Reexamining the Effect of Democratic Institutions on Inflows of Foreign Direct Investment in Developing Countries

Abstract

The effect of regime type on inflows of foreign direct investment (FDI) remains a matter of controversy. While some studies report a positive influence of democracy on FDI, others show a negative influence. This study reexamines this discrepancy using pooled panel data during the past 20 years and contributes to the existing literature in three ways. First, it refines the causal mechanisms underlying the democracy-related arguments of veto players, audience costs, and democratic hindrance with respect to foreign investment. Second, it introduces three accurate measures to capture each of those three causal arguments. Third, it briefly demonstrates how different measurements of the dependent variable can produce statistically spurious results. The empirical results reveal that democratic institutions are, at best, weakly associated with increases in FDI inflows (measured by FDI/GDP ratios). While multiple veto players (and, counterintuitively, democratic hindrance) may be positively associated with increases in FDI, audience costs are not linked to FDI activities. These findings have important policy implications given that developing democratic countries are trying to attract more FDI in order to achieve their economic growth and development targets.