniel Gingerich, Jude Hays, Nathan Jensen, Joseph Jupille, Moonhawk Kim, Robert McKnown, Sonal Pandya, Tom Pepinsky, Andy Rose, Idean Salehyan, Kathryn Sikkink, David Singer, Andy Sobel, Enrico Spolaore, Michael Tomz, Romain Wacziarg, and Jennifer Wolak provided helpful comments and/or generously shared their data. I am also grateful to Roger, Keith, Pete, and John for helping me get through extensive revisions. Replication materials are available at http://journals.cambridge.org/psr2010008. The research was funded in part by a developmental grant from the National Institute of Child Health and Human Development (NICHD)–funded University of Colorado Population Center (grant R1 HD51146). and Prskawetz 1998). There is growing evidence that emigr ´ es do benefit their homeland: return migration ´ constitutes a flow of knowledge of skills, and remittances provide enormous flows of capital. In this article, we add another layer to the literature on global migration by arguing that diaspora networks—cultural and/or familial linkages between migrant communities in the investing country and the migrant’s country of origin—play a pivotal role in the global allocation of capital. We provide some of the first quantitative evidence that diaspora networks act as a conduit for both portfolio and foreign direct investment (FDI) across country pairs. A focus on diasporas—an explicitly cross-border phenomena— also provides a fresh perspective on the factors influencing international investment. The existing literature on investment is primarily monadic, emphasizing the importance of credible commitments and institutional quality in the countries that seek global capital (e.g., Alfaro, Kelemli-Ozcan, and Volosovych 2006; Buthe ¨ and Milner 2008; Jensen 2003). We do not question the importance of credible commitments. However, focusing on institutional design only gets us part of the way toward understanding patterns of international investment. Because diasporas provide connections between home and host countries, these networks facilitate cross-border investment in numerous ways. Broadly speaking, migrant networks foster a greater degree of familiarity between home and host countries than may occur in their absence. Just as migrants may have a taste for commodities produced in their home country, they may also have a preference for home country investments—leading them to invest money in their country of origin. Diaspora networks can also help decrease asymmetries of information that, from the perspective of the theory of portfolio investment, can result in a less than optimal portfolio. The reduction in information asymmetries works through two channels. First, migrant communities in destination countries can provide investors with information about their homeland—information regarding the tastes of consumers in their country of origin— that can influence the decision of investors to invest there. Second, diaspora networks can have an indirect effect on investment because they may have knowledge about investment opportunities, information 584
American Political Science Review Vol.104.No.3 about regulations and procedures,or familiarity with asset pricing model.The standard international cap- language and customs that can decrease the transaction ital asset pricing model(ICAPM)predicts that in the costs associated with cross-border investment. absence of information asymmetries and transactions We test our argument using a dyadic data set com- costs.investors should hold domestic assets in their posed of both portfolio and FDI from as many as 56 portfolio in proportion to their country's share of source countries into up to 154 destination countries global capital market capitalization.2 However con- for the year 2002.The use of portfolio and FDI al- vincing in theory,overwhelming empirical evidence lows us to be more general about the implications demonstrates that investor behavior deviates consid- of our findings as these investment types are funda- erably from this benchmark model.The empirical find- mentally different.While portfolio investors purchase ing that investors forgo substantial gains by investing stocks and bonds in open markets,foreign direct in- at home rather than abroad has spawned a huge lit- vestors purchase fixed shares in plants or in machinery. erature trying to explain this "home bias,"a systemic More important,within a country,portfolio investment preference for assets that are available in their home opportunities are constrained by the shares issued by market (e.g.,Lewis 1999). corporate or government entities,whereas FDI possi- What does the literature say about the lack of inter- bilities are unbounded in both their content and their national diversification?In early work on the "home ownership stake. bias,"French and Poterba(1991)argue that investors Giving pride of place to migrant networks in ex- purchase domestic assets as a consequence of what they plaining the cross-national allocation of capital al- call"familiarity"effects.Tesar and Werner (1995)are a lows us to speak to a number of seemingly disparate bit more specific when they attribute the taste for home literatures.Broadly speaking,the emphasis on dias- rather than foreign assets to factors such as"language pora networks as a conduit for capital flows is a nat- [and]institutional and regulator difference"(p.479).In ural extension of Keohane and Nye's (1974)work addition to taste.Coval and Moskowitz(2001)attribute on transnational-or nongovernmental-relations be- the home bias to asymmetries of information and argue tween states.Although other scholarship from inter- that investors have better information about assets sold national relations fits within the category of transna- in geographically closer markets.3 tionalism,it tends to focus on nongovernmental or In a cross-national context,it is difficult to separate intergovernmental organizations (e.g.,Keck and familiarity and cultural preferences for home products Sikkink 1998:Slaughter 2004).Emphasizing the role from informational asymmetries.To minimize prob- of migrant networks in cross-national investment pro- lems of model misspecification associated with omitted vides another mechanism-this one noninstitutional- variable bias,empirical studies of cross-border invest- by which we can understand the growing degree of ment tend to exploit gravity-type models of interna- interdependence that exists within the international tional transactions.Drawn from gravity models of in- system.From the perspective of international relations ternational trade,which in turn are (loosely)derived theory,our emphasis on migrant communities influ- from Newton's Law of Gravity,these models hold that encing their homelands allows us to speak to the grow- bilateral transactions are a positive function of the size ing interest in diaspora politics (e.g.,Shain and Barth of the two economies(their mass)and a negative func- 2003;Sheffer 2003).By privileging human networks,we tion of the distance between them.In dealing with the highlight the importance of mechanisms other than for- empirical fact that investors exhibit a home bias,schol- mal institutions for channeling economic activity(e.g., ars"augment"these gravity models with a variety of Greif1989.1993). variables.Eichengreen and Luengnaruemitchai (2006), Our arguments and evidence are developed in this Lane and Milesi-Ferretti(2004),and Rose and Spiegel article.The first section contains our theoretical dis- (2008),for example,include variables that measure cussion and embeds our argument within the context whether the country pair shares a common language,a of international asset pricing theory.The next section common border,or a common colonial heritage.These lays out the empirical model and details the statisti- cal methodology we use.In the following section,we present our central statistical results and document the We reference much of this literature in what follows.For overviews, robustness of those findings.The last section concludes see Lane and Milesi-Ferretti (2004),Lewis (1999).Portes and Rey and offers suggestions for future research. (2005).and Sarkissian and Schill (2004). 2 See Lane (2005)and Lane and Milesi-Ferretti (2004)for studies of bilateral investment that are explicitly derived from the ICAPM Elton et al.(2003)provide a textbook exposition of the capital asset pricing model. Grinblatt and Keloharju(2001),Huberman(2001),and Portes and DIASPORA NETWORKS AND INVESTMENT Rey (2005)also find that investors tend to purchase assets sold in [more proximate markets.These articles attribute this behavior to Modeling Bilateral Investment the idea that investors have better(less asymmetric)information as distance between markets decreases.Coval and Moskowitz (1999, Our argument is that migrant networks are a mech- 2001)attempt to distinguish between familiarity and information anism helping direct portfolio and FDI from the mi- asymmetries.Their 1999 study documents that investors prefer to grant's host country to their country of origin.We invest in the "familiar,"whereas their 2001 article provides some evidence in favor of the information asymmetry hypothesis.It is situate our argument within the international finance worth noting that their earlier article does not distinguish between literature and ground it in the international capital the two explanations. 585
American Political Science Review Vol. 104, No. 3 about regulations and procedures, or familiarity with language and customs that can decrease the transaction costs associated with cross-border investment. We test our argument using a dyadic data set composed of both portfolio and FDI from as many as 56 source countries into up to 154 destination countries for the year 2002. The use of portfolio and FDI allows us to be more general about the implications of our findings as these investment types are fundamentally different. While portfolio investors purchase stocks and bonds in open markets, foreign direct investors purchase fixed shares in plants or in machinery. More important, within a country, portfolio investment opportunities are constrained by the shares issued by corporate or government entities, whereas FDI possibilities are unbounded in both their content and their ownership stake. Giving pride of place to migrant networks in explaining the cross-national allocation of capital allows us to speak to a number of seemingly disparate literatures. Broadly speaking, the emphasis on diaspora networks as a conduit for capital flows is a natural extension of Keohane and Nye’s (1974) work on transnational—or nongovernmental—relations between states. Although other scholarship from international relations fits within the category of transnationalism, it tends to focus on nongovernmental or intergovernmental organizations (e.g., Keck and Sikkink 1998; Slaughter 2004). Emphasizing the role of migrant networks in cross-national investment provides another mechanism—this one noninstitutional— by which we can understand the growing degree of interdependence that exists within the international system. From the perspective of international relations theory, our emphasis on migrant communities influencing their homelands allows us to speak to the growing interest in diaspora politics (e.g., Shain and Barth 2003; Sheffer 2003). By privileging human networks, we highlight the importance of mechanisms other than formal institutions for channeling economic activity (e.g., Greif 1989, 1993). Our arguments and evidence are developed in this article. The first section contains our theoretical discussion and embeds our argument within the context of international asset pricing theory. The next section lays out the empirical model and details the statistical methodology we use. In the following section, we present our central statistical results and document the robustness of those findings. The last section concludes and offers suggestions for future research. DIASPORA NETWORKS AND INVESTMENT Modeling Bilateral Investment Our argument is that migrant networks are a mechanism helping direct portfolio and FDI from the migrant’s host country to their country of origin. We situate our argument within the international finance literature and ground it in the international capital asset pricing model.1 The standard international capital asset pricing model (ICAPM) predicts that in the absence of information asymmetries and transactions costs, investors should hold domestic assets in their portfolio in proportion to their country’s share of global capital market capitalization.2 However convincing in theory, overwhelming empirical evidence demonstrates that investor behavior deviates considerably from this benchmark model. The empirical finding that investors forgo substantial gains by investing at home rather than abroad has spawned a huge literature trying to explain this “home bias,” a systemic preference for assets that are available in their home market (e.g., Lewis 1999). What does the literature say about the lack of international diversification? In early work on the “home bias,” French and Poterba (1991) argue that investors purchase domestic assets as a consequence of what they call “familiarity” effects. Tesar and Werner (1995) are a bit more specific when they attribute the taste for home rather than foreign assets to factors such as “language [and] institutional and regulator difference” (p. 479). In addition to taste, Coval and Moskowitz (2001) attribute the home bias to asymmetries of information and argue that investors have better information about assets sold in geographically closer markets.3 In a cross-national context, it is difficult to separate familiarity and cultural preferences for home products from informational asymmetries. To minimize problems of model misspecification associated with omitted variable bias, empirical studies of cross-border investment tend to exploit gravity-type models of international transactions. Drawn from gravity models of international trade, which in turn are (loosely) derived from Newton’s Law of Gravity, these models hold that bilateral transactions are a positive function of the size of the two economies (their mass) and a negative function of the distance between them. In dealing with the empirical fact that investors exhibit a home bias, scholars “augment” these gravity models with a variety of variables. Eichengreen and Luengnaruemitchai (2006), Lane and Milesi-Ferretti (2004), and Rose and Spiegel (2008), for example, include variables that measure whether the country pair shares a common language, a common border, or a common colonial heritage. These 1 We reference much of this literature in what follows. For overviews, see Lane and Milesi-Ferretti (2004), Lewis (1999), Portes and Rey (2005), and Sarkissian and Schill (2004). 2 See Lane (2005) and Lane and Milesi-Ferretti (2004) for studies of bilateral investment that are explicitly derived from the ICAPM. Elton et al. (2003) provide a textbook exposition of the capital asset pricing model. 3 Grinblatt and Keloharju (2001), Huberman (2001), and Portes and Rey (2005) also find that investors tend to purchase assets sold in [more] proximate markets. These articles attribute this behavior to the idea that investors have better (less asymmetric) information as distance between markets decreases. Coval and Moskowitz (1999, 2001) attempt to distinguish between familiarity and information asymmetries. Their 1999 study documents that investors prefer to invest in the “familiar,” whereas their 2001 article provides some evidence in favor of the information asymmetry hypothesis. It is worth noting that their earlier article does not distinguish between the two explanations. 585
Familiarity Breeds Investment August 2010 measures of commonality are then interpreted in the constraints imposed by information asymmetries and context of greater familiarity,better information,lower transactions costs.6 barriers to entry,and smaller transactions costs. Before discussing the role of familiarity and informa- Scholars also interpret negative coefficients on the tion asymmetries,we note that migrant networks can (log of)distance in gravity models of international have a direct and observable impact on cross-border investment as a proxy for information asymmetries investment when they,themselves.are the actors.In his The greater the distance from a market,so the argu- study of the Korean diaspora,for example,Choi(2003) ment goes,the greater the information cost and the documents how FDI into Korea-a form of investment lower the level of investment.Arguing that distance that came late to that country-was originally spurred proxies for information costs,however,is theoretically by ethnic Koreans residing in Japan.Migrant-based unsatisfying,and,in a series of articles,Portes and Rey investment also comes from nonwealthy expatriates. (2005;Portes,Rey,and Oh 2001)employ a more direct Schuttler(2007)and Schulte(2008)study,respectively, measure of information asymmetries and transactions the investment behavior of Moroccan and Turkish mi- costs by including a measure of bilateral telephone traf- grants living in Germany.Using ethnographic and sur- fic.They find that telephone traffic is associated with vey research,both scholars conclude that diaspora in- higher levels of bilateral portfolio investment.+ vestors are well-situated investment in their homeland These approaches remain incomplete.Even mod- because of cultural and linguistic familiarity.There are els that include measures of communication flows and larger literatures that make similar points about the communication costs find that investors retain a home ways in which migrant entrepreneurs have used home bias (e.g.,Loungani,Mody,and Razin 2002).Taking country connections to channel human,physical,and this as their point of departure,a growing literature ar- investment capital.9 gues that investment across country may be driven not Cross-national models of home country investment by familiarity,but rather by"cultural affinity,"whereby are difficult to test in the aggregate because even if individuals have more trust in individuals and institu- we surveyed investors it would be surprising if they tions from countries that share common cultural char- would admit to making bad investments or to being acteristics (e.g.,Guiso,Sapienza,and Zingales 2005; privy to private information.Because our interest is in Siegel,Licht,and Schwartz 2008).Cultural similarity, understanding broad patterns of global investment,we viewed within the context of ICAPMs.would constitute embed variables capturing migrant networks in well- a more direct measure of(the lack of)information costs established empirical models;our inferences are then and should be correlated with lower transactions costs conditional on the set of conditioning variables,and and a greater ease of doing business across border. our conclusions are thus statements about average be- This is where we join the literature on cross-border havior across a set of observations investment.Rather than developing empirical proxies At the aggregate level,then,how do migrants chan- for cultural affinity,economic familiarity,and infor- nel investment?We identify two channels:one result- mation asymmetries,we argue that diaspora networks ing from increased familiarity,and another associated help link sources of investment to specific destinations. with a decrease in informational asymmetries.These are discussed in turn. The familiarity effect takes hold when investors in Migrant Networks and Cross-border Capital a source country become familiar with characteristics How do migrant networks fit into an explanation for of the migrant's homeland through their connections cross-national investment?A network can be under- to,and observation of,migrant communities that ex- stood as a group of actors that either know about or can ist in their country.This "familiarity effect"occurs learn about each other's characteristics (Granovetter as migrants provide a signal to investors that allows 1973).Scholars have long recognized the importance of social networks for fostering economic exchange when formal institutions are absent or incomplete(e.g., 6 We should note that there are other mechanisms by which migrant networks channel capital back to their home country.Studies of over- Greif 1989:North 2005).5 From this perspective,we seas migrant communities have documented the role that coethnic can identify numerous ways in which migrant net- networks play in transmitting technical information and investment works facilitate cross-border investment,ways that are capital back to their country of origin (e.g.,Saxenian,2002,2006). More recent contributions have demonstrated the importance of consistent with prior research documenting departures migrant networks for channeling capital in the form of remittances from the ICAPM of international investment.Within (Leuth and Ruiz-Arranz 2006:Ratha and Shaw 2007). this context,migrant networks influence investment 7 Choi (2003)tells the story of Kyuk-ho Shin and Son Masayoshi- by facilitating the familiarity effect and by decreasing both of whom amassed their wealth while living in Japan and both of whom engaged in millions of dollars worth of FDI into Korea. Migrants are aware of this advantage,as Schulte(2008)documents with a quote from one of her interviewees:"Logically,one has advan 4 Loungani,Mody,and Razin(2002)reach a similar conclusion re- tages as a Turk when approaching business partners [in Turkey.One garding the positive relationship between bilateral telephone traffic speaks the same language,one is aware that small talk is required and FDI and one is on the same level of understanding,one socializes,one The relational approach to economic sociology focuses on rela- has the same humour,one shares interest in specific topics.That is a tions between parties to a transaction rather than on the transaction major advantage"(p.8). itself.This view,that economic processes are "embedded"in social Examples include Freinkman(2002)on Armenia,Kapur(2001) relations,has been used to study labor markets(Granovetter 1973). and Saxenian (2002)on India,Kleinman(1996)on Israel,and Rauch business transactions (Uzzi 1996),and FDI(Bandelj 2002.2007). and Casella (2002)and Weidenbaum and Hughes(1996)on China 586
Familiarity Breeds Investment August 2010 measures of commonality are then interpreted in the context of greater familiarity, better information, lower barriers to entry, and smaller transactions costs. Scholars also interpret negative coefficients on the (log of) distance in gravity models of international investment as a proxy for information asymmetries. The greater the distance from a market, so the argument goes, the greater the information cost and the lower the level of investment. Arguing that distance proxies for information costs, however, is theoretically unsatisfying, and, in a series of articles, Portes and Rey (2005; Portes, Rey, and Oh 2001) employ a more direct measure of information asymmetries and transactions costs by including a measure of bilateral telephone traf- fic. They find that telephone traffic is associated with higher levels of bilateral portfolio investment.4 These approaches remain incomplete. Even models that include measures of communication flows and communication costs find that investors retain a home bias (e.g., Loungani, Mody, and Razin 2002). Taking this as their point of departure, a growing literature argues that investment across country may be driven not by familiarity, but rather by “cultural affinity,” whereby individuals have more trust in individuals and institutions from countries that share common cultural characteristics (e.g., Guiso, Sapienza, and Zingales 2005; Siegel, Licht, and Schwartz 2008). Cultural similarity, viewed within the context of ICAPMs, would constitute a more direct measure of (the lack of) information costs and should be correlated with lower transactions costs and a greater ease of doing business across border. This is where we join the literature on cross-border investment. Rather than developing empirical proxies for cultural affinity, economic familiarity, and information asymmetries, we argue that diaspora networks help link sources of investment to specific destinations. Migrant Networks and Cross-border Capital How do migrant networks fit into an explanation for cross-national investment? A network can be understood as a group of actors that either know about or can learn about each other’s characteristics (Granovetter 1973). Scholars have long recognized the importance of social networks for fostering economic exchange when formal institutions are absent or incomplete (e.g., Greif 1989; North 2005).5 From this perspective, we can identify numerous ways in which migrant networks facilitate cross-border investment, ways that are consistent with prior research documenting departures from the ICAPM of international investment. Within this context, migrant networks influence investment by facilitating the familiarity effect and by decreasing 4 Loungani, Mody, and Razin (2002) reach a similar conclusion regarding the positive relationship between bilateral telephone traffic and FDI. 5 The relational approach to economic sociology focuses on relations between parties to a transaction rather than on the transaction itself. This view, that economic processes are “embedded” in social relations, has been used to study labor markets (Granovetter 1973), business transactions (Uzzi 1996), and FDI (Bandelj 2002, 2007). constraints imposed by information asymmetries and transactions costs.6 Before discussing the role of familiarity and information asymmetries, we note that migrant networks can have a direct and observable impact on cross-border investment when they, themselves, are the actors. In his study of the Korean diaspora, for example, Choi (2003) documents how FDI into Korea—a form of investment that came late to that country—was originally spurred by ethnic Koreans residing in Japan.7 Migrant-based investment also comes from nonwealthy expatriates. Schuttler (2007) and Schulte (2008) study, respectively, ¨ the investment behavior of Moroccan and Turkish migrants living in Germany. Using ethnographic and survey research, both scholars conclude that diaspora investors are well-situated investment in their homeland because of cultural and linguistic familiarity.8 There are larger literatures that make similar points about the ways in which migrant entrepreneurs have used home country connections to channel human, physical, and investment capital.9 Cross-national models of home country investment are difficult to test in the aggregate because even if we surveyed investors it would be surprising if they would admit to making bad investments or to being privy to private information. Because our interest is in understanding broad patterns of global investment, we embed variables capturing migrant networks in wellestablished empirical models; our inferences are then conditional on the set of conditioning variables, and our conclusions are thus statements about average behavior across a set of observations. At the aggregate level, then, how do migrants channel investment? We identify two channels: one resulting from increased familiarity, and another associated with a decrease in informational asymmetries. These are discussed in turn. The familiarity effect takes hold when investors in a source country become familiar with characteristics of the migrant’s homeland through their connections to, and observation of, migrant communities that exist in their country. This “familiarity effect” occurs as migrants provide a signal to investors that allows 6 We should note that there are other mechanisms by which migrant networks channel capital back to their home country. Studies of overseas migrant communities have documented the role that coethnic networks play in transmitting technical information and investment capital back to their country of origin (e.g., Saxenian, 2002, 2006). More recent contributions have demonstrated the importance of migrant networks for channeling capital in the form of remittances (Leuth and Ruiz-Arranz 2006; Ratha and Shaw 2007). 7 Choi (2003) tells the story of Kyuk-ho Shin and Son Masayoshi— both of whom amassed their wealth while living in Japan and both of whom engaged in millions of dollars worth of FDI into Korea. 8 Migrants are aware of this advantage, as Schulte (2008) documents with a quote from one of her interviewees: “Logically, one has advantages as a Turk when approaching business partners [in Turkey]. One speaks the same language, one is aware that small talk is required and one is on the same level of understanding, one socializes, one has the same humour, one shares interest in specific topics. That is a major advantage” (p. 8). 9 Examples include Freinkman (2002) on Armenia, Kapur (2001) and Saxenian (2002) on India, Kleinman (1996) on Israel, and Rauch and Casella (2002) and Weidenbaum and Hughes (1996) on China. 586
American Political Science Review Vol.104.No.3 investors to make inferences about the quality of labor. ern European and North American investors after the the work ethic,and/or the business culture that exists opening of markets in Eastern Europe.Investment in in a particular destination.A migrant community from Eastern European countries,she writes,was "often India residing in the United States,for example,can based on ethnic ties between sizable and relatively provide U.S.investors with a signal of the work ethic. affluent expatriate communities and their home coun- labor quality.and business culture that exists in India. tries"(p.421).There was an informational advantage These signals enhance the quality of information that as "firms amassed information about investment op- U.S.investors have about India allowing them to make portunities through their business or personal ties" forecasts about their ability to invest in potentially (p.412).This informational advantage can translate profitable assets offered on the Indian market.Kapur into higher than average expected returns if the mi- (2001),in his study of the Indian community residing in grant him-or herself has a higher level of human the United States,explains how the mere presence of capital.In his assessment of the Armenian diaspora, that community enhances investment opportunities in Freinkman(2002)notes that "when compared to the India:"Companies like Yahoo,Hewlett Packard and average economic agent,diaspora businessmen and General Electric have opened R&D centers in India professionals face a lower risk of becoming the first largely because of the confidence engendered by the movers.They benefit from a specific informational ad- presence of many Indians working in their US opera- vantage:common cultural background and established tions.This points to the cognitive effects arising from social links between diaspora and local entrepreneurs the projection of a coherent,appealing,and progressive help them to reduce transaction costs of new entry and identity on the part of the diaspora which signals an building new partnerships"(p.4). image of prosperity and progress to potential investors Connections between migrant communities across and consumers."10 countries may enhance cross-national investment,even Along with the provision of an image of their home when these connections do not provide specific infor country,migrant networks can provide business op- mation about investment opportunities.In reference portunities by decreasing asymmetries of information to the Maghribi traders of the eleventh century,Greif and by reducing transaction costs through formal(e.g., (1989,1993)argues that this trading network was effec- business)or information(e.g.,familial)contacts in their tive because it was able to credibly threaten collective home country.Again,the case of ethnic Turks resid- punishment by all merchants if even one of them de- ing in Germany is illustrative.Turkish migrants living fected.He shows that this coethnic network was able in Germany.Schulte (2008)notes,are more likely to to share information regarding the past actions of ac- invest in their homeland rather than in,say China tors (they could communicate a reputation),something because language and cultural knowledge more than that was essential for the efficient functioning of mar- compensate for what may be marginally lower returns. kets in the absence of formal legal rules.Weidenbaum This informational advantage does not privilege only and Hughes (1996)reach a similar conclusion about individual investors,rather it can work through the the effectiveness of The Bamboo Network,remarking larger network of coethnics.In The Bamboo Network, that "If a business owner violates an agreement,he is Weidenbaum and Hughes (1996)detail the compara- blacklisted.This is far worse than being sued,because tive advantage overseas Chinese have when it comes the entire Chinese networks will refrain from doing to investing in China and argue that it goes well be- business with the guilty party"(p.51). yond commonality of language,knowledge of cultural These informational effects are important because and legal barriers,and preexisting familial connec- they help investors overcome general barriers associ- tions.Wang's study shows how ethnic Chinese residing ated with transactions costs.Migrant communities can abroad provide a"linkage between China and the rest help facilitate cross-national portfolio investment by of the world [in that they]facilitate the understanding reducing barriers to entry-through knowledge of lan- of and access to guanxi networks by other foreign in- guage,institutional rules,and/or regulatory hurdles- vestors.Without the agency of ethnic Chinese,it would that may otherwise prevent a foreign investor from pur- have been much more difficult for foreign companies chasing equities or bonds.Knowledge of on-the-ground to use informal personal networks to complement and conditions is costly (and not necessarily private)and compensate for the weak formal legal institutions in provides investors with the ability to"match"invest- China"11(Wang 2000,p.161). ments with investment opportunities that may exist. Migrant networks provide investors with an infor- This"matching"function of migrant networks has been mational advantage because they are in a position to observed in studies of international trade.where Rauch have information regarding investment opportunities and Trindade(2002)find that migrant generated infor- in their home country.Bandelj(2002)provides some mation helps match buyers with sellers,a function that evidence concerning the investment behavior of West- becomes more important as goods become increasingly heterogeneous.12 It is important to note that the homeland govern- 10 Kapur and McHale (2006)refer to this as"branding"and argue ments are aware of key role that migrants play in that the Indian diaspora has created a brand name by signaling the oprodiityduofoy Guanxi is a close personal connection between individuals.A 12 The role of migrant networks in facilitating bilateral trade has guanxi network,therefore,is one that is based on trust and reputation been studies by Gould(1994)for the United States and by Head and ather than on external monitoring or enforcement. Reis (1998)for Canada 587
American Political Science Review Vol. 104, No. 3 investors to make inferences about the quality of labor, the work ethic, and/or the business culture that exists in a particular destination. A migrant community from India residing in the United States, for example, can provide U.S. investors with a signal of the work ethic, labor quality, and business culture that exists in India. These signals enhance the quality of information that U.S. investors have about India allowing them to make forecasts about their ability to invest in potentially profitable assets offered on the Indian market. Kapur (2001), in his study of the Indian community residing in the United States, explains how the mere presence of that community enhances investment opportunities in India: “Companies like Yahoo, Hewlett Packard and General Electric have opened R&D centers in India largely because of the confidence engendered by the presence of many Indians working in their US operations. This points to the cognitive effects arising from the projection of a coherent, appealing, and progressive identity on the part of the diaspora which signals an image of prosperity and progress to potential investors and consumers.”10 Along with the provision of an image of their home country, migrant networks can provide business opportunities by decreasing asymmetries of information and by reducing transaction costs through formal (e.g., business) or information (e.g., familial) contacts in their home country. Again, the case of ethnic Turks residing in Germany is illustrative. Turkish migrants living in Germany, Schulte (2008) notes, are more likely to invest in their homeland rather than in, say China, because language and cultural knowledge more than compensate for what may be marginally lower returns. This informational advantage does not privilege only individual investors, rather it can work through the larger network of coethnics. In The Bamboo Network, Weidenbaum and Hughes (1996) detail the comparative advantage overseas Chinese have when it comes to investing in China and argue that it goes well beyond commonality of language, knowledge of cultural and legal barriers, and preexisting familial connections. Wang’s study shows how ethnic Chinese residing abroad provide a “linkage between China and the rest of the world [in that they] facilitate the understanding of and access to guanxi networks by other foreign investors. Without the agency of ethnic Chinese, it would have been much more difficult for foreign companies to use informal personal networks to complement and compensate for the weak formal legal institutions in China”11 (Wang 2000, p. 161). Migrant networks provide investors with an informational advantage because they are in a position to have information regarding investment opportunities in their home country. Bandelj (2002) provides some evidence concerning the investment behavior of West- 10 Kapur and McHale (2006) refer to this as “branding” and argue that the Indian diaspora has created a brand name by signaling the potential productivity and trustworthiness of their countrymen. 11 Guanxi is a close personal connection between individuals. A guanxi network, therefore, is one that is based on trust and reputation rather than on external monitoring or enforcement. ern European and North American investors after the opening of markets in Eastern Europe. Investment in Eastern European countries, she writes, was “often based on ethnic ties between sizable and relatively affluent expatriate communities and their home countries” (p. 421). There was an informational advantage as “firms amassed information about investment opportunities through their business or personal ties” (p. 412). This informational advantage can translate into higher than average expected returns if the migrant him- or herself has a higher level of human capital. In his assessment of the Armenian diaspora, Freinkman (2002) notes that “when compared to the average economic agent, diaspora businessmen and professionals face a lower risk of becoming the first movers. They benefit from a specific informational advantage: common cultural background and established social links between diaspora and local entrepreneurs help them to reduce transaction costs of new entry and building new partnerships” (p. 4). Connections between migrant communities across countries may enhance cross-national investment, even when these connections do not provide specific information about investment opportunities. In reference to the Maghribi traders of the eleventh century, Greif (1989, 1993) argues that this trading network was effective because it was able to credibly threaten collective punishment by all merchants if even one of them defected. He shows that this coethnic network was able to share information regarding the past actions of actors (they could communicate a reputation), something that was essential for the efficient functioning of markets in the absence of formal legal rules. Weidenbaum and Hughes (1996) reach a similar conclusion about the effectiveness of The Bamboo Network, remarking that “If a business owner violates an agreement, he is blacklisted. This is far worse than being sued, because the entire Chinese networks will refrain from doing business with the guilty party” (p. 51). These informational effects are important because they help investors overcome general barriers associated with transactions costs. Migrant communities can help facilitate cross-national portfolio investment by reducing barriers to entry—through knowledge of language, institutional rules, and/or regulatory hurdles— that may otherwise prevent a foreign investor from purchasing equities or bonds. Knowledge of on-the-ground conditions is costly (and not necessarily private) and provides investors with the ability to “match” investments with investment opportunities that may exist. This “matching” function of migrant networks has been observed in studies of international trade, where Rauch and Trindade (2002) find that migrant generated information helps match buyers with sellers, a function that becomes more important as goods become increasingly heterogeneous.12 It is important to note that the homeland governments are aware of key role that migrants play in 12 The role of migrant networks in facilitating bilateral trade has been studies by Gould (1994) for the United States and by Head and Reis (1998) for Canada. 587
Familiarity Breeds Investment August 2010 facilitating investment and in further integrating their receive capital tend to have better institutions,more countries into the global economy.Gamlen (2008) stable economic policies,and better governance.14 notes that even developed states such as New Zealand. All empirical models are vulnerable to problems of Ireland,and Israel have well-developed diaspora en- omitted variable bias.We choose a very conservative gagement strategies designed to encourage active eco- strategy and estimate a cross-sectional model of bilat- nomic behavior on the part of their external citizens eral investment that contains fixed effects for both the In a response to a question from a member of their source and destination countries.Although this estima- parliament about how Scotland intends to engage their tion strategy sacrifices some richness in that we cannot diaspora residing in Canada,Scottish Executive Min- explore variation in host and homeland domestic insti- ister for Parliament declared,"The Scottish Executive tutions and policies,it allows us to concentrate on bi- intends to engage with and mobilize the Scottish dias- lateral characteristics that influence dyadic investment. pora to further Scotland's interests for the long-term Concretely,we write our model as benefit of our economy and society.We aim to encour- age the diaspora's active participation and engagement log0y)sd=δs+δd+φlog(I)+βXd+csd, (1) in promoting Scotland as a great country to visit,live, learn,work,do business and invest."13 Because they increase familiarity and decrease in- where ysd is the level of either portfolio or FDI from formation asymmetries,we hypothesize that larger mi- a source country (s)into a destination country (d).15 grant networks,all other things being equal,will exert Because we are working with a cross-section of country a positive influence on cross-border investment.The dyads,we control for unmeasured source and destina- effect of migrant networks should increase when the tion country characteristics through the inclusion of migrants themselves are the entrepreneurs,but this two sets of dummy variables:δ，andδa.Our variable increase may also be due to their ability to provide in- of interest is the log of the migrant stock (Ids)-the formation about opportunities to the investment com- population of migrants-from the destination country munity.Following Rauch and Trindade (2002),we also residing in the source country. hypothesize that migrant networks will be more im- The vector (Xsd)includes variables other than mi- portant for investment in heterogeneous(as compared grant stock that potentially influence cross-border in- with homogeneous)assets.This is because informa- vestment.Drawing on gravity-type models of FDI and tion costs-both asymmetries and transactions costs- portfolio investment,16 we control for the dyad's mar- associated with heterogeneous assets are substantially ket size,the bilateral distance between countries,the larger than those associated with homogeneous assets. existence of a common border,and a shared common When it comes to cross-border investment,we argue language.17 Market size is measured as the log of the that FDI is far more heterogeneous than portfolio in- product of the two country's gross domestic products vestment.Whereas portfolio investors choose debt or (GDPs).Given that distance is an imperfect measure equity stakes that are offered by an issuing agency of information costs,following Portes and Rey(2005). on an organized market,foreign direct investors can we include the log of bilateral telephone traffic take innumerable different ownership stakes across a Trade-in financial assets may also be influenced by countless number of commodity classes.We hypothe- shared policy variables.As in Lane and Milesi-Ferretti size,therefore,that migrant networks will have a larger (2004),we include variables capturing whether the two substantive effect on FDI than on portfolio investment. countries share a common exchange rate peg,have a It may be the case that migrant networks do not dual taxation treaty,or are members of a preferential matter at all and that they just proxy for greater cul- trade agreement.Given the importance of portfolio tural or informational similarities among countries- diversification in ICAPMs,we proxy for common eco- the sorts of variables identified in empirical studies of nomic shocks by including the (lagged)correlation of ICAPMs.To decrease the risk of incorrect inferences, the two country's growth rates. we go to great lengths to control for a variety of ways As discussed previously,it is difficult to differentiate that countries are connected with one another. between investment due to cultural affinity,market fa- miliarity,or information asymmetry.Our approach is EMPIRICS 14 See Alfaro.Kelemli-Ozcan,and Volosovych (2006).Buthe and Model and Variables Milner (2008).and Jensen (2003)for a discussion of destination country factors that are correlated with capital inflows. In addition to migrant networks,there are scores of is Source and destination countries are listed in Appendix A while factors that conceivably effect investment between two variable sources and definitions are contained in Appendix B. 16 Studies of FDI employing a gravity model include Wei (2000)and countries.In the source country,capital outflows can Loungani,Mody,and Razin (2002).Portes,Rey,and Oh(2001),Lane be influenced by high tax rates,the lack of protection and Milesi-Ferretti(2004),Portes and Rey (2005),Lane (2005),and for private property,high savings rates,etc.A similar Eichengreen and Luengnaruemitchai(2006)use a gravity model to list can be made for recipient countries:countries that examine bilateral investment in equities and bonds. 17 Some gravity models also include a variable indicating whether the two countries were ever in a colonial relationship.When included in our models,this variable was never statistically significant.We omit 13 Quoted from www.martinfrost.ws/htmlfiles/gazette/scot_diaspora. it from our specification because we also include a measure of shared html. legal origin as it is highly correlated with colonial status. 588
Familiarity Breeds Investment August 2010 facilitating investment and in further integrating their countries into the global economy. Gamlen (2008) notes that even developed states such as New Zealand, Ireland, and Israel have well-developed diaspora engagement strategies designed to encourage active economic behavior on the part of their external citizens. In a response to a question from a member of their parliament about how Scotland intends to engage their diaspora residing in Canada, Scottish Executive Minister for Parliament declared, “The Scottish Executive intends to engage with and mobilize the Scottish diaspora to further Scotland’s interests for the long-term benefit of our economy and society. We aim to encourage the diaspora’s active participation and engagement in promoting Scotland as a great country to visit, live, learn, work, do business and invest.”13 Because they increase familiarity and decrease information asymmetries, we hypothesize that larger migrant networks, all other things being equal, will exert a positive influence on cross-border investment. The effect of migrant networks should increase when the migrants themselves are the entrepreneurs, but this increase may also be due to their ability to provide information about opportunities to the investment community. Following Rauch and Trindade (2002), we also hypothesize that migrant networks will be more important for investment in heterogeneous (as compared with homogeneous) assets. This is because information costs—both asymmetries and transactions costs— associated with heterogeneous assets are substantially larger than those associated with homogeneous assets. When it comes to cross-border investment, we argue that FDI is far more heterogeneous than portfolio investment. Whereas portfolio investors choose debt or equity stakes that are offered by an issuing agency on an organized market, foreign direct investors can take innumerable different ownership stakes across a countless number of commodity classes. We hypothesize, therefore, that migrant networks will have a larger substantive effect on FDI than on portfolio investment. It may be the case that migrant networks do not matter at all and that they just proxy for greater cultural or informational similarities among countries— the sorts of variables identified in empirical studies of ICAPMs. To decrease the risk of incorrect inferences, we go to great lengths to control for a variety of ways that countries are connected with one another. EMPIRICS Model and Variables In addition to migrant networks, there are scores of factors that conceivably effect investment between two countries. In the source country, capital outflows can be influenced by high tax rates, the lack of protection for private property, high savings rates, etc. A similar list can be made for recipient countries: countries that 13 Quoted from www.martinfrost.ws/htmlfiles/gazette/scot_diaspora. html. receive capital tend to have better institutions, more stable economic policies, and better governance.14 All empirical models are vulnerable to problems of omitted variable bias. We choose a very conservative strategy and estimate a cross-sectional model of bilateral investment that contains fixed effects for both the source and destination countries. Although this estimation strategy sacrifices some richness in that we cannot explore variation in host and homeland domestic institutions and policies, it allows us to concentrate on bilateral characteristics that influence dyadic investment. Concretely, we write our model as log(y)sd = δs + δd + φ log(Ids) + βXsd + εsd, (1) where ysd is the level of either portfolio or FDI from a source country (s) into a destination country (d).15 Because we are working with a cross-section of country dyads, we control for unmeasured source and destination country characteristics through the inclusion of two sets of dummy variables: δs and δd. Our variable of interest is the log of the migrant stock (Ids)—the population of migrants—from the destination country residing in the source country. The vector (Xsd) includes variables other than migrant stock that potentially influence cross-border investment. Drawing on gravity-type models of FDI and portfolio investment,16 we control for the dyad’s market size, the bilateral distance between countries, the existence of a common border, and a shared common language.17 Market size is measured as the log of the product of the two country’s gross domestic products (GDPs). Given that distance is an imperfect measure of information costs, following Portes and Rey (2005), we include the log of bilateral telephone traffic. Trade-in financial assets may also be influenced by shared policy variables. As in Lane and Milesi-Ferretti (2004), we include variables capturing whether the two countries share a common exchange rate peg, have a dual taxation treaty, or are members of a preferential trade agreement. Given the importance of portfolio diversification in ICAPMs, we proxy for common economic shocks by including the (lagged) correlation of the two country’s growth rates. As discussed previously, it is difficult to differentiate between investment due to cultural affinity, market familiarity, or information asymmetry. Our approach is 14 See Alfaro, Kelemli-Ozcan, and Volosovych (2006), Buthe and ¨ Milner (2008), and Jensen (2003) for a discussion of destination country factors that are correlated with capital inflows. 15 Source and destination countries are listed in Appendix A while variable sources and definitions are contained in Appendix B. 16 Studies of FDI employing a gravity model include Wei (2000) and Loungani, Mody, and Razin (2002). Portes, Rey, and Oh (2001), Lane and Milesi-Ferretti (2004), Portes and Rey (2005), Lane (2005), and Eichengreen and Luengnaruemitchai (2006) use a gravity model to examine bilateral investment in equities and bonds. 17 Some gravity models also include a variable indicating whether the two countries were ever in a colonial relationship. When included in our models, this variable was never statistically significant. We omit it from our specification because we also include a measure of shared legal origin as it is highly correlated with colonial status. 588