Risky Business: Institutions vs. Social Networks in FDI

Abstract

Political economy accounts of economic integration strongly emphasize the importance of legal contract enforcement. We challenge extant research by showing that relational contracting, relationship-based contract enforcement, is more efficient for high-risk, human capital-intensive activities for which the costs of writing legally enforceable contracts are prohibitively high. We disaggregate foreign direct investment (FDI) into two distinct varieties: mergers and acquisitions (M&A) and venture capital (VC). We propose that VC flows are less sensitive to host institutions but correlate strongly with skilled migrant networks that monitor compliance and impose reputational costs. Our empirical analysis of dyadic VC and M&A flows covers over 100 countries during 1980-2009. We control for other mechanisms through which migrant networks facilitate FDI and verify our results with industry-level analyses. These findings suggest that relational contracting facilitates global integration of dynamic, knowledge-intensive industries even in the presence of weak institutions.

Keywords: foreign direct investment (FDI), political risk, migrant networks, venture capital

JEL Classification: F21, F22, F23, G24, G34