An investigation of the effect of civil liberties and political rights on Foreign Direct Investment

Globalization has affected the economic activity of the countries across the world through liberalization of trade and exchange regimes. Moreover, the enhancements in information technology in turn have made it possible for firms to coordinate their activities in a more efficient way, in recent decades. In this setting it is easier for firms to outsource their activities to other countries through Foreign Direct Investments (FDI) in order to gain competitive advantage. FDI has been considered as one of the factors that significantly influence the economy of countries through affecting the balance of payments, increasing employment, transfer of technology and resources. Since FDI is generally considered as one of the factors that has a great potential to contribute to economic activity of the countries, particularly in case of developing and less developed countries, the disparity in the level of FDI flows observed in case of many developing countries has led to plethora of research on the subject relating the inequalities to macroeconomic factors, institutional factors, and economic geography. In spite of the fact that the literature on FDI, is well developed on a number of areas, the literature on the effect of institutional factors on FDI activity, and in particular the effect of civil and political liberties on FDI flows remains limited and subject to contrary results that renders it inconclusive. This research explores the effect of civil and political liberties on FDI flows. In doing so, we review the literature on determinants of FDI, and establish the firms’ motivations as factors that affect their FDI behaviour. Furthermore we introduce, and conceptually bridge the Varieties of Capitalism of Hall and Soskice (2001) into IB literature, in order to distinguish between the behaviour of firms from various market economies (i.e. LMEs, CMEs, and Nordic) based on the labour law policies of the firms’ home countries. Consequently the incorporation of VoC into IB literature allows us to build on the works of Due et al (1991) and Gold (1993) and Hall and Soskice (2001), and explore the effect of the differences that exist in the way firms in different market economies coordinate their activities, and afford us the possibility of explaining the firms coordination of their FDI activity in the light of their market structures, and underlying institutional differences that influence their behaviour with regard to FDI. We also review the literature on institutional determinants of FDI in order to enrich our understanding of the institutional factors that influence FDI activity. In reviewing the literature on institutional determinants of FDI, we specifically adopt meta analysis methods in order to examine whether there are systemic biases introduced to the literature through the common choices made in terms of scale and study properties (i.e. the choice of country level analysis, data range and decade influences; etc.). We find that firms’ motivations influence the type of relationships found between FDI and the existing level of civil and political liberties in countries. The use of composite measures such as democracy instead of their disaggregated individual constructing sub measures such as civil and political liberties generally leads to provision of distorted results. We also find that the choice of host country influences the relationship between FDI and democracy as well as political liberties. Similar to the arguments put forward by Busse (2004) we find that FDI activity has been subject to changes in different decades as a result of changes in the firms’ motivations and market structure. Moreover, we theoretically explore the effect of civil liberties and political rights on the initial cost of FDI and thereby FDI activity. The models provided build upon the works of Grout (1984); Hart and Moutos (1995) and Adam and Filippaios (2007). It is assumed that the decision of FDI is influenced by the initial cost of investment into the designated host country. Therefore, firms are considered to bargain with employee representatives (labour unions) in the host country before deciding upon their investment abroad, in order to obtain full information with regard to the initial costs of investment. Our theoretical model demonstrates that the effect of civil liberties channelled through union power in the bargaining processes over wages and employment, on aggregated FDI flows is negative, while the effect on sectoral FDI flows is non-linear where the non-linearity stems from the level of labour to capital share of production of specific sectors considered. Furthermore, our theoretical model shows that the effect of political rights channelled through taxes on income and profit tend to be positive on FDI flows irrespective of the level of aggregation. Our empirical investigation of the theoretical findings using the data on the FDI from 8 host countries into 140 developed, developing and less developed host countries for the period of 1990-2009, show that the effect of civil liberties on aggregated FDI flows is negative, while a positive effect is reported for the effect of political rights on aggregated FDI flows. In contrast, considering the effect of civil and political liberties on sectoral FDI (manufacturing and services sectors) we find a non-linear effect reported for both factors, indicating that the effect of civil and political liberties on sectoral FDI flows are non-linear across sectors. Our sensitivity analyses explores the effect of civil and political liberties on aggregated and disaggregated FDI flows into two main group of countries: countries with high and moderately high level of civil liberties; countries with moderately low level of civil liberties. The results provide further empirical evidence on the non-linear effect of civil and political liberties on sectoral FDI flows into host countries with various levels of civil liberties. However, the effect of civil liberties is shown to be linear and negative on aggregated FDI flows into all countries, irrespective of their level of civil liberties. In contrast a non-linear effect of political rights on aggregated FDI flows into host countries with various levels of civil liberties is observed. This research contributes to the literature in several ways: Firstly, it contributes to the theory by bridging the IB literature to the literature from political science on Varieties of Capitalism. Secondly, it provides a theoretical framework, and empirical analyses that explore the FDI activity in the sectoral level. Thirdly, it demonstrates that the use of aggregated data leads to findings linear relationships where the in reality the effects of civil liberties and political rights on FDI are not linear. Fourthly, it provides a number of recommendations for future research.