Countries around the world have opened their economies to foreign investors by liberalizing foreign direct investment (FDI) laws and actively promoting FDI inflows (UNCTAD 2003). Yet only a handful of countries in the developing world are attracting sizeable FDI inflows. Economists argue that the main reason for the lack of capital flowing from the capital rich north to the developing south is the potential for high levels of political risk in emerging markets.
Numerous studies in political science and economics have attempted to pinpoint the policies and political institutions that affect FDI flows, but most works suffer from two sets of flaws. First, many works utilize macro-level data to test micro-level theories. Theories on the relationship between political risk and multinational investment center on the decisions of individual firms while the majority of empirical analyses use aggregate levels of foreign direct investment to test these theories.
Second, many of these studies utilize an overly simplistic model of multinational investment decisions. In most cases, scholars focus on a firm’s dichtomous decision of whether or not to enter a market based on the level of political risk. They then conclude that MNCs avoid investments in high risk countries. Although this is certainly one part of the multinational’s decision, it ignores both the flexibility of MNC production strategies and the ability of firms to affect the political environment. In short, firms may still enter into high risk environments though they might employ different strategies. This can include making investment decisions that minimize the risks for the multinational investors, such as investing in more liquid operations that the firm can easily disinvest from if the political situation worsens and actively participating in politics to affect outcomes.
My theory and preliminary empirical results suggest that MNCs make strategic decisions based on the types of political institutions in the host country. Although political risks come in numerous forms such as nationalizing firm assets, restricting a company’s ability to repatriate profits, and changing tax rates, we can generalize these risks as all contract risks. Thus I differentiate political risk from the uncertainty of future policies. Political risk is the probability that governments will renege on agreements with multinational investors.
My central argument is that firms tailor their operations to different political environments. In countries with low levels of political risk, multinationals will set up operations similar to those in advanced industrialized countries. In countries that have higher levels of political risk, multinationals will structure operations that both limit the level of political risk and increase the firm’s influence over domestic politics. The structure of these multinational investments will affect the wages paid, taxes collected, and other spillovers to the local economy.
