Foreign Direct Investment and Democracy: A Robust Fixed Effects Approach to a Complex Relationship

• Author: Vincenzo Verardi,Rodolphe Desbordes
• Published date: 01 February 2017
• DOI: http://doi.org/10.1111/1468-0106.12204
• Date: 01 February 2017

FOREIGN DIRECT INVESTMENT AND DEMOCRACY: A

ROBUST FIXED EFFECTS APPROACH TO A COMPLEX

RELATIONSHIP

RODOLPHE DESBORDES*University of Strathclyde

VINCENZO VERARDI University of Namur and University of Brussels

Abstract. We develop a new robust-to-outliers dummy estimator that we subsequently apply to

investigate the impact of various democratic attributes on foreign direct investment in recent

years. We find that democracy has generally a positive impact on foreign direct investment,

once outliers are controlled for, but that this relationship is very specific to each host country’s

characteristics.

1. INTRODUCTION

The impact of democracy on foreign direct investment (FDI) in developing

countries is a hotly debated issue. Jensen (2003, 2008) and Azémar and

Desbordes (2009) provide an overview of the literature on FDI and democracy.

On the one hand, it has been argued that democratic forms of government at-

tract FDI because they tend to be predictable and credible, thanks to vertical

and horizontal accounting mechanisms. The combination of periodic elections

and widespread diffusion of information ensures that politicians make clear their

preferences, do not renege on their promises once in power, and, more broadly,

do not abuse their position for private gains. Strong checks and balances in-

crease policy stability, and, ultimately, the protection of property rights, because

the existence of several distinct veto players hinders any changes in the status

quo. When policy changes do occur, institutionalized channels of influence/

lobbying can allow foreign investors to mitigate any adverse effects. Consoli-

dated democracies also guarantee orderly and non-violent changes of govern-

ment within the current institutional framework.

On the other hand, the virtues of democracy can easily be seen as disadvan-

tages to countries wanting to attract multinational enterprises. Politicians’desire

to win elections may lead them to promise and adopt popular but economically

harmful policies. Political turnover creates uncertainty about the persistence of

policies, whereas an increase in the number of veto players has the potential to

result in long-term reform sclerosis. Foreign firms may suffer from a political li-

ability of foreignness and be discriminated against relative to their better

politically-connected domestic competitors. Finally, a related but more sinister

view is that freedom of expression and open media can prevent foreign firms

*Address for Correspondence: Department of Economics, Sir William Duncan Building, University

of Strathclyde, 130 Rottenrow, Glasgow G4 0GE, Scotland, UK. E-mail: rodolphe.

desbordes@strath.ac.uk. Vincenzo Verardi is associated researcher of the FNRS and gratefully ac-

knowledges their financial support

Pacific Economic Review, 22: 1 (2017) pp. 43–82

doi: 10.1111/1468-0106.12204

© 2017 John Wiley & Sons Australia, Ltd

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from colluding with officials in order to obtain generous entry deals or to de-

crease market competition. Hence, FDI may be attracted by autocracies.

This ambiguous theoretical impact of democracy on FDI is mirrored in the

empirical literature. As described in Table 1, studies find positive (Harms and

Ursprung, 2002; Jensen, 2003; Busse, 2004; Azémar and Desbordes, 2009), neg-

ative (Li and Resnick, 2003) or insignificant (Blanton and Blanton, 2007; Büthe

and Milner, 2008; Choi and Samy, 2008) impacts, depending on the econometric

model, the proxy for democracy and the sample used.

The presence of outliers (i.e. observations that are substantially different from

the bulk of the data) has sometimes been blamed for this variety of findings.

Some researchers have attempted to deal with these atypical observations

(Jakobsen and De Soysa, 2006; Choi, 2009; Li, 2009). However, it is unlikely

that they have solved this issue in a satisfactory manner. Popular robust estima-

tors (e.g. median regression estimator or M-estimator) are sensitive to outliers

present in the values of explanatory variables and outlier diagnostics (e.g. the

Cook distance) frequently fail to detect atypical observations as they fundamen-

tally rely on the extremely non-robust-to-outliers least-squares estimator

(Verardi and Croux, 2009). Problems of inadequate econometric identification

and treatment of outliers thus remain pervasive in the FDI literature.

A related issue is the increasing use of the fixed effects estimator to control for

unobserved time-invariant unit-specific effects that may be correlated with the

explanatory variables. While this estimator may reduce any omitted variable

bias, it does not protect against outlier contamination. An aggravating problem

is that the most resistant robust regression methods are ill-designed to analyse

econometric models, which include a large number of dummies. While some

robust panel data estimators have been proposed, they appear not to be consis-

tent when the number of time periods is small, and cannot deal with dummies

not related to the within transformation (Aquaro and Pavel, 2010).

In this paper, we revisit the link between FDI and democracy in develop-

ing countries, during the 1998–2006 period. We pay particular attention to

the multi-faceted nature of democracy, the influence of outliers, and the het-

erogeneous relationship that may exist between these two variables. We use

a variety of measures to explore how each particular dimension of democ-

racy can influence FDI. We develop a new robust dummy estimator, which

allows us to control for outliers in a fixed effects panel data model. Finally,

we investigate whether the impact of democracy on FDI depends on natural

resources, income inequality, and their interaction. Our results show that

democracy generally has a positive impact on FDI, once outliers are con-

trolled for, but that this relationship is very specific to each host country’s

characteristics.

The rest of the paper proceeds as follows. Section 2 introduces our new robust

dummy estimator and explains its advantages over existing robust regression

methods. Section 3 provides Monte-Carlo simulations highlighting the good

performance of our estimator. Section 4 replicates a key study on FDI and

democracy to highlight that the correct treatment of outliers is a key issue.

Section 5 describes the data used in our original empirical analysis and motivates

R. DESBORDES AND V. VERARDI44

© 2017 John Wiley & Sons Australia, Ltd

Table 1. Selective review of the impact of democracy on FDI

Reference Citations Sample Main estimator(s) Dependent variable Main proxy (proxies)

Explicit control

for outliers Findings

Harms and

Ursprung (2002)

258 62 developing

countries;

1989–1997

Between

(cross-sectional);

fixed effects

FDI/population Freedom house

indexes of

political

rights and

civil rights

Yes Positive but

statistically

significant only

with a between

estimator

Jensen (2003) 653 114 developed

and developing

countries;

1970–1997

Fixed effects;

dynamic

FDI/GDP Polity III score No Positive

direct impact

Li and

Resnick (2003)

587 53 developing

countries;

1982–1995

Pooled FDI Polity IV score No Negative direct

impact; indirect

positive impact

via strengthening

property rights

protection

Jakobsen and

De Soysa (2006)

88 99 developing

countries;

1984–2001

Pooled;

dynamic

ln(FDI) Polity IV score Yes; log

transformation

to attenuate

influence of

outliers in

dependent

variable; China

dummy variable

Positive direct

impact

Blanton and

Blanton (2007)

114 129 developing

countries;

1980–2003

Pooled FDI/GDP Polity IV score No Statistically

insignificant

impact

Busse and

Hefeker (2007)

576 83 developing

countries;

1984–2003

Fixed effects/

DIFF-GMM;

dynamic

ln(FDI + sqrt(FDI

2

+1)) ICRG

democracy

index

No but

dependent

variable is

transformed

Positive direct

impact

(Continues)

FOREIGN DIRECT INVESTMENT AND DEMOCRACY 45

© 2017 John Wiley & Sons Australia, Ltd