Political Risk, Macroeconomic Uncertainty, and the Patterns of Foreign Direct Investment

Abstract

While recent times have witnessed a surge of foreign direct investment (FDI) inflows into the developing world, these inflows remain below optimal levels. In this article, we use data on African, Asian, and Latin American economies to investigate the role of political risk and macroeconomic uncertainty—stemming from the foreign exchange market—as determinants of the patterns of FDI. Moreover, given the low share of FDI going into African economies, we place special attention on the differential impact of these variables on FDI flows into Africa. The results of this study point to the fact that, in general, political risk and exchange rate uncertainty reduce FDI. However, it is shown that the impact of political risk is more severe for FDI flowing into African economies.

Keywords:

• FDI
• macroeconomic uncertainty
• political risk

Notes

¹ The concept of political risk has not received a clear cut definition. However, for the purpose of this article we will use the definition provided by Haendel (1979), who defines political risk as the risk or probability of occurrence of some political event(s) that will change the prospects for the profitability of a given investment. Political risk refers to political instability and host country institutional inefficiencies.

² See http://www.times-publications.com/ for more information.

³ The countries in this study are Botswana, Egypt, Gabon, Ghana, Guinea-Bissau, Kenya, Malawi, Sierra Leone, South Africa, Togo, Uganda, Zambia, Argentina, Bolivia, Brazil, Chile, Colombia, Mexico, Nicaragua, Peru, Venezuela, China, India, Indonesia, Malaysia, Philippines, Singapore, and Sri Lanka. The selection of countries was based on data availability.

⁴ We aggregate the monthly conditional variances into annual frequency to obtain our annual uncertainty measures.

⁵ We use the real rather than the nominal exchange rate, since uncertain price levels as well as exchange rates are relevant for long-term investments. All real exchange rates are bilateral exchange rates vis-à-vis the U.S. dollar. The real exchange rates are calculated by multiplying the ratio of prices in the United States relative to national prices by the nominal exchange rates. Thus an increase in the real exchange rate index would indicate an appreciation of the U.S. dollar.

⁶ For the sake of robustness, we included the standard deviation (and variance) of exchange rates as a measure of volatility in our estimations. As often reported in the literature, the estimates turned out to be statistically insignificant (see Bailey and Tavlas 1991; Campa 1993; Benassy-Quere et al. 2001; Ruiz and Pozo 2008). Therefore, to maintain the focus on the concept of uncertainty, the results are not presented here (available upon request).

⁷ See Enders (2004) for more Details on the Lagrange Multiplier Test (LM Test).

⁸ Most empirical work finds that GARCH (1,1) adequately represents the conditional variance (see Bollerslev, Chou and Kroner 1992). In cases where the GARCH (1,1) does not fit the series well, ARCH(1) is often adequate.

⁹ For sake of space and focus, the results of the ADF test are not presented here but available from the authors upon request.

¹⁰ While our results regarding literacy rates indicate that this variable is statistically insignificant, this is an issue that deserves to be explored further. For more details refer to Suliman and Mollick (2009)

¹¹ We have to note however, that the estimates seem rather low for a persistency measure. The implications, while out of the scope of this paper, grant further investigation of this issue.