Foreign direct investment, corruption and democracy

Abstract

This article is the first to show that foreign investors care about economic freedoms, rather than political freedoms, in making decisions about where to locate capital. Hence more democratic countries may receive less Foreign Direct Investment (FDI) flows if economic freedoms are not guaranteed. One reason could be that democratizing developing economies are often unable to push through the kind of economic reforms that investors desire due to the presence of competing political interests. This could potentially explain why countries like China and Singapore that rank poorly on the democracy index but are relatively high on the property rights index do well in terms of FDI inflows.

Keywords:

• foreign direct investment
• spatial econometrics
• emerging economies
• panel data
• democracy
• corruption

JEL Classification::

• F2
• C3
• C21
• C33
• F23

Notes

¹ http://www.transparency.org/policy_research/surveys_indices/cpi/2006.

² Hansen et al. (2003).

³ As they say, on average almost 60% of inward FDI to China, Malaysia, Thailand and Vietnam originate from no more than three sources. In the case of Indonesia this share is 33%. Similarly, FDI is generally highly concentrated in only a few sectors. These patterns no doubt can help explain the above general findings about the interrelationship of FDI flows. For example, the strong negative co-movement between Malaysia and Indonesia is in all likelihood closely related to the fact that two out of the three most important FDI sectors are common and in addition they share Japan as a key source of FDI.

⁴ Gwartney and Lawson (2004).

⁵ See the Appendix for years for which the CPI is available.

⁶ We can also drop these years from the sample without affecting our results.

⁷ We did a Granger causality test of FDI flows and GDP as described in Nonnenberg and Mendonca (2004). Results indicate that while FDI is Granger-caused by GDP, GDP is not significantly influenced by FDI flows.

⁸ We can easily include only log(GDP) or log (GDP growth) instead of both in the regression, without affecting the results.

⁹ Their measure of democracy is derived from the Polity IV measure of Marshall and Jaggers (2000).

¹⁰ There is no data for Hong Kong for this variable.

¹¹ The property rights index is discussed in detail later.

¹² If we include only the interacted variable and democracy on the right hand side, the coefficient on democracy is negative and significant, while the interacted variable does not turn up significant.

¹³ This also suggests that in Wei (1999), the corruption variable may simply be a proxy for property rights protection.