Impact of Political Risk on Foreign Direct Investment Decisions: Literature Review

Chapter 2: Literature Review

2.1: Introduction

This chapter provides a review of the recent contribution of literature on FDI and the determinants of such investment. In attempting to comprehend the complex factors that impact the attractiveness of particular geographic locations, it is essential that a thorough analysis of current literature is undertaken.

With the growth of FDI in recent years, there has been a growing body of research on the topic as economists, academics and policy-makers alike have sought to determine the macroeconomic factors that influence FDI. Studies on FDI flows by Asiedu (2006) and Jadhav (2012) have looked at various determinants of FDI to countries, including the relevance of trade openness, market size, labour productivity and political stability and have provided the grounding for this literature review.

2.2: Trade Openness

Reviewing the existing literature on trade openness highlights that there is not a clear definition of trade openness or trade liberalisation. For some authors, trade openness implicitly refers to trade policy orientation. For others, trade openness is a far more complex notion that covers the policy orientation of countries, in addition to other domestic policies (such as macroeconomic policies or institutional ones (Huchet-Bourdon et al., 2013). The following literature more or less relate to the two alternative definitions of trade openness mentioned above.

FDI is essential in the development of economies due to its ability to transfer technology, managerial skills and improve the overall productivity of the host nation (Ho and Rashid, 2011).  As a result, many countries have adopted liberal and economic policies to attract more FDI. Several studies have investigated the link between trade openness or trade liberalisation but have drawn mixed results. Wheeler and Mody (1992) found that in the case of US firms the degree of openness of the economy had a negative impact on FDI inflows. Research in China by Li and Clarke-Hill (2004) found that more open policies on FDI had little impact on attractiveness. However, other recent studies seem to confirm a positive a relationship between trade liberalisation and FDI inflows. Hufbauer et al. (1994) showed that trade openness of the host countries pays a significant and consistent role in the investment decisions of the US and Japan. Sekkat et al. (2007) found that increased openness as well as the improvements of other aspects of the investment climate (such as the political and economic environment) is a key factor for the attractiveness of FDI. Buthe and Milner (2008) state that in order for countries to attract FDI the regulatory and government policies should be open and flexible, yet robust, in order to strike a balance between the two.

Moran (1998) suggests that a more liberal environment tends to attract more ‘dynamic’ FDI from MNCs looking to establish export-oriented operations. Azzimonti and Sarte (2007) found that a host country government that enforces strict trade laws and policies can be a hindrance to the MNC investing in that country. According to Blomstrom (2003) investment incentives can be identified as a significant determinant in attracting FDI into a country. In support of these findings, Branstetter et al., (2002) discovered that China has a high influx of FDI in selected regions as they have policies to form special economic zone that allow for investment incentives; in the form of the preferential tax and administrative treatments of MNCs located there. However, Li (2006) adds that FDI incentives encourage ‘rent seeking’ behaviours in host countries whereby governments directly pick winners and losers in the market, discriminate against small and local firms. And these ‘incentives help MNCs strengthen their completeness and their ability to monopolise the market’. Thus, Li (2006) recommends the following to attract more FDI: ‘The more cost-effective strategy to attract foreign capital is by building and strengthening the governance institutions in a country’ and by improving the ‘investment environment’.

2.3: Market Size

Market size is an important economic determinant of FDI inflows and it corresponds to the needs of firms, especially MNCs to grow and/or to stay competitive by gaining access to new markets at home and abroad and/or increasing existing market shares. Several studies have identified the domestic market size and more importantly access to larger regional market as location-specific determinants of FDI (Wheeler and Mody, 1992; Lim, 2001). Khan (2012) cite that there ought to be a significantly large market size in a country for the MNCs to reap the benefits of investing in that country, a potentially large number of users/buyers of products, commodities or services are important. In support of Khan (2012), Monterro (2008) notes that the markets size of the host country receives a great deal of attention from MNCs, especially markets which have a potential to grow. Monterrro (2008) cites that Market size is generally measured by GDP, per capita income or size of the middle class. Market size is important for FDI as it provides potential for local sales, greater profitability of local sales to export sales and relatively diverse resources, which make local sourcing more feasible. Thus, a large market size provides more opportunities for sales and also profits to foreign firms, and therefore attracts FDI. Further, Love and Lage-Hidalgo (2000) cite that market size positively affected investment flows from US to Mexico between 1967 and 1994. Lipsey (1999) concludes that market size is an important determinant of FDI flows to Asia for the case of those affiliates that sell mostly in the international market. This could offer an explanation as to how China, with a significantly large market size has managed to attract large inflows of FDI since the early 1980s (Lipsey, 1999).

Further reviews of literature have show that the growth of the domestic economy and host country’s market size increases inward FDI. Mody et al. (1998) found that Japanese investors in Asia considered the size of the host country’s domestic market to be an important factor in investment. Durham (2002) cites that along with market size, the prospects of growth (generally measured by growth rates) also has a positive influence on FDI inflows.  Some evidence suggests that although the determinants for both Japanese and US MNCs are different, the market size is a shared determinant (Fountas and Aristotelous, 1995).

Siddiqi (2007) introduce another dimension in the literature by introducing the role of population size on market size and FDI inflows. Siddiqi (2007) suggests that the population of the country is a key FDI driver, because the bigger the population the bigger the market size and MNCs can take advantage of this, citing developing economies such Nigeria are potential destination for investment due their population sizes. Larger marketplace allows investors the opportunity to exploit ‘economies of scale’, thus catering for wider markets. Foreign companies are attracted to locations with rapidly expanding urban middle-class clientele, boosting high disposable incomes.

2.4: Labour Productivity

Although market size has been shown to be a very robust determinant of FDI, the quality of the human capital base is also an important asset in attracting MNCs. The OECD (2003) found that the presence of accessible human capital is an important factor when investors select an investment location. Studies by Barrell and pain (1996), UNCTAD (2008) have found that FDI increases with low-cost labour in the host country and a highly productive workforce Cheng and Kwan (2000) By contrast, Artige and Nicolini (2006) found that labour productivity was not consistent as a factor in FDI and its influence depended on the location and sector. Moreover, Groh and Wich (2009) argued that low-cost labour is not a primary motivator for investment and the combination of wage cost and productivity is more important. Sawkut et al (2007) highlight that a more educated workforce is generally more productive as it implements new technology more quickly and the level of tertiary education plays a key role in attracting high value-add MNCs (Miyamoto, 2003). Earlier empirical surveys of US MNCs in Ireland, by Gunnigle and McGuire (2001), found that labour quality and productivity was perceived favourably by executives. However, a study of US MNCs investing in Ireland and Bahrain showed that the availability of a skilled workforce was significantly more important in FDI decisions than low-cost labour (Gilmore, et al., 2003).

Azzimonti and Sarte (2007) note that lower labour costs attract FDI, this depends on the level of skills required by the MNCs and industry, however an educated labour force is critical. Drahokoupil (2008) asserts that at times having both an educated and cheap labour force is not always mutual, with higher level of skills required comes an associated cost of attaining and retaining these skills. Nonnemberg and de Mendonça (2004) cite that a country that has a high standard of education and presents a sustainable education policy that is aimed at increasing the level of education will be more attractive than a country that does not.

2.5: Political Risk

Researchers have defined political risk, in as many ways as there are authors of this topic. Therefore, it is important to elaborate on the political risk concept used. This dissertation draws from upon the definition, developed by Simon (1984), as it provides a more complete conceptualisation of the political risk facing MNCs (Oseghale, 1993). Simon (1984) defines political risk as “governmental or societal actions and policies, originating either within or outside the host country, and negatively affecting either a selected group of, or the majority of, foreign business operations and investments.”

In formulating a definition of political risk, the difference between risk and uncertainty is crucial. Risk and uncertainty are often treated as synonymous, however, there is a distinction. Firstly, the characteristics of risk are, a choice of action, a magnitude of loss, and a chance of loss. Conversely, uncertainty refers to a condition where you are not sure about the future outcomes (Gough, 1988).

2.5.1: The Relationship Between Political Risk and FDI

Swathappa (2012) suggest that macro-political risks are those risks which are country specific and affect all companies seeking opportunities to invest in the host country – examples of this macro-risks can be civil wars, protests, riots etc. Kobrin (1978) defines sovereign risk as events such as corruption, political coups, war damage etc.

According to Li (2006) the international business literature introduces an interesting intellectual puzzle regarding the impact of political risk on FDI. McKinskey (2017) note that there is a trend in executives considering political risk and instability in their investment decisions. In order to be comprehensive, the impact of political risk on FDI has been analysed from existing empirical literature.

Although there is limited literature that explicitly explores the relationship between political risk and FDI, however studies have highlighted the importance of political stability in attracting FDI into a country/region. An analysis conducted by Sekkat et al. (2007) highlights the importance of the investment environment, which not only includes traditional FDI determinants such as infrastructure endowment, but economic and political environment as well, in increasing FDI inflows. Sekkat et al. (2007) found that the improvement in the environmental and political climate can be even more important in the attraction of FDI than trade openness.

In their work, ODI (1997) and Ursprung (2002) found that FDI tends to flow into countries/regions with civil and political freedom. The authors worked with the hypothesis that ‘political repression boosts FDI’ and arrived at the conclusion that the hypothesis was not supported. On the other hand, MNCs appear to be attracted by countries/regions in which civil and political freedom is respected and upheld. Rodrik (1996) introduce another dimension in the literature by linking democracy with FDI. The study highlights democracy as a key determining factors that influences political risk and implies that countries with weaker democratic rights attract less capital from the US.

In their work, Busse and Hefeker (2005) found that some indicators for political risk and institutions closely associated with FDI, such as;

1. government stability
2. law and order,
3. quality of the bureaucracy.

They further establish a significant link a much larger number of indicators. In addition to the three mentioned indicators, they include investment profile, internal and external conflict, ethnic tensions and democratic accountability as important determinants of foreign investment flows. The study concludes that the largest political indicators were government stability and law and order, indicating that changes in these components of political risk and institutions are highly relevant for investment decisions of multinationals.

Another paper published by Busse (2003) offered invaluable information for this dissertation, especially in the use of democracy indicators like political rights and civil liberties as linked to FDI. His findings include a clear causation for countries with improving democratic rights and liberties received more FDI per capita. The paper also shows a positive and statistically significant relationship between democracy and FDI did not hold in the 1970s, this is when MNC’s preferred repressive regimes. The trend changed over the following years to embrace higher political rights and civil liberties of a market economy Busse (2003).  Janeba (2001) uses differing government credibility as an explanation for the lack of foreign investment in many developing nations and transition economies. This study pinpoints the fact that MNC’s will invest in politically stable but high-cost locations.

In Stasavage (2002) study pertaining to political instability and private investments, he explicitly mentions that there is a negative link between macroeconomic and political uncertainty and levels of private investment.  His work further reveals that when investments are irreversible, firms may delay or not pursue investment out of fear that the economic environment might change. He also reveals that political conditions affect perceived risk of opportunism for investors.

Smarzynska and Wei (2000) study the impact of corruption in a host country on foreign investors’ preference for a joint venture versus a wholly owned subsidiary and find that as corruption leads to a less transparent bureaucratic system, foreign investors especially those with sophisticated technology, lean towards a local joint venture partner since they worry about leakage of technological know-how. They find their results to be broadly consistent with this hypothesis. Mody et al. (2003) look at the role of information in driving FDI flows, and find that transparency can have positive impacts. Historically, an important host country determinant of FDI has been the availability of natural resources.

Schneider and Frey (1985) found that political and social unrest in the host country had a negative effect of foreign investment inflows. They report that political instability and occurrences of disorder deters risk-averse foreign investors. Singh and Jun (1995) highlight that political instability is a ‘complex phenomenon’ and the empirical evidence regarding the impact of political risk on investment is not clear due to the difficulty in gathering reliable quantitative estimates of political risk. However, for host countries with a high level of FDI (such as Ireland) the significance of political risk is found to be greater. Furthermore, Nigh (1985) found that for developed countries, the political events between the host and home countries were some significant determinants of FDI, whereas the political events within the host country itself had no impact on FDI.

Furthermore, Groh and Wich (2009) found that the political environment has less impact on FDI for more developed countries. Research by Kobrin (1979) found that institutional features such as political stability and government intervention in the economy are important determinants of foreign investment. According to Kinoshito and Campos (2002) political stability is described as a ‘necessary condition’ for a host country to attract foreign investment. Thus, political instability detracts from the local investment climate and creates an unfavourable business environment for investment (Schneider & Frey, 1985). In support of this, according to the survey of the Multilateral Investment Guarantee Agency (MIGA), foreign investors from both industrialized and developing nations chose political risks as one of the biggest challenges they face in developing and emerging markets (MIGA, 2010).

The contrast in results may reflect the difficulty in measuring perceived risk and the differing proxy indicators used to determine risk levels (Lim, 2001).

2.6: Conclusion

The review of relevant literature has enabled a fundamental understanding of the dynamics of political risk and its impact on FDI. This chapter has highlighted the important determinants of FDI as elucidated by the academic and empirical literature. The locational determinants of FDI are clearly driven by policy, economic and business facilitation drivers but the actual determinants depend greatly on the context and motives of the MNC. Dunning (1995) highlights that the factors of FDI are complex and there is no single explanation for all FDI determinants. Thus, the attractiveness of location is part tangible, part intangible and is strongly influenced by government within a ‘complex web of interrelated factors’. The next chapter describes and evaluates in detail the methods, techniques and procedures used in the investigation which link to the scope and aims of the dissertation.