Foreign direct investment and civil rights: testing decreasing returns to civil rights.

• Author: Ponce, Aldo Fernando
• Position: Report

Overview

This study addresses the relationship between quality of democracy and the level of inflows of foreign direct investment (FDI inflows). In particular, it examines how effective improvements in political and civil rights are to attract inflows of foreign direct investment for democracies. I contend that advances in the quality of democracy--specifically in the area of civil rights--present positive but decreasing marginal returns for attracting FDI inflows. In other words, as the quality of democracy progresses, the marginal returns to civil rights decline. I empirically prove this regularity in polities with recent democratization experiences--more precisely by using panel data regressions within the Latin American and Eastern European contexts from periods following their democratization (1991-2003).

Due to the evidence of decreasing returns to civil rights, I conclude that 1) countries that boost the scope of civil rights after democratizing (despite its diminishing but positive returns) are relatively more successful in attracting FDI inflows than those with extreme levels; 2) politicians and policy-makers should expand the provision of civil rights selectively if the maximum impact in terms of foreign investment (and eventually more economic development through foreign direct investment) becomes a priority; and 3) despite the existence of diminishing returns, the impact of any increase in the scope of civil rights is almost always positive on the amount of FDI inflows.

In order to extend the literature on the role of political variables in attracting FDI inflows, I estimate the impact of changes in the quality of democracy during the first stages of democratic consolidation on the behavior of foreign investment inflows. After verifying the existence of decreasing returns to the quality of democracy--measured by the scope of civil rights--new venues for further research are suggested to explore why and how different components of civil rights can produce such a property (decreasing returns to civil rights).

Politics and Foreign Direct Investment

Previous studies on the role of good governance or other political variables (concerning democratic quality) in attracting FDI inflows have mainly concentrated on the relationship between FDI inflows and 1) type of regime (whether democratic or not); or 2) only one aspect of democratic consolidation or political condition (e.g., corruption, tests of expropriation, political risks insurance, tax incentives, and property rights).

Using the first approach, several scholars have focused on determining the link between regime type and investor confidence (Jessup 1999; Jensen 2003; Li and Resnick 2003; O'Neal 1994). For example, O'Neal (1994) finds that authoritarian regimes provide investors with higher returns of profitability in developing countries. However, overall investment flows are not generally related to regime type. Likewise, Jessup (1999) argues that authoritarian regimes in developing nations attract more international investment. On the other hand, Jensen (2003) concludes that democratic governments attract higher levels of FDI. Between these divergent views, Li and Resnick (2003) were perhaps the first to suggest that democratic institutions can affect FDI inflows both positively and negatively. However, Li and Resnick mainly focus on the role of property rights, arguing that increases in democracy improve property rights protection, thus encouraging FDI inflows. Like Li and Resnick, another group of scholars tested the hypothesis that enforcement of property rights can increase the attractiveness of a host country for foreign investors (Biglaiser and Danis 2002; Jensen 2003).

The second approach has more recently incited debate among scholars. This research has tended to move away from aggregate FDI flows. Traditionally, these studies were focused on the role of corruption in explaining FDI inflows. New studies, however, include tests of expropriation (Li 2009), political risks insurance (Jensen 2008), and tax incentives (Li 2006).

Democracy, Civil rights, Political rights, and Foreign Direct Investment

As noted above, regime type and specific political conditions--as explanatory variables of foreign direct investment--have been addressed in the literature. Even when FDI flows have been disaggregated, regime type has always been a focus of every study, evaluating the relationship of a certain political or economic variable and FDI flows under democracy or autocracy. In general, too much attention in the FDI literature has focused on regime type.

However, other aspects and features of the quality of democracy or the level of democratic consolidation may also matter when explaining FDI inflows. In fact, some of these may better explain the role of democracy in attracting FDI inflows. More precisely, regime type cannot determine whether (and what to extent) the degree of institutional development can explain the amount of FDI inflows within a group of democracies. Variations in the degree of institutional development or democratic quality might considerably matter when explaining institutional effectiveness in attracting FDI inflows. In addition, the marginal impact of improvements in institutional development on FDI inflows might not be constant or fixed over time. As institutional development or quality of democracy increases, the impact on FDI--positive or negative--might also change. By only taking into account the type of regime, the study risks missing the potential existence of relevant dynamics in the relationship between democratic quality and FDI inflows.

Concerning more focused studies, different analyses on the role of either corruption or property rights only account for one aspect of democratic consolidation, not the level of democratic development as a whole (disaggregated into two general categories: political and civil rights). In order to go beyond these limits and evaluate the implications of the level of democratic development on FDI inflows, the index created by the Freedom House Institute is employed.

Despite of being often accused of a conservative bias, the Freedom House Index offers several advantages not present in other indexes: 1) it covers the entire period in which economic liberalization took place (in this project from 1985 to 2003); 2) it evaluates a broad range of characteristics associated with democratic consolidation or quality of democracy; 3) it disaggregates its scores on democratic consolidation into two categories: political (6) and civil rights (7).

Thus, the Freedom House Index includes several political and civil rights seen in any democratic consolidation process. Within the category of political rights, procedural democratic features such as free and fair elections; fairness of electoral laws; rights to organize political parties; opportunities for the opposition to gain political power through elections; political and electoral rights of cultural, ethnic, religious, or other minority groups; the degree of corruption; accountability of the executive, and respect for the ethnic composition of a country are all included.

Likewise, the category of civil rights incorporates other procedural democratic features such as independence of the media; freedom of religious institutions and communities; academic freedom; freedom in private discussion; freedom of assembly, demonstration, and open public discussion; freedom of organization for nongovernmental organizations (NGOs); freedom of organization for trade unions and peasant organizations; independence of the judiciary; rule of law; protection from political terror; equal legal treatment of various segments of the populace; state control of travel or choice of residence and employment; right to own property and establish private businesses; personal social freedoms (including gender equality, choice of marriage partners, and size of family); equality of opportunity, and the absence of economic exploitation.

The design of these indexes--like the Freedom's House Index--can certainly help test theories on democratic consolidation (8). In particular, the Freedom House Index takes into account several aspects of procedural definitions of democracy (9) (which herein are called political and civil rights). Any expansion of such rights has always been seen as normatively "good." Thus, this paper pushes beyond these normative considerations to evaluate whether political and civil rights can increase the amount of FDI inflows, and through further investment, eventually foster economic growth. (10)

Along with the benefits of the Freedom House Index noted above, the use of this index provides additional advantages. First, the political rights index concentrates on characteristics pertaining to the type of regime such as free and fair elections, fairness of electoral laws, rights to organize political parties, and opportunities for the opposition to gain power through elections (which could be to some degree accounted for by the minimalist definition of democracy) that have been traditionally measured through the use of a dichotomous or a trichotomous variable (Schumpeter 1942). Conversely, the political rights index allows for additional variation (based on a 1 to 7 scale), which could help provide a more precise and detailed estimation of marginal increases in FDI inflows due to improvements in the scope of political rights of a polity.

In general, the opening of the political system, a product of the democratization process, immediately allows for substantial improvements in enforcing property rights, judicial decisions, and the rule of law. This provides political information that is necessary and relevant for potential foreign investors as they decide where to invest. Considering this argument, I put forth the following hypothesis:

Hypothesis I: Because most of the gains in political rights are associated with the democratization process (and only...