Trading Spaces: The Political Economy of Foreign

Direct Investment Regulation Sonal S. Pandya

Department of Government

Harvard University

FDI Central to International Economy

• Single largest source of global capital flows

• Generates 20% of world trade flows

• Promotes economic development

Research Question

Why do countries regulate foreign direct investment?

Restrictions Vary By Industry

Industry-Level Foreign Ownership Restrictions25 Latin American Countries, 1997-2000

Two-digit Industry Categories # Restricting Countries

64 Post and telecommunications 1092 Recreational, cultural and sporting activities 940 Electricity, gas, steam and hot water supply 866 Insurance and pension funding 812 Mining of uranium and thorium ores 762 Air transport 705 Fishing, operation of fish hatcheries and fish farms 611 Extraction of crude petroleum and natural gas 660 Land transport; transport via pipelines 610 Mining of coal and lignite; extraction of peat 5

Restrictions on Foreign Direct Investment by Region and Decade

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1963-1969 1970-1979 1980-1989 1990-2000

Asia Latin America

Restrictions on Foreign Direct Investment in Latin America by Industry and Decade

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1963-1969 1970-1979 1980-1989 1990-2000

Perc

ent o

f Tw

o-D

igit

ISIC

Ind

ustr

ies

Res

tric

ted

Primary Industries Manufacturing Industries Services Horizontal Restrictions

Existing Explanations Insufficient

• Nationalism can’t account of multiple dimensions of variation

• Scholarly literature makes assumptions re: governments preferences for FDI

No Microfoundations

Political Economy Approach Identifies Sources of Variation

• FDI inflows redistribute income

• Political cleavages between winners and losers

• Politicians negotiate tradeoffs

Vertical FDI

Home Country Host Country

FDI Inflow

Finished Product

Politics of Vertical FDI

• Vertical FDI’s Economic Effect Increases labor demand

• Political cleavage Labor vs. Capital

Local wages & production costs increase

• Salient Political Institution Partisanship

Horizontal FDI

Home Country Host Country

FDI Inflow

Finished Product

Politics of Horizontal FDI

• Horizontal FDI’s Economic Effect Increases market competition

• Political cleavage Producers vs. Consumers

Local firms’ profit & prices decrease

• Salient Political Institution Electoral Competition

Alternate Explanation: Nationalism

• FDI increases foreign ownership

Foreign ownership threatens national identity

Hypotheses

• Left governments are less likely to restrict vertical FDI

• Electoral competition reduces the probability of restrictions on horizontal FDI

• Nationalist governments more likely to restrict FDI

Measuring FDI Regulation

• Foreign ownership restriction1 = banned, only minority share allowed

0 = no limit

• Data coded from US Commercial Guides

119 countries, 58 industries, 1990s (pooled)

Approx. 30% of country-industries restricted

Measuring Propensity Vertical FDI Restrictions

• Interaction of Host Labor Supply and Industry Labor Demand

Data:

Average Schooling

Industry per worker value-added for US-based multinational firms

Partisanship

Left Party x(Low Skill)

-2.71 # (1.64)

Right Party x(Low Skill)

0.0362 (0.58)

Support for Vertical FDI at Low Skill Levels

# = significant at .1 level

Logit Model Estimates

Measuring Industry’s Propensity to Receive Horizontal FDI Restriction

• Incentives to enter market via horizontal FDI

Data Host country GDP

Gravity model estimates of trade barriers

Degree electoral competition

Expected Probability of Foreign Ownership Restrictions at Varying Levels of Democracy Level of Democracy E (Foreign Ownership Restriction

| Level of Democracy)

No executive/legislature 1

Unelected executive/legislature 1

Elected, one candidate 0.99

One party, multiple candidates 0.998

Multiple parties legal but only one won seats

0.985

Multiple parties compete and won seats but one party holds more than 75% of seats

0.89

Largest party received less than 75% of seats

0.50

Nationalist Governments Less Likely to Restrict

Shift to executive from nationalist party decreases expected probability of ownership restriction by 24 percentage points*.

*standard deviation = .08

Summary of Results

• Left parties less likely to restrict FDI in lower skilled industries

• Weak democracies use FDI restrictions as substitutes for trade restrictions; in stronger democracies restrictions less sensitive to market entry barriers

• Governments led by nationalist executives less likely to restrict FDI