Bullish on Democracy

Bullish on Democracy

Mini Teaser: Contrary to covnventional wisdom, foreign direct investment by multinational corporations has bolstered transitions to democracy--more so, it turns out, than official development aid.

by Author(s): Minxin PeiMerritt Lyon

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, as anyone who remembers the publication of Richard Barnett and Ronald Muller's Global Reach in 1974 knows. However, as the pace of globalization accelerates (yes, it is, by the way, despite 9/11), and the backlash against globalization gains political momentum, the ethical role of international private investors has again become a divisive controversy. That controversy, which generally pits the business community against an array of international non-governmental organizations, is fueled most often by specific incidents: high-profile investment projects in countries with poor human rights record, revelations of child labor and sweatshop abuses, and allegations of environmental damages attributed to foreign corporations. Public outrage, abetted by a media generally inclined against business, is often followed by calls for consumer boycotts or other political sanctions against the offending firms.

Over time, the accumulation of such incidents has encouraged a widespread perception that multinational corporations are irresponsible global citizens who care only about fattening their own bottom lines. Conventional wisdom even among the more knowledgeable public (and some academics) holds that MNCs, guided by profit-maximizing strategies, flock to authoritarian regimes capable of repressing demands for economic justice and the costs of meeting environmental standards.1

But despite the prevalence of such views, there is almost no empirical evidence that any of this is true. Indeed, a growing body of research suggests instead that foreign direct investment (FDI)2 is generally beneficial to developing countries, creating the socioeconomic conditions conducive to the improvement of human rights and environmental quality in host countries.3 Several studies indicate that MNCs, particularly those based in open societies, find that it makes better business sense (and enhances profitability) to "export human rights" and to implement stricter environmental regulations in the developing world. An empirical study of the relationship between foreign direct investment and human rights has produced evidence that FDI is associated with more political rights and civil liberties in developing countries.4

Similarly, a growing body of research shows that MNCs are not engaged in an environmental race to the bottom. Instead, scholars have found a strong connection between corporations' environmental performance and superior financial performance, and that global environmental standards and strict compliance may increase the market value of compliant firms in developing countries.5 Others have found a link between environmental management and stock performance through both tangible economic influences and what has been termed the "reputation effect."6 Still, other studies have found a strong correlation between environmental performance and profitability at the firm level.7 In other words, MNCs may actually be more environmentally responsible than local competitors.8

CAN THE same be said for democratization? Are MNCs good for the political quality-of-life of the countries in which they invest? Our evidence, based on examining FDI patterns following democratic regime transitions in 23 countries since the mid-1970s, indicates that FDI investors--mainly MNCs--have been far more socially responsible, even virtuous, than many have supposed.9 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 compared with 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 measu re of foreign investors' confidence in the long-term prospects of a given country than portfolio investments. Rising FDI investments in new democracies represent a form of economic endorsement by international investors. Such endorsement seems to carry weight, too; a striking feature of the Third Wave transitions is that no new democracy has been subsequently toppled by an economic crisis.

But how, and why, have MNCs aided democratic transitions? In theory, the prospects of the establishment and consolidation of democratic institutions should bolster the confidence of FDI investors for two reasons. First, as a general rule, private property rights are more secure in democracies than autocracies. This is because the power of the government in a democracy is more constrained, not just by electoral mechanisms and presence of opposition parties, but also by courts. Second, democratic institutions may offer long-term peaceful solutions for social and ethnic conflicts, thus contributing to political stability. In several countries, such as El Salvador, Guatemala and Nicaragua, democratic transitions also brought to an immediate end long-running civil conflicts.

But matters are not nearly so simple. Clearly, most political benefits of democratization may be realized, if at all, only when new democratic institutions become consolidated and mature. In the short-run, the benefits are often elusive. Indeed, FDI investors face unusually high economic risks when they invest in newly democratized nations, and these risks are often compounded because the disruptions engendered by political transition often occur within a context of macroeconomic crises that almost invariably result from the mismanagement of the previous regime.10 FDI investors must also brace themselves for high political risks in new democracies. Political fragmentation and national disintegration are real possibilities, particularly in multiethnic societies where ethnic minorities often view the downfall of the old regime as an opportunity to break away completely--Indonesia offers a recent example of such a phenomenon as does the Chechen uprising against post-Soviet Russia. Most critically, many new de mocracies face enormous challenges in developing effective governing capacity in a short period of time. For FDI investors, negotiating with poorly coordinated bureaucracies in a new democracy can often be a nightmare--and the specter of a restoration of the old guard can hang over the proceedings, as well.

If such risks abound, why then do FDI investors show such confidence in democratizing countries and in new democracies? Part of the answer is that their confidence is selective and nuanced. 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 decrease in stability (Panama in 1987-88; the Philippines in 1983-84), or suffered hyperinflation (Brazil in 1983-85).11

On the other hand--and much less obviously--democratic transitions seem to whet FDI investors' appetites 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.12 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.13 Clearly, FDI in post-transition countries gained importance as a significant source of capital formation.14

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.

There are exceptions, however. FDI investors have been particularly averse to sending capital to post-transition countries struck by hyperinflation.15 They also have tended to shun countries where regime transition was inconclusive and the old guard retained a strong presence in the government--for example in Russia, Ukraine or Belarus. In addition, countries that risk further disintegration following a democratic transition do not seem to attract FDI. (Post-Suharto Indonesia and Russia immediately following the Soviet collapse are apt examples.) Generally, those newly democratized countries with large economies and bright growth prospects (Spain, South Korea, the Philippines and Chile) were favored destinations of FDI and received, in absolute terms, more FDI than smaller and slow-growing economies.16

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.

FDI versus Official Assistance

THE PROMOTION of democracy has long been, at least in official rhetoric, a key foreign policy objective of nearly all Western governments. Transitions from authoritarian rule to democracy in the developing world are treated as strategic opportunities to enlarge the global community of democracies, particularly so after this past September 11. In many instances, Western governments have greeted such regime transitions with expressions of political support and pledges of financial assistance. On the basis of official pronouncements, it is thus easy to form the impression that fragile new democracies, usually born under adverse economic circumstances, must rely on the generosity of Western governments to put their economic house in order.

The reality, however, is quite different. 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.17 Private FDI flows to these countries rose by 45 percent in relative terms, and exceeded total ODA funds by a third.18 This suggests that, as a group, Western governments are less regime-sensitive and bullish on new democracies than private FDI investors.

Analysis of ODA data raises other intriguing issues. Western governments tended to increase ODA to those newly democratized countries torn by civil war or leftist insurgencies. For example, Central American countries (El Salvador, Guatemala and Honduras) saw some of the largest increases in their ODA after they became democratic in the mid1980s. In the three-year post-transition period, they received $2.5 billion--12 percent of total ODA flows to new democracies in the three-year post-transition period. The same pattern held in the Philippines, where the huge increase in ODA (from $1.27 billion to $2.38 billion from the three-year pre-transition period to the three-year post transition period following the overthrow of the Marcos regime in 1986) took place for strategic reasons. Thus, ODA was used primarily as a policy instrument to bolster newly-elected pro-Western governments that faced serious political challenges, not as a humanitarian or economic policy tool.

That ODA serves political and Strategic rather than humanitarian and economic considerations seems confirmed by the data from Africa. Poor African countries that had received the bulk of ODA (about half of the total ODA in our sample) prior to their democratization saw a large drop in ODA during their transitions to democracy in the early 1990s. Five of the six African countries (Central African Republic, Ghana, Malawi, Mali and Mozambique) saw a net decrease of $1.6 billion in ODA in the three-year post-transition period as compared to the three-year pre-transition period. FDI in the same five countries showed a net increase of $755 million in the same three-year post-transition period. If we include data from east European countries following the collapse of communism in the former Soviet bloc, we find additional empirical evidence that ODA flows are generally determined by strategic interests rather than the recipients' humanitarian needs or any strictly economic criteria.19 This pattern suggests that O DA is not an effective financial vehicle to support new democracies that emerge in countries considered strategically marginal to the West--unless the United States and others change their approach to foreign assistance, as they have recently promised to do. We will see if, and how, that promise is kept.

The Democracy Exception

IN THE CASE of supporting new democratic regimes, FDI investors appear to have pursued private profit and provided global public goods at the same time. This raises an obvious question: If FDI investors could be socially responsible in one case, might they extend their virtues into other areas such as labor rights and environmental production? Probably not: A set of unique circumstances surrounding democratic transitions has enabled FDI investors to do good while trying to do well, but it may be impossible to reproduce these circumstances for the production of other types of global public goods. Three arguments support such a conclusion.

First, the production of a social good in developing countries receiving external aid or investment requires not only outside funds, expertise and other types of assistance, but the cooperation and commitment of the indigenous political leadership. Where such cooperation and commitment is lacking, external aid is likely to be ineffective.20 In most instances, democratic transitions signal the resolve for change and reform by the indigenous political elite. In the short-term, the new ruling elite's commitment to political and economic reform may also appear to be strong and credible. All else equal, these two factors are likely to sway FDI investors to favor newly democratized countries in their investment decisions because these signals represent new political, rather than economic, opportunities to reduce the risks of their capital.

Second, FDI investment in newly democratized countries is different from other forms of "socially responsible investing." There is practically no opposition to FDI investment, either in the host or the source countries, because it does not directly pit one interest group against another. In other forms of socially responsible investing, however, investment outcomes seldom can make all stakeholders happy. For example, explicit investment decisions affecting labor rights or environmental standards unavoidably create enemies either in the business community or among groups defending labor rights and the environment. Political controversies in host and source countries poison the investment climate, often to such an extent that MNCs may decide to abandon their plans altogether, ultimately hurting all stakeholders involved.

Third, FDI in new democracies also appears to have avoided one pitfall often experienced by other forms of socially responsible investment: manipulation by host-country governments. MNCs are fierce competitors internationally for new markets and investment opportunities, and such competition allows host country governments to play one MNC off against another in extracting the most favorable terms (especially when such countries enjoy competitive advantages such as market size and possession of valuable resources). More important, in the absence of a united front among MNCs (wouldn't that be collusion?), socially responsible investment is practically impossible because host countries will invariably offer more flexible terms to competing bidders m order to get the proffered capital. Some authoritarian regimes--such as China, Iran and the former Soviet Central Asian republics--have become quite deft at this game, much to the frustration of human rights advocates. By comparison, few extraneous social conditions get attached to FDI investments in newly democratized countries, thus leveling the playing field for everyone.

Clearly, FDI investors in new democracies do best for themselves and for the host countries when they are able to operate under the political radar screen, avoiding the politicization of their business efforts. Nor is anyone's interest generally served by trying to raise that profile. In the case of explicitly "socially responsible" investment, businesses making one socially responsible investment decision should expect to be asked to make others. Those MNCs that allow themselves to be portrayed as capitalist defenders of freedom may be called upon to intervene in human rights, labor standards and other contentious issues in their host countries, which is an honor most MNCs could--and will--do without. Asking too much of MNCs can lead ultimately to their doing too little.

EVEN THOUGH the unique conditions responsible for channeling rising FDI to new democracies are unlikely to be reproduced for making MNCs more socially responsible in other areas, the bullishness shown by FDI investors on new democracies is good news. MNCs can be responsible global citizens as long as their operating environment is neither politicized nor polarized. At the same time, Western governments should re-examine aid policies that are inconsistent with official rhetoric, inadequate relative to the needs of new democracies and stingy compared with private sector efforts. International non-governmental organizations may also benefit from learning that multinational corporations may have done good while doing well in the developing world; such knowledge may help them to make allies out of a group that has been unfairly and counterproductively vilified in the debate on globalization.

1 See Anita Chan and Robert A. Senser, "China's Troubled Workers", Foreign Affairs, (March/April 1997), pp. 104-17; Stephen Hymer, "The Multinational Corporation and the Law of Uneven Development", George Modelski, ed., Transnational Corporations and World Order (New York: W.H. Freeman, 1979), p. 386; Herman Daly, Beyond Growth: The Economics of Sustainable Development (New York: Beacon Press Books, 1997); and Daly, "Fostering Environmentally Sustainable Development: Four Parting Suggestions for the World Bank", Ecological Economics 10 (1994), pp. 183-7; Raymond Vernon, "Transnational Corporations: Where are They Coming From, Where are They Headed?" Transnational Corporations 1, 2 (August 1992), pp. 7-35; Stuart L. Hart and Gautum Ahuja, "Does it Pay to Be Green? An Empirical Examination of the Relationship Between Emission Reduction and Form Performance", Business Strategy and the Environment 5, 1 (1996), pp. 30-7.

2 Following the IMF, we define FDI as the flow of investment capital into "the reporting country." This includes "equity capital, reinvested earnings, other capital, and financial derivatives associated with various inter-company transactions between affiliated enterprises." FDI also "reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise in another country." The minimum requirement is "10% ownership" and "some control" over internal management.

3 Kathleen Pritchard, "Human Rights and Development: Theory and Data" in David Forsythe, ed., Human Rights and Development (New York: Macmillan, 1989), p. 329.

4 William H. Meyer, "Human Rights and MNCs: Theory versus Quantitative Analysis", Human Rights Quarterly 18 (1996), pp. 368-97.

5 Glen Dowell, Stuart Hart, and Bernard Young, "Do Corporate Global Environmental Standards Create or Destroy Market Value?" Management Science (August 2000), pp. 1059-74.

6 Robert D. Klassen and Curtis P. McLaughlin, "The Impact of Environmental Management on Firm Performance", Management Science (August 1996), pp. 1199-214.

7 Mark Cohen, Scott A. Fenn and Jonathan Naimon, Environmental and Financial Performance (Washington: IRRC, 1995).

8 Gunnar Eskeland and Ann E. Harrison, "Moving to Greener Pastures? Multinationals and the Pollution Haven Hypothesis", World Bank Policy Research Working Paper 1744 (Washington: World Bank, 1997).

9 The 23 countries are: Argentina, Benin, Bolivia, Brazil, Central African Republic, Chile, Ecuador, El Salvador, Guatemala, Honduras, Ghana, Malawi, Mali, Mozambique, Panama, Paraguay, Peru, Philippines, South Korea, Spain, Thailand, Turkey and Uruguay. Of the 81 electoral democracies born between 1974 and 2000, 71 resulted from transitions from authoritarian rule. However, FDI data for a number of countries do not exist. The former Soviet bloc countries had little or no FDI prior to their revolutions in 1989-91. Nine island nations that became democratic were tiny economies with no recorded FDI. Our sample includes countries for which FDI data in the periods before, during and after regime transition are available. This represents coverage of 52 percent of the new democracies that were comparable destinations for FDI (defined in terms of politically unrestricted access to FDI both prior to and after democratic transitions).

10 Of the 23 countries studied, 65 percent were coping with serious inflation during the three years leading up to the transition. Hyperinflation (averaging over 100 percent) was observed in two countries, very high inflation (between 20 and 100 percent) in nine, and high inflation (10-20 percent) in four. Only 30 percent were experiencing moderate-to-high rates of growth; in fact, growth was negative in nine countries and stagnant to slow (0-3 percent) in seven.

11 On average, nine countries in our 23-country sample reported drops in FDI in the two years prior to the transition year, while nine countries reported falling FDI in the transition. Most year-on-year decreases in FDI, however, tended to be large in percentage terms (over 30 percent). About ten out of 26 instances of falling FDI were below 30 percent.

12 If FDI rose in countries like Spain, South Korea, Chile and Thailand before they were democracies, one might expect that this would tend to depress the statistical increase in FDI after transition. Logic suggests that the smoother the democratization process, the smaller the FDI delta before and after transition, but the more abrupt the process, the greater the FDI delta. Some might conclude that the delta, by itself, can be misleading as an indicator, and needs to be seen in the context of other measures, like the total share of FDI investment a country attracts in given economic sectors. But the number of so-called smooth transitions is too small to test the proposition.

13 This result was skewed by a large fall of FDI (about $1.8 billion) in Brazil in the three-year post-transition period. Excluding Brazil, the net increase of FDI would have been $10 billion, or 81 percent.

14 In the three-year pre-transition period, the average FDI/GDP (foreign direct investment to gross domestic product) ratio in the sample countries was 0.46 percent; this ratio rose to 1.147 percent in the three-year post-transition period.

15 Brazil and Bolivia--the two countries that saw a decline of FDI in the three-year period after transition--experienced severe hyperinflation (averaging 333 percent a year in Brazil and 4,680 percent a year in Bolivia). In Argentina, which had average annual inflation rate of 435 percent in the three-year post-transition period, FDI remained stagnant.

16 FDI in these four countries in the three-year post-transition period accounted for nearly half of all the FDI made in the sampled countries.

17 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.

18 Democratic transitions brought increased ODA to 13 countries but reductions in nine countries; but those reductions outweighed the increases in absolute terms.

19 In the three-year period following the transitions in eastern Europe, ODA flows to Albania, Bulgaria, Hungary, Poland, Romania and Czechoslovakia amounted to $10.61 billion (slightly less than the $10.68 billion in FDI flows to the same countries in the same period).

20 See Bruce Bueno de Mesquita and Hilton L. Root, "The Political Roots of Poverty", The National Interest (Summer 2002).

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.

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