Political Violence and Foreign Direct Investment

The international business literature presents an interesting intellectual puzzle regarding the effect of political instability and political risk on foreign direct investment (FDI). Survey evidence shows that multinational executives take into account political instability in making investment decisions, while econometric studies produce conflicting findings. In this paper, I offer a new theory that explains how political violence, an extreme form of political instability, affects FDI. The new theory differs from previous arguments on three points. First, the theory considers how rational expectations and uncertainty on the part of foreign investors affect the ways in which political violence influences investment behaviors. Second, the new theoretical argument argues for the need to investigate separately the effects of different types of political violence (civil war, interstate war, and transnational terrorism). Third, I consider FDI inflows as resulting from two distinct but related decisions, including the investment location choice and the decision on investment amount, and sort out statistically the separate effects of political violence on these two processes. The empirical analysis of FDI inflows covers about 129 countries from 1976 to 1996. The statistical findings largely support my theoretical expectations. My theory helps reconcile the inconsistent econometric findings on the effect of political instability on FDI flows. 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 3B2v8:07f XML:ver:5:0:1 RGSM V012 : 12011 Prod:Type: pp:2312255ðcol:fig::NILÞ ED: PAGN: SCAN: 14/3/06 11:24 Regional Economic Integration Research in Global Strategic Management, Volume 12, 231–255 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1064-4857/doi:10.1016/S1064-4857(06)12011-2 231 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 The international business literature presents an interesting intellectual puzzle regarding the effect of political instability and political risk on foreign direct investment (FDI). In an early review of studies on political risk, Kobrin (1979) concludes that the empirical evidence is inconsistent and mixed regarding the effect of political instability on FDI stocks or flows. Later econometric studies continue to produce mixed findings. For example, Schneider and Frey (1985) find that political instability has a negative effect on FDI flows. Nigh (1985) finds in an analysis of 24 countries over 21 years that both internation and intra-nation conflict and cooperation affect manufacturing FDI flows by U.S. firms. But Fatehi-Sedeh and Safizadeh (1989) QA :1 fails to find statistical association between political stability and FDI. In a cross-sectional analysis of FDI flows to 36 countries for 1977 and 1982, Loree and Guisinger (1995) find that political stability significantly promotes FDI inflows in 1982, but not in 1977. Olibe and Crumbley (1997) do not find consistent evidence that political risk index influences U.S. FDI flows to 10 out of 13 OPEC countries. Using data from all reported manufacturing plant openings from 1984 to 1987, Woodward and Rolfe (1993) find that political stability increases the probability of a country being selected as an investment location. More recently, in a pooled analysis of 52 developing countries from 1982 to 1995, Li and Resnick (2003) do not find that political instability has any statistically significant effect on FDI inflows, but regime durability encourages FDI inflows. Sethi, Guisinger, Phelan, and Berg (2003) find that political instability, measured by a composite variable on a 100-point scale, does not influence U.S. FDI flows to 28 countries from 1981 to 2000. Globerman and Shapiro (2003) conduct a twostage analysis of U.S. FDI flows to 143 countries from 1994 to 1997, in which the first stage investigates the causal factors of the probability that a country is an FDI recipient while the second stage examines the determinants of the amount of FDI received. They find that an index of political instability and violence, including armed conflict, social unrest, terrorist threats, etc., does not influence the probability whether a country receives any FDI inflow, but reduces the amount of FDI inflow a country receives. That is, the average size of an FDI transaction may change independently of the probability of a country receiving the FDI. The econometric evidence is obviously mixed and inconsistent across studies. In contrast, evidence from studies of responses of executives to interviews and questionnaires (e.g., Bass, McGreggor, & Walters, 1977; Aharoni, 1966) typically demonstrates that political risk and stability are important considerations when investors make investment decisions. More recently, Porcano (1993) finds in a survey of Canadian, British, and Japanese firms of 36 QUAN LI 232