Politics, Instability, and International Investment Flows
University of Iowa - Henry B. Tippie College of Business
March 13, 2011
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.
Number of Pages in PDF File: 35
Keywords: political instability, investment
JEL Classification: G15, G18, G38, K42, O43
Date posted: March 14, 2011