Politics, Instability, and International Investment Flows

Abstract

In this paper, we propose a political theory of international equity flows. We analyze the choice between foreign direct investment (FDI) in which investor retains control and foreign portfolio investment (FPI) in which control remains in the hands of the other party. The central trade-off in the model is the following: FDI mitigates agency problems and reduces tunnelling, while with FPI domestic partners are able to lobby the government. As a result, FPI allows foreign investors to get preferential arrangements, such as firm-specific tax breaks, which they would not get with FDI. We also look at the role of political instability in this trade-off. Political instability diminishes the relative value of FPI as compared with FDI as it decreases the probability of getting tax breaks through political connections of domestic partners in the future. Consistent with stylized facts and existing empirical evidence, our model shows that FDI should be relatively more attractive when investor protection is worse, when political inequality is lower, or when political instability is higher. It also produces predictions for the effect of crisis in different countries. It shows that the effect of crisis is expected to be more important in countries with more stable politics and in countries in which corporate insiders have more influence on political process.