Democratic Governance and Multinational Corporations:Political Regimes and Inflows of Foreign Direct Investment Nathan M.Jensen Foreign direct investment(FDI)is a key element of the global economy.FDI is an engine of employment,technological progress,productivity improvements, and ultimately economic growth.FDI provides both physical capital and employ- ment possibilities that may not be available in the host market.More importantly, FDI is a mechanism of technology transfer between countries,particularly to the less-developed nations.Because of these significant benefits,attracting FDI has become one of the integral parts of economic development strategies in many countries. Although few scholars dispute the aggregate economic benefits of FDI,critics argue that the benefits of multinational production come with substantial costs for governments and their citizens.The need to attract FDI pressures governments to provide a climate more hospitable to foreign corporations-potentially altering pat- terns of domestic economic policy,and possibly even challenging the de facto sovereignty of the nation-state and the capacity for democratic governance.De- mocracy is often seen as an inefficient institutional structure in the global economy. This article empirically assesses these predictions about the political precondi- tions for attracting FDI using both cross-sectional and panel regression analysis for 114 countries.The cross-sectional regressions estimate the effects of eco- nomic conditions,policy decisions,and democratic political institutions in the 1980s on the level of FDI inflows in the 1990s.In the panel regressions,I explore how Special thanks to Geoffrey Garrett for his extensive comments on this project and a number of other related projects on the determinants of foreign direct investment.I would also like to thank Nancy Brune,Jose Cheibub,Lilach Gilady,Witold Henisz,Charles Martin,Fiona McGillivray,Bruce Rus- sett,Andy Sobel,Jason Sorens,Thomas Konig,Leonard Wantchekon,James Vreeland,the editors of 10,and three anonymous reviewers for helpful comments and suggestions.Thanks to Nancy Brune for making her capital account liberalization data available. 1.Jessup 1999 argues that authoritarian regimes in developing countries attract more international investment.Oneal 1994 finds that authoritarian regimes provide investors with higher returns in devel- oping countries,although overall investment fows are not related to regime type. International Organization 57,Summer 2003,pp.587-616 2003 by The IO Foundation. D0:10.1017/S0020818303573040
Democratic Governance and Multinational Corporations: Political Regimes and Inflows of Foreign Direct Investment Nathan M+ Jensen Foreign direct investment ~FDI! is a key element of the global economy+ FDI is an engine of employment, technological progress, productivity improvements, and ultimately economic growth+ FDI provides both physical capital and employment possibilities that may not be available in the host market+ More importantly, FDI is a mechanism of technology transfer between countries, particularly to the less-developed nations+ Because of these significant benefits, attracting FDI has become one of the integral parts of economic development strategies in many countries+ Although few scholars dispute the aggregate economic benefits of FDI, critics argue that the benefits of multinational production come with substantial costs for governments and their citizens+ The need to attract FDI pressures governments to provide a climate more hospitable to foreign corporations—potentially altering patterns of domestic economic policy, and possibly even challenging the de facto sovereignty of the nation-state and the capacity for democratic governance+ 1 Democracy is often seen as an inefficient institutional structure in the global economy+ This article empirically assesses these predictions about the political preconditions for attracting FDI using both cross-sectional and panel regression analysis for 114 countries+ The cross-sectional regressions estimate the effects of economic conditions, policy decisions, and democratic political institutions in the 1980s on the level of FDI inflows in the 1990s+ In the panel regressions, I explore how Special thanks to Geoffrey Garrett for his extensive comments on this project and a number of other related projects on the determinants of foreign direct investment+ I would also like to thank Nancy Brune, Jose Cheibub, Lilach Gilady, Witold Henisz, Charles Martin, Fiona McGillivray, Bruce Russett, Andy Sobel, Jason Sorens, Thomas König, Leonard Wantchekon, James Vreeland, the editors of IO, and three anonymous reviewers for helpful comments and suggestions+ Thanks to Nancy Brune for making her capital account liberalization data available+ 1+ Jessup 1999 argues that authoritarian regimes in developing countries attract more international investment+ Oneal 1994 finds that authoritarian regimes provide investors with higher returns in developing countries, although overall investment flows are not related to regime type+ International Organization 57, Summer 2003, pp+ 587–616 © 2003 by The IO Foundation+ DOI: 10+10170S0020818303573040
588 International Organization changes in economic policies and political institutions affect changes in FDI in- flows in the period from 1970-97.I then use a Heckman selection model to ex- plore the robustness of the relationship between democratic governance and FDI. Lastly,I explore the causal link between democracy and FDI by empirically as- sessing the effects of democratic governance on country credibility.In this section I test the effects of democratic institutions on country sovereign debt ratings for seventy-nine countries from 1980 to 1998. My results are inconsistent with the dire predictions regarding the effects of the competition for FDI on domestic politics.Democratic political institutions are as- sociated with higher levels of FDI inflows.Democratic governments,even when controlling for other political and economic factors,attract as much as 70 percent more FDI as a percentage of GDP than their authoritarian counterparts.This result is robust under different model specifications and types of empirical tests. The remainder of this article is organized as follows.The first section presents some descriptive statistics on FDI flows.The second section examines the exist- ing work on the determinants of FDI flows and provides the theoretical links be- tween economic policy,political institutions,and FDI inflows.The third section discusses the causal links between democracy and higher levels of FDI inflows. The fourth section provides a brief overview of the empirical tests used in this analysis.The following two sections construct empirical tests of the determinants of FDI flows,examining the levels of FDI using cross-sectional data (fifth sec- tion),and changes using panel data,including a Heckman selection model (sixth section).The seventh section examines the link between democracy and credibil- ity by empirically examining the effects of democratic institutions on country sov- ereign debt ratings.The final section concludes. Multinational Corporations and Domestic Economies The focus of this work is on one of the most stable and economically important international capital flows-FDI.2 FDIs are defined as private capital flows from a parent firm to a location outside of the parent firm's home nation.These invest- ments consist of equity capital,intercompany debt,and reinvested earnings.An investment is considered FDI,as opposed to portfolio investment,if it is large enough to give the parent firm some amount of control over the management of the enterprise-usually more than 10 percent of the firm.3 FDI,unlike portfolio investments,has long time horizons and is generally not done for speculative pur- poses,but rather to serve domestic markets,exploit natural resources,or provide platforms to serve world markets through exports. 2.See Lipsey 1999 for a discussion of the stability of FDI flows relative to other investment flows. 3.These are the statistical rules used by the International Monetary Fund (IMF).See IFC 1997,9
changes in economic policies and political institutions affect changes in FDI in- flows in the period from 1970–97+ I then use a Heckman selection model to explore the robustness of the relationship between democratic governance and FDI+ Lastly, I explore the causal link between democracy and FDI by empirically assessing the effects of democratic governance on country credibility+ In this section I test the effects of democratic institutions on country sovereign debt ratings for seventy-nine countries from 1980 to 1998+ My results are inconsistent with the dire predictions regarding the effects of the competition for FDI on domestic politics+ Democratic political institutions are associated with higher levels of FDI inflows+ Democratic governments, even when controlling for other political and economic factors, attract as much as 70 percent more FDI as a percentage of GDP than their authoritarian counterparts+ This result is robust under different model specifications and types of empirical tests+ The remainder of this article is organized as follows+ The first section presents some descriptive statistics on FDI flows+ The second section examines the existing work on the determinants of FDI flows and provides the theoretical links between economic policy, political institutions, and FDI inflows+ The third section discusses the causal links between democracy and higher levels of FDI inflows+ The fourth section provides a brief overview of the empirical tests used in this analysis+ The following two sections construct empirical tests of the determinants of FDI flows, examining the levels of FDI using cross-sectional data ~fifth section!, and changes using panel data, including a Heckman selection model ~sixth section!+ The seventh section examines the link between democracy and credibility by empirically examining the effects of democratic institutions on country sovereign debt ratings+ The final section concludes+ Multinational Corporations and Domestic Economies The focus of this work is on one of the most stable and economically important international capital flows—FDI+ 2 FDIs are defined as private capital flows from a parent firm to a location outside of the parent firm’s home nation+ These investments consist of equity capital, intercompany debt, and reinvested earnings+ An investment is considered FDI, as opposed to portfolio investment, if it is large enough to give the parent firm some amount of control over the management of the enterprise—usually more than 10 percent of the firm+ 3 FDI, unlike portfolio investments, has long time horizons and is generally not done for speculative purposes, but rather to serve domestic markets, exploit natural resources, or provide platforms to serve world markets through exports+ 2+ See Lipsey 1999 for a discussion of the stability of FDI flows relative to other investment flows+ 3+ These are the statistical rules used by the International Monetary Fund ~IMF!+ See IFC 1997, 9+ 588 International Organization
The Political Economy of FDI 589 The importance of FDI to capital accumulation is large and growing.Inter- national capital flows have increasingly become dominated by flows of private capital.In 1990,44 percent of all international capital flows were private.This rose to 85 percent in 1996,with FDI being the largest single type of capital flow. FDI has outpaced international trade,growing at an average rate of 13 percent per year from 1980-97,as compared to an annual 7 percent growth rate for exports.3 In 1998 alone,FDI flows increased 25 percent.A simple snapshot of FDI as a percentage of gross domestic investment,averaged for the 1980s,is presented in Table 1.6 In the vast majority of countries,FDI accounts for a substantial amount of domestic investment. These figures obscure an even more important element of FDI flows-the role of multinational production in transferring technology.The potential for techno- logical transfer is obvious if one examines the characteristics of most multi- national firms."Multinationals tend to be important in industries and firms with four characteristics:high levels of research and development(R&D)relative to sales;a large share of professional and technical workers in their workforce;prod- ucts that are new or technically complex;and high levels of product differentia- tion and advertising.These characteristics appear in many studies,and I have never seen any of them contradicted in any study."7 Investments by these technologi- cally advanced firms translate directly into growth-promoting technical advances for the host nation.8 Although the direct effects of FDI on capital accumulation and technological transfer are economically the most important,other economic and political effects of FDI should not be overlooked.FDI is often concentrated in export sectors,gen- erating foreign exchange for the host nation.FDI is also a means of generating employment-both directly,through the foreign firm,and through the indirect ef- fects on the economy,such as domestic industries emerging to compliment the new foreign firms.9 These material benefits of FDI force governments into a competition for scarce international capital.In this article I focus specifically on the relationship between democratic governance and FDI inflows.Drawing on the vast literature on the effects of democracy in interstate relations and democratic theory,I identify a num- 4.IFC1997,14. 5.Mallampally and Sauvant 1999. 6.Data are unweighted averages from the World Development Indicators 2000.Negative values represent disinvestment by multinationals. 7.Markusen 1995,172. 8.Wang 1990;and Grossman and Helpman 1991 provide the theoretical foundation for this.Em- pirically,Luiz R.de Mello Jr.1999 uses panel data for fifteen Organization for Economic Cooperation and Development(OECD)countries and seventeen non-OECD countries from the period 1970-90 and finds that FDI does increase growth,but the growth-enhancing effects are dependent on the level of technological backwardness.For the backward countries,FDI is more productive than domestic invest- ment.A study by Barrel and Pain 1999 finds that for four industrialized European countries,a one- percentage increase in FDI increased technological progress by 0.18 percent. 9.See OECD 1995;and Markusen and Venables 1999
The importance of FDI to capital accumulation is large and growing+ International capital flows have increasingly become dominated by flows of private capital+ In 1990, 44 percent of all international capital flows were private+ This rose to 85 percent in 1996, with FDI being the largest single type of capital flow+ 4 FDI has outpaced international trade, growing at an average rate of 13 percent per year from 1980–97, as compared to an annual 7 percent growth rate for exports+ 5 In 1998 alone, FDI flows increased 25 percent+ A simple snapshot of FDI as a percentage of gross domestic investment, averaged for the 1980s, is presented in Table 1+ 6 In the vast majority of countries, FDI accounts for a substantial amount of domestic investment+ These figures obscure an even more important element of FDI flows—the role of multinational production in transferring technology+ The potential for technological transfer is obvious if one examines the characteristics of most multinational firms+ “Multinationals tend to be important in industries and firms with four characteristics: high levels of research and development ~R&D! relative to sales; a large share of professional and technical workers in their workforce; products that are new or technically complex; and high levels of product differentiation and advertising+ These characteristics appear in many studies, and I have never seen any of them contradicted in any study+”7 Investments by these technologically advanced firms translate directly into growth-promoting technical advances for the host nation+ 8 Although the direct effects of FDI on capital accumulation and technological transfer are economically the most important, other economic and political effects of FDI should not be overlooked+ FDI is often concentrated in export sectors, generating foreign exchange for the host nation+ FDI is also a means of generating employment—both directly, through the foreign firm, and through the indirect effects on the economy, such as domestic industries emerging to compliment the new foreign firms+ 9 These material benefits of FDI force governments into a competition for scarce international capital+ In this article I focus specifically on the relationship between democratic governance and FDI inflows+ Drawing on the vast literature on the effects of democracy in interstate relations and democratic theory, I identify a num- 4+ IFC 1997, 14+ 5+ Mallampally and Sauvant 1999+ 6+ Data are unweighted averages from the World Development Indicators 2000+ Negative values represent disinvestment by multinationals+ 7+ Markusen 1995, 172+ 8+ Wang 1990; and Grossman and Helpman 1991 provide the theoretical foundation for this+ Empirically, Luiz R+ de Mello Jr+ 1999 uses panel data for fifteen Organization for Economic Cooperation and Development ~OECD! countries and seventeen non-OECD countries from the period 1970–90 and finds that FDI does increase growth, but the growth-enhancing effects are dependent on the level of technological backwardness+ For the backward countries, FDI is more productive than domestic investment+ A study by Barrel and Pain 1999 finds that for four industrialized European countries, a onepercentage increase in FDI increased technological progress by 0+18 percent+ 9+ See OECD 1995; and Markusen and Venables 1999+ The Political Economy of FDI 589
590 International Organization TABLE 1.FDI as a percentage of gross domestic investment St.Kitts and Nevis 55.56 Honduras 5.92 Turkey 2.09 Singapore 41.50 Senegal 5.79 Central African Rep. 2.05 Sierra Leone 37.87 Malawi 5.75 Mozambique 2.02 Trinidad and Tobago 28.11 Greece 5.33 Chad 1.97 Fiji 25.64 Paraguay 5.33 Iceland 1.95 Jamaica 23.40 Nicaragua 5.25 Lesotho 1.93 Seychelles 22.08 France 4.91 Syria 1.87 New Zealand 21.26 Colombia 4.82 Israel 1.76 Vanuatu 19.51 Argentina 4.72 Philippines 1.60 Ecuador 17.90 Thailand 4.65 Cameroon 1.46 Dominican Republic 16.32 Bolivia 4.43 Chile 1.44 Grenada 15.43 Namibia 4.34 Gambia 1.39 Belize 14.85 Venezuela 4.28 El Salvador 1.38 Panama 14.76 Indonesia 4.26 Guinea Bissau 1.37 Portugal 13.20 Denmark 4.18 Algeria 1.32 Malaysia 13.12 Tunisia 3.77 Sri Lanka 1.17 Netherlands 13.09 Mexico 3.75 Togo 0.92 Nigeria 12.52 Norway 3.74 South Korea 0.84 Costa Rica 11.73 Guinea 3.65 Poland 0.59 United Kingdom 11.72 Kenya 3.14 Burkina Faso 0.43 Ghana 11.70 Jordan 2.97 Rwanda 0.41 Spain 11.20 Egypt 2.95 India 0.34 Australia 10.17 Brazil 2.95 Burundi 0.30 Papua New Guinea 9.84 United States 2.90 Japan 0.19 Benin 8.89 China 2.83 Bulgaria 0.08 Cyprus 8.37 Pakistan 2.69 Bangladesh 0.05 Guatemala 8.33 Sweden 2.66 Zimbabwe -0.39 Canada 8.11 Morocco 2.64 Mali -0.63 Cote d'lvoire 8.03 Mauritania 2.59 Congo -0.71 Switzerland 7.69 Gabon 2.53 Iran -1.05 Guyana 7.38 Italy 2.45 Comoros -2.03 Madagascar 6.64 Finland 2.19 Peru -2.85 Ireland 6.49 Austria 2.13 Zambia -11.54 Mauritius 6.16 Source:World Development Indicators 1998 ber of causal mechanisms by which democracy has a positive effect on FDI in- flows.Before examining the role of democracy on FDI inflows,I describe the economics of FDI. Determinants of FDI John Dunning's ownership,location,and internalization (OLI)framework is gen- erally considered the paradigmatic theory of the multinational firm's investment decisions,where multinational enterprises (MNEs)invest internationally for rea-
ber of causal mechanisms by which democracy has a positive effect on FDI in- flows+ Before examining the role of democracy on FDI inflows, I describe the economics of FDI+ Determinants of FDI John Dunning’s ownership, location, and internalization ~OLI! framework is generally considered the paradigmatic theory of the multinational firm’s investment decisions, where multinational enterprises ~MNEs! invest internationally for reaTABLE 1. FDI as a percentage of gross domestic investment St+ Kitts and Nevis 55+56 Honduras 5+92 Turkey 2+09 Singapore 41+50 Senegal 5+79 Central African Rep+ 2+05 Sierra Leone 37+87 Malawi 5+75 Mozambique 2+02 Trinidad and Tobago 28+11 Greece 5+33 Chad 1+97 Fiji 25+64 Paraguay 5+33 Iceland 1+95 Jamaica 23+40 Nicaragua 5+25 Lesotho 1+93 Seychelles 22+08 France 4+91 Syria 1+87 New Zealand 21+26 Colombia 4+82 Israel 1+76 Vanuatu 19+51 Argentina 4+72 Philippines 1+60 Ecuador 17+90 Thailand 4+65 Cameroon 1+46 Dominican Republic 16+32 Bolivia 4+43 Chile 1+44 Grenada 15+43 Namibia 4+34 Gambia 1+39 Belize 14+85 Venezuela 4+28 El Salvador 1+38 Panama 14+76 Indonesia 4+26 Guinea Bissau 1+37 Portugal 13+20 Denmark 4+18 Algeria 1+32 Malaysia 13+12 Tunisia 3+77 Sri Lanka 1+17 Netherlands 13+09 Mexico 3+75 Togo 0+92 Nigeria 12+52 Norway 3+74 South Korea 0+84 Costa Rica 11+73 Guinea 3+65 Poland 0+59 United Kingdom 11+72 Kenya 3+14 Burkina Faso 0+43 Ghana 11+70 Jordan 2+97 Rwanda 0+41 Spain 11+20 Egypt 2+95 India 0+34 Australia 10+17 Brazil 2+95 Burundi 0+30 Papua New Guinea 9+84 United States 2+90 Japan 0+19 Benin 8+89 China 2+83 Bulgaria 0+08 Cyprus 8+37 Pakistan 2+69 Bangladesh 0+05 Guatemala 8+33 Sweden 2+66 Zimbabwe 20+39 Canada 8+11 Morocco 2+64 Mali 20+63 Côte d’Ivoire 8+03 Mauritania 2+59 Congo 20+71 Switzerland 7+69 Gabon 2+53 Iran 21+05 Guyana 7+38 Italy 2+45 Comoros 22+03 Madagascar 6+64 Finland 2+19 Peru 22+85 Ireland 6+49 Austria 2+13 Zambia 211+54 Mauritius 6+16 Source: World Development Indicators 1998+ 590 International Organization
The Political Economy of FDI 591 sons of ownership,location,and internalization.0 Firms have ownership advan- tages when they have access to some asset or process that provides some advantage over existing firms in the foreign market.These can be physical,for example pat- ented products or production processes,or more intangible,such as global brand name recognition.Multinational firms invest abroad to exploit these firm-specific advantages in foreign markets and secure higher returns. Firms may also be motivated to invest abroad because of locational advan- fages.Firms often invest in production facilities in foreign markets because trans- portation costs are too high to serve these markets through exports.This could either be directly related to the physical nature of the good,as with a high bulk item or a service that needs to be provided on site,or because of policy factors such as tariff rates,import restrictions,or issues of market access that make phys- ical investment advantageous over serving the market through exports.The loca- tional advantage could also be related to the actual endowments of the host location-either the richness of its natural resources or the high quality and low cost of its labor force. The third and most complex factor is that of internalization advantages.Al- though the other two OLI factors highlight reasons why firms would move pro- duction to a foreign location,they do not give any reason as to why a firm would simply not license a foreign producer to make the item for the parent firm.A multi- national could simply provide the technology needed for the production process and the blueprints for the product to a local firm.This concept of internalization advantages captures the firm-specific motivations for a firm choosing to produce the product within the organization itself in a foreign location. Closely related to Dunning's work,other scholars have developed a number of theoretical models to explain firms'decisions to invest abroad.These models can be roughly classified as theories based on "vertical"firms,"horizontal"firms,and the"knowledge-capital model"of multinational firms.Vertical firms separate pro- duction activities by the level of capital intensity,producing different goods and services at different physical locations.2 Although these theories are important contributions to the understanding of multinationals'investment decisions,theo- ries based on vertical multinationals have failed to account for the existence of firms replicating the production of the same goods and services in different phys- ical locations. Markusen explained this pattern of replicating production by creating a model of "horizontal"firms with firm-level economies of scale that integrate hori- zontally across national borders.3 These horizontal models have been integrated, 10.Dunning 1981.For an interesting discussion on the OLI framework and recent work done in relation to it,see Markusen 1995. 11.See Markusen and Maskus 1999a and 1999b. 12.Helpman 1984. 13.Markusen 1984.For a review of recent contributions to this literature,see Markusen and Maskus 1999a
sons of ownership, location, and internalization+ 10 Firms have ownership advantages when they have access to some asset or process that provides some advantage over existing firms in the foreign market+ These can be physical, for example patented products or production processes, or more intangible, such as global brand name recognition+ Multinational firms invest abroad to exploit these firm-specific advantages in foreign markets and secure higher returns+ Firms may also be motivated to invest abroad because of locational advantages+ Firms often invest in production facilities in foreign markets because transportation costs are too high to serve these markets through exports+ This could either be directly related to the physical nature of the good, as with a high bulk item or a service that needs to be provided on site, or because of policy factors such as tariff rates, import restrictions, or issues of market access that make physical investment advantageous over serving the market through exports+ The locational advantage could also be related to the actual endowments of the host location—either the richness of its natural resources or the high quality and low cost of its labor force+ The third and most complex factor is that of internalization advantages+ Although the other two OLI factors highlight reasons why firms would move production to a foreign location, they do not give any reason as to why a firm would simply not license a foreign producer to make the item for the parent firm+ A multinational could simply provide the technology needed for the production process and the blueprints for the product to a local firm+ This concept of internalization advantages captures the firm-specific motivations for a firm choosing to produce the product within the organization itself in a foreign location+ Closely related to Dunning’s work, other scholars have developed a number of theoretical models to explain firms’ decisions to invest abroad+ These models can be roughly classified as theories based on “vertical” firms, “horizontal” firms, and the “knowledge-capital model” of multinational firms+ 11 Vertical firms separate production activities by the level of capital intensity, producing different goods and services at different physical locations+ 12 Although these theories are important contributions to the understanding of multinationals’ investment decisions, theories based on vertical multinationals have failed to account for the existence of firms replicating the production of the same goods and services in different physical locations+ Markusen explained this pattern of replicating production by creating a model of “horizontal” firms with firm-level economies of scale that integrate horizontally across national borders+ 13 These horizontal models have been integrated, 10+ Dunning 1981+ For an interesting discussion on the OLI framework and recent work done in relation to it, see Markusen 1995+ 11+ See Markusen and Maskus 1999a and 1999b+ 12+ Helpman 1984+ 13+ Markusen 1984+ For a review of recent contributions to this literature, see Markusen and Maskus 1999a+ The Political Economy of FDI 591