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Effects of Political Factors on FDI flows

In recent years, we are witnessing increased levels of investment capital

flows at the international level. Among the many factors that are attributed to the

increase in the amount of foreign direct investment (FDI) flows, globalization is one

of them. Globalization has been characterized by a surge in the volume of trade and

FDI across countries (Das 2013, 93). It has even been said that FDI has grown at a

faster rate than most other international transactions, particularly trade flows

between countries (Blonigen 2005, 383). This increasing trend in the global system

calls our attention to investigate and study the underlying factors that determine

FDI flows across countries.

It is not surprising that economic factors play a role in the decision-

makingprocess of foreign direct investment, due to the fact that economic actors

want a return to their investment and profit maximization is a major incentive for

investors. However, the impact of political factors in countries where investment

capital is coming in or going out is also an important one. After all, a country in

which there is high political unrest or instability has more risk and uncertainty,

making it less attractive for investment. This is especially important when looking at

developing countries that are largely characterized by an unstable political

environment.This literature review examines to what extent political factors,

institutions, and governance infrastructure play a role in determining foreign direct

investment flows across countries.

There is a debate within the FDI literature in regards to the impact that

institutions, investment climate, political risk, and other political factors have on

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determining foreign direct investment. This is evident, as the vast amount of

literature concerning FDI determinants does not sufficiently focus on the impact

that such factors have on foreign investment. The determinants of FDI can be

studied from different perspectives. The first approach is examining it at the micro-

level from the firms’ perspective. The second approach is looking at the macro-level

from the country’s perspective by dividing it into the home country determinants, in

terms of FDI outflows, and the host country determinants, in terms of FDI inflows.

Firms’ Perspective

Spero and Hart briefly define foreign direct investment (FDI) as financial

transfers by a multinational corporation (MNC) from the country of the parent firm

to the country of the host firm to finance a portion of its overseas operations (Spero

and Hart 2010, 452). There are a lot of factors that go into the decision as to

whether or not a firm should invest in a certain country.One of the most widely cited

theories regarding a firm’s decision to engage in FDI is Dunning’s eclectic theory of

international direct investment known as the “OLI Paradigm”. The propensity of a

firm to invest abroad depends on its ownership (O) specific advantages, location (L)

specific advantages, and internalization (I) advantages. According to Dunning, the

ownership specific advantages refer to the ‘extent to which [a firm] possesses or can

possess assets which its competitors do not possess’; the internalization advantages

account for whether it is in the firm’s interest to sell those assets to other firms or

make use and ‘internalize’ them itself; the location specific advantages address how

profitable it is to use those assets for production in foreign countries rather in the

home country (Dunning 1980, 9). Krifa-Schneider and Matei state that both

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ownership and internalization advantages are specific motives of the firm, however,

the notion of location-specific advantages depict properties of the host country that

make it attractive for FDI (Krifa-Schneider and Matei 2010, 54). Past studies on

economic development view institutions, which are location specific, as an

important location advantage of host countries aiming to attract FDI.

It is clear that there is unequal distribution of foreign direct investment

across different countries. However, it is important to note that the political

environment of these countries plays a role in this unequal distribution. There are

three components of country risk namely, political risks, financial risks, and

economic risks. Political risk, which is concerned with issues such asgovernment

stability, internal and external conflict, corruption and ethnic tensions, law and

order, democratic accountability of government and quality of bureaucracy, is more

critical in importance due to the multifaceted nature of its impact (Krifa-Schneider

and Matei 2010, 55).According to Busse and Hefeker, changes in government policy

and/or political institutions could affect investment behavior of multinational

corporations as that will also affect the risk premium associated with investment

projects; thus, the location decision of the investment is influenced by political risk

(Busse and Hefeker 2007, 398). This clearly illustrates how political factors and

institutions affect foreign direct investment decisions of firms.

Country’s Perspective

There have been previous discussions that suggest a country’s economic

performance, in the long run, is determined to a great extent by institutions and

policies that influence the political, institutional, and legal environment of the

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country.Globerman and Shapiro refer to these institutions as the governance

infrastructure of a country, which help to define its investment environment

(Globerman and Shapiro 2002, 1899). Accordingly, there are various aspects of a

country that determine FDI flows at the country-level. The next section will discuss

both host-country determinants and home-country determinants.

(a) Host Country determinants of FDI

These refer to the FDI determinants of the host country in which the investment is

taking place; hence, we are looking at FDI inflows. The investment environment of a

country affects capital inflow because the characteristics of the host country will

either attract or repel FDI.It is widely accepted that host-country characteristics

such as the size of the economy, GDP per capita, trade openness, inflation rate, labor

costs, real exchange rate, and so on have an impact on investment inflow. However,

it is plausible that FDI will be attracted to regions characterized by more favorable

governance infrastructures (Globerman and Shapiro 2002, 1900). Furthermore,a

positive governance infrastructure would include an effective, impartial and

transparent legal system that protects property and individual rights; public

institutions that are stable, credible and honest; and government policies that favor

free and open markets (Globerman and Shapiro 2002, 1901). These conditions

encourage FDI. When discussing about conditions that are impartial and

transparent, it begs the question as to whether or not being a democracy helps to

attract high levels of FDI inflow. Some authors argue that democracy promotes FDI

inflows by providing certain advantages to the MNCs such as better property rights

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protection. On the other hand, others argue that a democracy may generate policy

outcomes hurting foreign investment inflows, because democratic constraints may

weaken the monopolistic positions of MNCs, prevent host governments from

offering financial and fiscal incentives, and provide local business protection from

foreign competition (Yang 2007, 422). As a result, it is not clear, within the

literature, as to whether or not there is a relationship between regime type and FDI

inflows.

(b) Home Country determinants of FDI

Certain home country characteristics, such as export-oriented government policies,

that might have led to growth in some countries could affect or change the levels of

inward and outward FDI. According to the Investment Development Path (IDP)

theory, countries go through certain stages of development. The first stage is

characterized by pre-industrialization in which no inbound and outbound

investment takes place. This is followed by countries attracting inward investment

in the resource-based and labor-intensive sectors. Next, the investment continues to

grow and expand to different sectors of the economy (Das 2013, 97). Inward FDI has

been shown to promote host country efficiency and so as capital accumulates, it

encourages the emergence of domestic MNCs who will then start to invest abroad,

making it an FDI outflow.

Institutional factors in the home country have also been emphasized in the

literature regarding FDI outflows. Poor institutional factors in the home country,

such as regional protectionism, quota allocations, high tax rates, corruption,

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regulatory uncertainty, insufficient protection of intellectual property rights and

governmental interference, may push firms to invest abroad in pursuit of more

efficient institutions (Das 2013, 98). Hence, as political risk increases in the home

country, capital tends to move out of the country to escape from that risk by being

invested abroad. This suggests that developing countries need to place greater

emphasis on ‘reducing political instability by improving governance standards’ in

order to prevent capital flight or outflows (Das 2013, 105).

Critique and Discussion

Throughout the scholarly work, it is apparent that the main approaches that

were taken revolved around the distinction between FDI inflow and outflow, as well

as, between developed and developing countries. This is certainlynot a sufficient

way to explain the elaborate process of foreign direct investment and the various

factors that influence it.

The more recent body of literature has done a good job of incorporating

relevant components in analyzing determinants of FDI flows. In addition to the

widely accepted GDP, Trade Openness, Exchange rate, and Labor costs, recent works

have focused on human capital and environmental sustainability. Education level,

literacy rate, life expectancy, air quality, public health, and environmental regulation,

have been included as part of the empirical testing. Some of these new additions, for

instance environmental quality, are of importance especially in an age where

“sustainability” is a major trend and buzzword. However, there are also drawbacks

to the body of literature. Most of the authors admit that variables such as political

factors, political risk, “institutions”, and governance infrastructures are not well

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defined. There is no consensus among experts as to how such variables should be

described. Most of the time, various indices are used in place of these factors andthis

creates a problem, especially when conducting empirical analysis, because it is hard

to quantify and measure them accurately.

Studying the determinants of FDI can be extremely beneficial both for firms

and for countries. It helps firms make better, well-informed investment decisions.

Countries can also adopt policies that better facilitate the movement of investment

flows into and out of the country. The literature makes a contribution by making us

understand the reason why there is unequal distribution of FDI. Moreover, it

encourages countries to develop more sound policies that promote a favorable

political, institutional, and legal environment.

Surprisingly, the majority, although not all, of the theoretical framework

behind this research relies on Dunning’s original “OLI” paradigm and it’s future

modifications or revisions. This theory has micro-foundations, which might not be

suitable to explain macro-level behavior. Further literature in this area should really

focus on addressing the need for a distinction between a micro-level approach and a

macro-level approach. There is a lot of focus on determinants that affect decision-

making at the firm level, but not at the country level. So far in the literature, it is

evident that certain firm-level decisions have been used to explain country level

behavior. Thus, future research should target at explaining the existing complication

in analysis due to the fact that it is unclear whether the main actor affecting FDI

flows is the country or the firm.

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Earlier on in this literature review, it is stated that political factors affecting

FDI flows have been undermined compared to economic factors. Institutions and the

political environment are neglected from being recognized as one of the main

determinants of FDI. Instead of looking at these political governance attributes as

mere complements to economic determinants, I suggest that experts need to further

the FDI literature by studying its relationship with governance infrastructure and

institutions in order to obtain a multifaceted understanding of the factors the

influence foreign direct investment flows across countries.

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Works Cited

Blonigen, Bruce A. 2005. “A Review of the Empirical Literature on FDI

Determinants.” Atlantic Economic Journal 33(4): 383–403.

Busse, Matthias, and Carsten Hefeker. 2007. “Political Risk, Institutions and Foreign

Direct Investment.”European Journal of Political Economy 23(2): 397 – 415.

Das, Khanindra Ch. 2013. “Home Country Determinants of Outward FDI from

Developing Countries.” Margin: The Journal of Applied Economic Research 7(1):

93–116.

Dunning, John. 1980. “Toward an Eclectic Theory of International Production: Some

Empirical Tests.” Journal of International Business Studies11(1): 9-31.

Globerman, Steven, and Daniel Shapiro. 2002. “Global Foreign Direct Investment

Flows: The Role of Governance Infrastructure.” World Development 30(11):

1899–1919.

Krifa-Schneider, Hadjila, and Iuliana Matei. 2010. “Business Climate, Political Risk

and FDI in Developing Countries: Evidence from Panel Data.”International

Journal of Economics and Finance 2(5): 54–65.

Spero, Joan E. and Jeffrey A. Hart. 2010. The Politics of International Economic

Relations. Seventh Edition. New York: Thomson Wadsworth.

Yang, Benhua. 2007. “Autocracy, Democracy, and FDI Inflows to the Developing

Countries.”International Economic Journal 21(3): 419–39.