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Abstract

This paper studies how factors such as corruption perception and the level of democracy influence foreign direct investment to developing economies. Our results suggest that less corrupt countries and less democratic countries receive more foreign direct investment. What could account for this pattern of investment?

This paper is the first to show that perceptions of corruption are highly correlated with indices of economic freedom, but uncorrelated with indices of political freedom. Hence less corrupt countries which provide the right kind of economic environment for investors, such as personal property protection, the right to move capital in and out of the country, or the ability to trade openly in world markets receive more FDI flows. At the same time, while democratic countries ensure provision of political and civil rights for citizens, these are not an automatic guarantee of economic freedoms. In fact, the correlation between the democracy index and these indices of economic freedom is surprisingly low. Hence more democratic countries may receive less FDI flows if economic freedoms are not guaranteed. There could be at least two explanations for why this may happen. First, democratizing developing economies are often unable to push through the kind of economic reforms that investors desire due to the presence of competing political interests. For instance, in some countries such as India, foreign capital is viewed by certain sections as being antagonistic to the interests of the poor and working classes. Hence liberalization measures often meet strong opposition from these groups. This is corroborated by the significant negative coefficient on left-leaning democracies in our regression equation. Second, our sample includes several countries in East Asia and South America that underwent major financial crises in the 1990s. Our results could partly be driven by the inability of these countries to liberalize economically and attract foreign capital subsequent to these crises. Hence the negative coefficient on democracy needs to be interpreted with caution. Democratization could encourage capital inflows provided political freedoms go hand in hand with economic freedoms. Our results might help explain why countries like China and Singapore that rank poorly on the democracy index but are relatively high on the property rights index (and in the case of Singapore, on the capital mobility index as well), do well in terms of FDI inflows.

Our results also suggest that there is a diversion of FDI towards countries that are perceived to be less corrupt along these dimensions away from more corrupt countries. For instance, an improvement in the relative level of (perceived) corruption in China could (ceteris paribus) have adverse consequences for other countries in the South Asian region.

Further, we find that former and current communist countries that started out with inefficiently high capital-output ratios due to heavy state-led industrialization may attract more inflows as they attempt to substitute ‘efficient’ foreign capital for ‘inefficient’ domestic capital.

Aparna Mathur is a research fellow at AEI. Kartikeya Singh works for Pricewaterhouse Coopers.

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