Democratic Governance and Multinational Corporations: Political Regimes and Inflows of Foreign Direct Investment by Nathan M. JensenSummary by: Masaki Koiso and Abyasa Kamdani

Foreign direct investment (FDI) is one of the most important elements of global economy. It enables nations to transfer innovative ideas, technology, and other capital goods, which in turn would affect the state of these economies. The benefits of FDI are essential because some may not be available in the host market, particularly in less-developed countries. FDI is now treated as a fundamental basis of the market. The biggest three benefits of FDI are:

1. Provision of high quality or low cost labor force2. Provision of technological progress 3. Provision of productivity improvements

Because these factors are deeply connected with economic growth, FDI can lead the economy of a country. But, how do we decide the amount of total investment? Since there are differences between countries, domestic economy and government policy, this paper analyzes the relationship between the FDI and democratic governance. It seems some researchers found that more democratic countries tend to be conservative against FDI. Though FDI brings great opportunity for growth, domestic economies can also be negatively affected through its competitive character, which affects the government and citizens. Interestingly though, this paper expelled results that were inconsistent with the general notion of how democratic governance leads to less FDI inflows.

Discussion Question:What are some effects or examples of foreign direct investment that could negatively affect the lifestyle of natives?

Multinational Corporations and Domestic Economies

FDI is one of the most stable and economically important international capital flow. The importance of FDI is large and growing. In 1990, 44% of all international capital flows were private. This rose to 85% in 1996, with FDI being largest single type of capital flow. The table 1 is the FDI as a percentage of gross domestic investment of 1980s. In the vast majority of countries, FDI accounts for a substantial amount of domestic investment. Multinationals tend to be more important in industries and firms with four characteristics:

1. High levels of R&D relative to sales2. A large share of professional and technical workers in their workforce3. Products that are new and technically complex4. High levels of technical differentiation and advertising

Investment by these technologically advanced firms translate directly into growth-promoting technical advances for the host nation.

Determinants of FDI

Firms have ownership advantages when they have access to some asset or process that provides them with some advantage over other existing firms in the foreign market. There are three main reasons for these advantages:

1. Global brand name2. Locational advantage (Investment abroad)3. Internalization advantages

Firms who advance into foreign countries can capture many benefits as they are familiar to world markets, have lower cost of production, and in turn- can spread their scale of selling.

Discussion Question:If you were the head of a large firm who seeks to invest abroad what kind of qualities would you look for in a country?

Democracy and FDI

The relationship between political institution and economy has a similar meaning to the relationship between democracy and economy. Many scholars suggest that ensuring property rights is a central element to economic development. This fact implies the importance of the policy institution. To protect property, democracy contributes the property protection structure. Macroeconomic performance on the democracy is relatively important to foster these property rights, and these rules also influence the workforce. FDI can lead to lower cost worker, andthis impact of lower wage has been overemphasized as a determinant of FDI. The decision of employment change from FDI is depend on the country’s situation.

Empirical Tests- Overview

Relationship between FDI and democracy is conducted in four sets of empirical tests:1. Effects of democratic institutions on FDI inflows in cross section of countries in 1990s2. Relationship of democratic institutions on FDI inflows using a time series cross sectional

analysis of more than 100 countries for almost 30 years3. Heckman selection model to further examine robustness of this relationship4. Causal mechanism linking democracy and FDI by examining effects of democratic

institutions on sovereign debt ratings The first 3 tests confirms the hypothesis that democratic institutions is associated with higher levels of FDI inflows while the final test highlights the link between democracy and credibility.

Empirical Analysis- Cross Sectional Results

A research was conducted using the ordinary least squares regression (OSL) of 79 countries with White’s correction for heteroscedasticity on the determinants of FDI.

Independent Variables:- Growth - Development Level- Market Size- Trade - Government Consumption- Budget Deficit- Democracy

Dependent Variable: Average net FDI inflows as percentage of GDP from 1990 to 1997

The cross sectional test involves both developed and developing countries. According to the results, international relations play a large part in foreign direct investment. With increase in trade, higher levels of natural resources and more economic growth leads to more foreign investment. In addition, countries with higher budget deficits also attracts more investors due to the higher rate of returns while development level has no significant effect. Interestingly, higher FDI Inflows Control is correlated with higher FDI. The researcher justified this data from the

view that certain countries receiving more foreign capital needs to start limiting what enters, and thus the higher capital control. Overall, different levels of democracy is significant to FDI inflows where moving from an authoritarian regime to democratic can increase the inflows by 60%.

Discussion Question:What makes a democratic regime more attractive to investors opposed to a authoritarian one?

Time- Series Cross Sectional Results

Similar to the Cross Sectional test, the Time- Series also compares these developed and developing countries only now they add a time span of 30 years with the results measured each year. The results are also quite similar except that Trade is no longer a significant variable and Economic growth has changed and significantly positively associated with higher levels of FDI as a percentage of GDP. This could be due to the business cycle as the data is measured within a longer time period. Democracy remains positive and significant in all models as the results are very similar to cross sectional data.

Further on, the researcher used a new type of model called the Heckman, which accounts for the poor countries with a democratic system barely surviving due to poor economic conditions. Thus, to control this bias, the researcher used the Heckman selection model which uses GDP per capita and the number of past democratic breakdowns to generate estimates of democratic regimes. Overall, he found that the Ordinary Least Squares Regressions has understated the

effects of democracy on FDI and therefore the correlation of democracy and FDI is even stronger.

Democracy and Sovereign Debt Risk As the results show democracy leads to higher levels of FDI, these democratic systems also increase credibility to political leaders. To examine the causal mechanism leading democratic institutions to higher levels of government credibility, the researcher examined democratic institutions’ affect on sovereign debt ratings of governments. He found that democratic institutions, when all other economic factors are controlled, are generally with lower levels of political risk in terms of sovereign debt. Therefore, democratic governments generally attract higher level of FDI.

Discussion Question:What are some disadvantages of a democratic government in regards to covering sovereign debt?

Conclusion

In sum, all of the empirical tests shows that democracies attract higher levels of foreign direct investment. The sovereign debt risk presents results that shows democratic governments are generally associated with lower country risk and therefore can lower the risks for both lenders and multinational investors as well. The results in this paper challenges the prediction of Democratic institutions inefficiently attracting multinational corporations, in fact there exists 70% more FDI as a percentage of GDP in democratic than authoritarian governments.