Investing in Democracy

February 19, 2003

Investing in Democracy

One of the most contentious issues in globalization is the international social responsibility of investors-mainly multinational corporations (mncs)-in industrialized democracies.

One of the most contentious issues in globalization is the international social responsibility of investors-mainly multinational corporations (mncs)-in industrialized democracies. To be sure, the debate over how (and if) these investors can simultaneously pursue profits and global public goods has a long and contentious history, generally pitting the business community against an array of international non-governmental organizations.  

Are mncs good for the political quality-of-life of the countries in which they invest? Our evidence, based on examining FDI (foreign direct investment) patterns following democratic regime transitions in 23 countries since the mid-1970s (1), indicates that investors-mainly MNCs-have been far more socially responsible, even virtuous, than many have supposed. FDI investors have quickly embraced new democracies immediately following a regime transition; overall, the evidence shows a significant increase in fdi within the three years of regime transition over the three-year period prior to transition. FDI investors' confidence in new democracies has played an important role in the consolidation of many democracies since the late 1970s. Unlike international portfolio investors, who can exit a country at the tap of a few computer keys, FDI investors cannot quickly liquidate their investments (mostly factories and equipment). Ironically, the illiquidity of FDI thus becomes a better measure of foreign investors' confidence in the long-term prospects of a given country than portfolio investments.  

Analysis of FDI flows shows that investors have been highly discriminating in reacting to pending regime changes. Generally speaking, and as common sense would suggest, FDI has been most likely to increase in countries that were evolving gradually and peacefully toward democratic rule (such as South Korea, Spain, Chile and Thailand), but has tended to flee pre-transition countries that were at war (Argentina in 1982), experienced a sudden increase in instability (Panama in 1987­-88; the Philippines in 1983-84), or suffered hyperinflation (Brazil in 1983-85).  On the other hand-and much less obviously-democratic transitions seem to whet fdi investors' appetite for high-payoff risk. In 18 of the 23 newly democratized countries we studied, total FDI in the three-year post-transition period rose dramatically over a similar three-year period prior to the transition.  The magnitude of increase was also large-in excess of 100 percent in all but one country. The aggregate amount of FDI for the 23 countries as a group was $26.6 billion in the three-year period following transition, about $8.2 billion more than the total amount of fdi in the three-year period prior to the transition-an increase of 45 percent. Clearly, FDI in post-transition countries gained importance as a significant source of capital formation. 

Remarkably, such rapid rises in FDI took place in generally unfavorable macroeconomic environments. In the three-year period after transition, inflation remained very high (over 20 percent a year) in twelve countries while growth was stagnant or negative in eleven countries; macroeconomic trends were favorable (characterized by falling inflation and rising growth) in only seven countries. This suggests that, in general, short-term macroeconomic risks do not deter fdi investors from increasing their investments in new democracies. 

While FDI investors usually give new democracies the "benefit of the doubt", longer-term FDI flows-flows beyond the three-year transition period-depend mainly on the institutional health of destination countries. Regression analysis of the relationship between FDI, political risk and various macroeconomic indicators (inflation and GDP growth) shows that political risk has been more significant than macroeconomic performance as a determinant of fdi flows to new democracies four to eight years after regime transition. Indeed, political risk is more statistically significant eight years after transition than four years after, indicating the increasing influence of post-transition institutional development on fdi investment decisions. In other words, phony or shaky new democracies cannot expect to keep fdi investors happy-at least not many or for very long.  

Moreover, the data show that official development assistance (ODA) to new democracies has played a much smaller role in injecting fresh financial resources into those countries than has FDI. Despite the rhetoric, net flows in ODA to newly democratized regimes in the three-year post-transition period in our sample were actually negative. At the aggregate level, the total amount of ODA to the 22 countries (excluding Spain, for which ODA data were not available) in our sample in the three-year period after transition actually fell by $103 million from the three-year period prior to transition. This was in sharp contrast to the net increase of $3.6 billion in FDI in the same period for the same countries. Private FDI flows to these countries rose by 45 percent in relative terms, and exceeded total ODA funds by a third. This suggests that, as a group, Western governments are less regime-sensitive and bullish on new democracies than private investors.  

(1)    The 23 countries are: Argentina, Benin, Bolivia, Brazil, Central African Republic, Chile, Ecuador, El Salvador, Guatemala, Honduras, Ghana, Malawi, Mali, Mozambique, Panama, Paraguay, Peru, the Philippines, South Korea, Spain, Thailand, Turkey and Uruguay.

(2)   The total amount of ODA in the three-year pre-transition period in our sample was $19.98 billion, about $3.34 billion more than the amount of FDI in the same period. But the total amount of ODA in the three-year post-transition period was $19.88 billion, virtually unchanged from the three-year pre-transition period, but $2.04 billion less than the FDI in the same period. The net decrease of ODA relative to FDI was $5.38 billion.

 

Minxin Pei is a senior associate and co-director of the China Program at the Carnegie Endowment for International Peace. Merritt Lyon is a junior fellow at the Carnegie Endowment.