FDI Inflow and Bilateral Political Relationship -Theory and Evidence

Abstract

This research reveals the inherent dynamics between the amount of foreign direct investment (FDI) inflow in the host country and its political relationships with other countries. We demonstrate in a two-stage sequential game model that there exists an inverted U-shape relationship between FDI inflow and bilateral political relations. Employing the political relationship index (PRI) to test our theory using Chinese data from 2002 to 2016, we find that the empirical results are broadly consistent with the theories proposed herein. When there is an initial rise in the level of bilateral political relationships, there will be more FDI inflows into that country due to a decline in the level of economic and political uncertainties. However, when the level of bilateral political relationships exceeds a certain threshold, the FDI inflow will tend to deteriorate. This indicates that an excessive level of political relationship rules out the earning opportunities due to the decrease and removal of the preferential policy on supporting business in the over-maturation of the host country. Our empirical results are also valid after using robustness checks and IV tests. We provide the case of the Sino-U.S. relationship to illustrate our general findings.

Keywords: FDI inflow; Bilateral political relationship; Political relationship index; Sequential game model

JEL Classification: F14, F51, C32, O57, P45