Politics, Instability, and International Investment Flows

Abstract

In this paper, we analyze the role of political instability for the organizational form of foreign investment, i.e. whether it has the form of a majority- or minority-owned investment. We focus on the instability generated by the change of the party in power in a democratic system, rather than on the risk of change of political regime or expropriation risk associated with this change. The central trade-off in our theoretical model is the following: in majority-owned establishments, a foreign investor retains the control and enjoys fewer agency problems, while for minority-owned investments or joint ventures domestic partners of a foreign investor can lobby the government for some preferential arrangements, such as firm-specific tax breaks. Political instability decreases the payoff to political connections in the future and, therefore, decreases the attractiveness of minority-owned investments. The implications of our model are supported by empirical tests using three different sources: a World Bank survey of small firms in developing countries, aggregate BEA data on U.S. foreign affiliates, and SDC mergers and acquisitions data.

Keywords: political instability, investment

JEL Classification: G15, G18, G38, K42, O43