Democracy, Property Rights, and Foreign Direct Investment

Mark David Nieman and Cameron G. Thies

University of Iowa

Abstract

States compete for Foreign Direct Investment (FDI) inflows, since they are an

important source of employment and technology. However, the role played by a

state’s regime type in attracting FDI remains mired in debate. Some scholars find

a positive relationship with democracy, whereas others do not, while some

suggest that property rights are responsible for attracting FDI. We attempt to sort

out the roles that democracy and property rights play in attracting FDI from 1970

to 2008 through careful theorizing and the use of a non-nested hierarchical

modeling strategy. Our theoretical and empirical analyses demonstrate that the

effect of property rights on attracting FDI is contingent on democratic institutions.

Democratic institutions influence property rights by providing: 1) a coherent logic

to the property rights regime that is created in a state, and 2) a legitimate way to

manage conflicts that arise in dynamic economies. We find that in the absence of

democratic institutions, property rights protections actually exert a negative

impact on FDI. However, as the level of democratic institutionalization improves,

the effect of property rights on FDI becomes increasingly positive. The

hierarchical model allows us to see that this conditional effect varies among

countries and changes over time, but is generally positive for both developing and

developed countries across all regions.

2

Introduction

While it has long been known that political decisions impact economics, the relationship between

regime type and foreign direct investment (FDI) remains mired in controversy. Some studies

show a positive relationship between democracy and FDI, whereas others do not (Busse 2004;

Busse and Hefeker 2007; Choi and Samy 2008; Jakobsen and de Soysa 2006; Jensen 2003; Li

2009b; Li and Resnick 2003; Oneal 1994). This ambiguity in empirical findings is perplexing

because, as Ahlquist notes, investors are thought “to be concerned with the stability of the

political apparatus as well as more macro- and micro-level industrial and regulatory policies”

and are expected to “respond to changes in institutional variables” (2006, 682).

Some of the ambiguity regarding the effect of democracy on FDI results from different

operational measures of FDI. Li and Resnick (2003) operationalize FDI as net FDI inflows and

find that democracy has both positive and negative effects on FDI, with democracy exerting no

statistical influence when accounting for the rule of law. Choi (2009) replicates the work of Li

and Resnick (2003) and finds that when FDI is measured as net FDI inflows as a percent of GDP

(see also Jensen 2002, 2003, 2004), democracy has a positive impact on FDI. Some have

suggested that it is property rights protections rather than democracy that attract FDI, though the

two phenomena are notoriously intertwined (Li 2006, 2009b; Li and Resnick 2003).

We sort out the disparate empirical findings in the literature by considering the

theoretical relationship between regime type and property rights protections. We expect that

their interplay, rather than one or the other in isolation, is responsible for attracting higher levels

of FDI. In particular, we argue that the effect of property right protections is conditioned by

democracy. Democracy is thought to influence the impact of property rights through two

intertwined mechanisms: 1) democratic institutions provide a coherent logic from which to frame

3

the property rights regime, and 2) democracies are better apt than autocratic regimes to

legitimately manage conflicts that emerge as different groups win and lose in a dynamic

economic setting (Chang 2003; Sunstein 1997). The effect of democratic institutions is important

because property rights protection is more than simply stating that individuals have the right to

private property; enforcement of property rights under changing technological conditions and in

dynamic economies, as well as how property rights are truncated in the face of other rights, must

also be addressed. We find empirically that the effect of property rights on FDI is contingent on

the strength of democratic institutions in a state through the use of a non-nested hierarchical

statistical model. In non-democracies, strong property right protections fail to secure FDI. Yet,

in democratic states, property right protections demonstrate a positive effect on attracting FDI.

Regime Type and FDI

FDI is defined as “a category of cross-border investment associated with a resident in one

economy having control or a significant degree of influence on the management of an enterprise

that is resident in another economy” (International Monetary Fund 2007, 100).1 Since this

definition requires that private capital flows have a lasting management interest in the company

that is acquired or created, it is more than simple portfolio diversification.2 FDI is an important

source of employment and technology to host countries that is thought to spur economic growth

and development. As a result, states frequently compete for FDI inflows by adopting domestic

policies that generate an attractive investment climate (Jensen 2008; Li 2006; Li 2009a). The

more FDI inflows a state receives, the more potential benefits it obtains. The fact that FDI

accounts for more than 50 percent of all resource flows to developing countries undoubtedly

1 A firm is assumed to have “control of a significant degree of influence” when it holds 10 percent of more of voting

stock (World Bank 2011). This is the standard measure used throughout the literature. 2 Portfolio investment is “crossborder transactions and positions involving debt or equity securities, other than those

included in direct investment or reserve assets” (International Monetary Fund 2007, 110).

4

explains why it has been an appealing topic of study in International Political Economy (World

Bank 2011).

Previous literature on the relationship between democratic regimes and FDI has produced

conflicting outcomes. Li and Resnick (2003) claim that democracy has both positive and

negative effects on FDI inflows. These contrasting claims can be found throughout the literature.

Competing expectations also exist regarding whether the competitive political environment in

democracies encourages FDI or not. In addition, the relationship between democracy and

property rights is not clearly specified in the existing literature.

The argument that democracy reduces FDI inflows begins with the observation that

multinational corporations (MNCs) and domestic companies compete to seek preferential

policies from the government. Democracies must appease domestic interests to remain in power

and are therefore less likely in general to offer advantages to MNCs. However, in order to attract

FDI, democracies may attempt to solicit domestic support by offering welfare incentives to

domestic political actors (Busch and Reinhardt 2000; Hays 2009; Hiscox 2002; Mukherjee,

Smith, and Li 2009). Cushioning institutions, such as welfare and job retraining, could also be

combined with the effects of increased wages and employment to increase domestic pressure for

FDI. This leads Jakobsen and de Soysa (2006) to conclude that democracies may actually create

a favorable environment for FDI. Their argument is that the largest electoral constituency in a

democracy is labor, which benefits from FDI due to increased wages resulting in competition

between domestic and foreign firms. Since labor benefits from foreign investment, policymakers

should therefore pursue policies supporting FDI.

On the other hand, O’Donnell (1978, 1988) argues that authoritarian regimes are better

equipped to make more favorable entry level arrangements with foreign investors. Autocrats

5

seek FDI inflows for their own private economic benefits and the interests of the elites that they

serve. Authoritarian institutions are rarely constrained by either electoral consequences or

structural veto players, which allows them to ignore the domestic public’s concerns about

welfare, wages and employment (Bueno de Mesquita et al 2003). Authoritarian regimes are

therefore more able to provide favorable entry and tax incentives to MNCs (Li 2006).

While democratic regimes may generally be constrained in their ability to offer attractive

entry incentives to MNCs owing to their large number of veto players, this resistance to drastic

policy change also provides a benefit. MNCs can use existing democratic institutions to enforce

favorable arrangements negotiated with the democratic government and make it more difficult

for the government to reverse policies. While authoritarian governments can grant better entry

level agreements to MNCs, they provide MNCs with little room for domestic recourse should the

leader or leaders renege on their initial commitments. Though the expropriation of firms has

become less common over time, there is still a non-zero probability that an authoritarian

government may confiscate MNC property or engage in other infringements on such property

rights (Li 2009a). As Buthe and Milner note, "more subtle government interventions that reduce

the profitability of investments have become the key political concern of investors" (2008, 741).

This reasoning leads Jensen (2003) to assert that democratic governments provide a more

stable market for FDI and thus receive a greater proportion of it than authoritarian governments.

Echoing Olson (1991), Jensen notes that authoritarian governments are predatory and cannot

credibly ensure property rights while democratic institutions are able to protect the property

rights of foreign investors. Thus, transparent legal systems are much more predictable than

depending solely on the word of government officials (Jensen 2003; Li and Resnick 2003).

6

Li and Resnick (2003) go on to argue that democracy does not attract more FDI than

authoritarian regimes, ceteris paribus. Instead, their argument focuses on property right

protections. While democratic regimes tend to provide more secure property rights protections to

MNCs, it is property right protections that investors seek. Therefore, any advantage that

democracies enjoy in attracting FDI is primarily due to their strong rule of law. Once this is

accounted for, Li and Resnick (2003) posit that any democratic advantage will dissipate. Li

(2006, 64) continues this line of reasoning, arguing that "one reason that democracy and

autocracy adopt different levels of tax incentives is because they differ systematically in terms of

property rights protection and policy credibility." Jensen (2008) also notes that investors would

prefer participating in transparent legal systems to relying solely on an authoritarian government

to enforce contracts and intellectual property rights, as evident in the higher risk that private

insurance companies associate with authoritarian regimes compared to democratic regimes.

In addition to these theoretically divergent expectations concerning regime type and

property rights, Jakobsen and de Soysa (2006) note important methodological and data issues

that contribute to the regime type-FDI controversy. Jakobsen and de Soysa argue that with a

larger sample and time frame, Li and Resnick (2003) would find a positive relationship between

democracy and FDI. To test this, Jakobsen and de Soysa expand upon Li and Resnick’s data and

control for China in their statistical analysis. Jakobsen and de Soysa argue that while China is

highly authoritarian, it has strong property right protections and thus attracts a large sum of FDI

inflows. In fact, Chang (2003, 11) suggests that China accounts for 10% of the world’s total FDI.

Thus, the inclusion of China biases the results and leads to incorrect inferences that are made

about the general effects of regime type. Jakobsen and de Soysa find that when China is

controlled for, democracy attracts FDI even in the presence of property right protections. Choi

7

(2009) criticizes the methods employed by Li and Resnick (2003) and argues that the negative

result for democracy stems from Li and Resnick's operationalization of FDI as net inflows and

that the case of China is simply an outlier, albeit an important one.

Finally, the relationship between democracy and rule of law may not be as strong as is

often assumed. In fact, Choi (2009, 158) notes in his replication of Li and Resnick that

“interestingly, the entire replication data show a weak correlation of 0.20 between democracy

and property rights. Perhaps, as Weimer (1997, p. 8) points out, the correlation between

democracy and the security of property rights is imperfect.” Simmons (2000) finds similar

results, noting that democracy and rule of law are actually not highly correlated. Furthermore,

she warns that "popular participation along with weak guarantees for fair enforcement of

property rights can endanger these rights" (2000: 828; see also Li 2009b).

As this review of the literature shows, both democratic and authoritarian regimes have

theoretical advantages to offer foreign investors. Authoritarian regimes are not constrained by an

electorate when negotiating with foreign investors. They can engage foreign firms and make

generous entry level offers. Democracies must appease their electorate while at the same time

negotiating with foreign investors. On the other hand, labor is the largest constituency in

democracies. Labor may support FDI as it provides employment and drives up wages obtained

from domestic firms that compete with foreign companies. Furthermore, the greater numbers of

institutions and veto players in a democracy prevents the government from behaving in a

predatory manner with MNCs. Despite the differing expectations found in the literature

regarding the impact of regime type on attracting FDI, it is important to note that each position

argues that regime type is important. Yet, the relationship between regime type and property

right protections remains unclear.

8

Democratic Institutions and Property Right Regimes

The role of institutions is often neglected when discussing property rights; this is

unfortunate because “the delineation of property rights is not independent of what rights

members of a society accept as legitimate, and as a result most, if not all, property rights are

‘truncated’ in a most complex manner (Chang 2003, 181; see also Barzel 1989). We argue that

previous studies have ignored the true manner in which democracy affects investment. Rather

than acting as an independent factor, democracy enhances the effects of property right

protections by creating institutions that: 1) provides a coherent logic for the creation and

enforcement of legal protections in a property rights regime, and 2) managing conflicts that

emerge as different groups win and lose in a dynamic economy. These two roles of democracy

are intertwined, as a coordinated economic vision is necessary to address the concerns of those

groups that lose as the economy changes and engage in subsequent mobilization against the new

economic arrangements (Chang 2003, 52-63; Sunstein 1997, Ch 6 and Ch 8).

Dreher, Gaston, and Martens (2008, 124) argue that strong property rights and the right

institutions promote economic growth. Chang (2003, 11) goes even farther, arguing that the

property rights regime on its own is a minor determinate of FDI, lagging behind other factors

such as large or growing markets, the quality of the existing infrastructure, and the quality of

labor (human capital). Instead, he points to the need for strong institutions (e.g. contract laws) in

order for property rights protections to actually impact the economy. As evidence, he points to

“the fact that, during the last few decades, many countries have tried to copy the Anglo-

American model with little success is a testimony to the difficulty of building the ‘special’

institutions that are required for an effective functioning of market-oriented trade and industrial

policies” (Chang 2003, 14). Sunstein agrees, suggesting that well-drafted constitutions provide

9

the foundation for the state to create ownership rights from which all future private property

rights are grounded. This is necessary to prevent a system in which property rights definitions are

open to reinterpretation and readjustment (Sunstein 1997, 209-210).

Logic of a Property Right Regime

A state needs institutions when creating property rights because it “cannot grant property

(and other) rights to people in a coherent way, unless it has a certain vision of what it regards as

the desirable future” (Chang 2003, 55-56). Democracies have important financial and legal

institutions that autocracies either do not have or do not permit to act outside the range of the

executive. These independent institutions provide checks on executive power and introduce

additional veto players into the process of economic policy formations, including the formation

and enforcement of property rights. In addition, democratic institutions derive legitimacy from

the process in which they are formed, as constituents have at least some level of control over

them or those who oversee them. These institutions must meet and adhere to the principle of the

existing legal framework (e.g. constitution), ensuring philosophical and legal contiguity

(Sunstein 1997, Ch 8). In addition, democracies have more veto players, making changes to these

basic principles less likely and are thus more likely to delineate property rights in the same

manner over time (Tsebelis 1995, 2002). This creates a common vision of how property rights

are assigned and in what way they are enforced.

More concretely, since democratic institutions are more flexible than their autocratic

counterparts owing to their decentralized nature, they can more easily adapt and generate a

coherent set of property laws during times of technological and societal change. Thus, the state

acts as a visionary that provides the foundation and direction in goals that private firms then

fulfill. Chang (2003; 53) argues that “by providing such a vision at the early stage of change, the

10

state can drive private sector agents into a concerted action without making them spend resources

on information gathering and processing, bargaining and so on.” By creating this clear vision, the

state is able to lower transaction costs and reduce uncertainty regarding future policy in a

dynamic economy. This promotes investment by strengthening the effectiveness of the state’s

property right protections.

Managing Emergent Conflicts

Democracies are more effective than autocracies at managing conflict. This stems from

their ability resolve disputes via non-violent, legitimate processes. Democracies provide

legitimate methods for groups to raise their voice, air grievances, and seek compensation for

losses that do not exist in autocratic regimes, such as politically relevant legislatures and

independent courts. Democratic legislatures often feature compromises and tradeoffs among

political parties representing various domestic interests. Independent judiciaries provide a non-

violent outlet for conflicts to be settled between individuals regarding specific claims.

The ability to manage conflict enhances property right protections under democratic

regimes. Conflict management is an important consideration for long-term economic growth and

attracting foreign investment. Under static conditions, the market is often thought to be the most

efficient mechanism to resolve conflict (e.g. Friedman 2002, Hayek 1976). Yet, in practice

markets are not static and considerations of dynamic efficiency should also be addressed, even

though this seldom happens (Joskow and Rose 1989). In particular, technological changes affect

how existing property right protections are interpreted and applied. The manner in which new

property right protections are allocated change the relationships between production factors,

increasing the likelihood of conflictual outcomes (Chang 2003, 56-57; Kuznets 1973).

11

This means that states can realistically rely on the market solution to resolve conflicts

only where technological change is gradual, when the costs paid by the losing parties are low, or

they are prevented from organizing politically. Instead, some other institution must exist in order

to manage conflicts. Chang (2003, 58) argues that the state itself is best suited to undertake this

task since “it is the ultimate guarantor or property (and other) rights and (normally) the most

important actor in setting and executing the public agenda for changes in rights and institutions.”

It does this by creating institutions, such as courts, regulatory agencies, and legislative oversight

that can quickly respond to technological change and address emergent conflicts in a consistent

and coherent manner.

When property rights change either in the face of technological change or owing to other

structural factors, “those who are to lose will try to mobilize against the new institutional

arrangements and sometimes will succeed in doing so” (Chang 2003, 56; see also Garrett 1998;

Fordham 2008, and Hays 2009). If losing parties are able to succeed in overturning the new

institutional arrangements, the state’s economy will suffer since it will be less competitive

globally. However, if losing parties mobilize and institutional structures do not exist for these

groups to legitimately air their grievances, they may turn to illegitimate means, up to and

including violence (Barber 1995; Nieman 2011; Rosenau 2003). The outcome of this is that “in

societies where the state fails to manage conflict in an appropriate way, people will be reluctant

to take risks or commit their resources in specific investments and therefore the dynamism of the

economy may suffer” (Chang 2003, 61-62; see also Keynes 1997, 373). Thus, strong conflict

management institutions encourage long-term investment, such as FDI, and improve economic

dynamism (Chang 2003, 63).

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Our theoretical argument that democratic institutions are better than their autocratic

counterparts at creating a property rights regime and managing conflict produces the following

hypothesis:

H1: The effect of property rights on FDI inflows is conditioned by a state’s level of

democracy.

Methodology

This paper examines the effects of democracy, property rights, and their interactive effect on

attracting FDI in 124 countries between 1970 and 2008. While the theory posited above expects

that property rights and democracy are determinants of investment, there are likely country and

time specific effects as well. Figure 1 demonstrates that FDI has changed greatly over time. This

means that while states continue to compete for FDI, the supply has increased substantially as

firms are more willing to create lasting impacts in markets outside their home nation’s borders.

Ignoring this temporal variation would lead to biased estimates of our theoretically relevant

variables.

< Figure 1 about here >

A hierarchical model is used to account for the multilevel structure of cross-sectional

time-series data. Further, we use a non-nested hierarchical model since neither state, nor year, are

nested within the other (Gelman and Hill 2007, 2). As a result, there are three error components

that must be accounted for in order to reduce inefficiency: individual, state, and year. While each

of these types of error is constant within units, they differ between units. As Gill (2009, 395)

notes, “ignoring the aggregate information excludes potentially important effects and treating the

aggregate information as individual level effects confuses covariance in the model.” To account

for this, our model takes the general form:

13

0

jt j t jt jt

j j

t t t

y x

where y is the dependent variable, α and γ are random intercepts, β is a coefficient, x is a

parameter, ε is a random component, and j and t are subscripts for country and time, respectively.

The random intercepts include both systematic and random components with 20,j N and

20,t N . Inclusion of random intercepts avoids common problems associated with pooling

data (Green, Kim and Yoon 2001).

The use of a hierarchical model produces several benefits over other commonly used

approaches, such as panel corrected standard errors (PCSEs) with fixed effects (Beck and Katz,

1995). For instance, we are able to explicitly model time rather than simply treating it as a

nuisance, as is the case with PCSEs (Shor et al. 2007, 171). In contrast to PCSEs, our

hierarchical model allows the standard errors to vary over time (Gelman and Hill 2007, 289-292;

Shor et al 2007, 172). The net effect of this is that the hierarchical model estimates standard

errors more precisely, permitting more accurate testing of the hypothesis. We can also

investigate the effect of property rights and democracy on each country by over-parameterizing

the model rather than resort to the use of a reference category, as is true with models employing

fixed effects (Gelman and Hill 2007, 68).3 Finally, this approach also allows us to avoid the

dangers noted by Buthe and Milner (2008) of including developed and developing countries in

the data set as coefficients for each country can easily be recovered and displayed to verify

trends identified in the statistical analysis and note outliers (Gelman and Hill 2007). Thus, our

3 Gelman and Hill (2007, 269) note this is possible “because of the partial pooling of the j ’s toward the group

level linear model.” This means that the group level intercepts are estimated in part by the group level predictors.

14

coefficients for each country are the same as they would be using split samples between

developed and developing countries, while we gain the increased efficiency of pooling the data.

Dependent Variable

The dependent variable of interest in this study is FDI. We operationalize FDI in terms of net

FDI inflows per capita.4 This operationalization accounts for both the actual inflows of FDI and

the effects of country size (Choi 2009, Li 2009b). The country size standardization reduces the

influence of possible outliers that might otherwise bias the results owing to the aggregated nature

of the data.5 This allows the data to adhere to the normal i.i.d. assumption (Choi 2009, 154)

while at the same time accounting for country size (Busse and Hefeker 2007, 403; Hegre 2009).

The data for net FDI inflows are obtained from the World Development Indicators (World Bank

2011). Population figures are taken from the Correlates of War’s National Material Capabilities

(V3.02) data set (Singer, Bremer and Stuckey 1972).

Independent Variables

Two independent variables are tested in this study: Democracy and Property Rights. The

Democracy variable is operationalized as the Xconst component of the polity2 score acquired

from the Polity IV project (Marshall and Jaggers 2008). This means that our Democracy variable

ranges from 1-7. We use this component to represent democracy for a number of reasons. First,

and most importantly, the Xconst component most closely operationalizes our theoretical

depiction of democracy. Democratic institutions are expected to provide a coherent logical basis

for the creation, interpretation, and enforcement of property right laws. Any such institutions

4 In order to check robustness, we also conducted analyses using FDI as a percent of GDP. Results did not

substantively change. 5 Data are aggregated at the state level. While Pinto and Pinto (2008) and Blanton and Blanton (2009) demonstrate

there is utility to disaggregating FDI among sectors, this type of data are largely limited to OECD countries,

restricting the analysis to developed countries.

15

necessarily restrict the executive’s ability to unilaterally expropriate foreign property or to

change to the domestic property rights regime structure on their own. Further, Gleditsch and

Ward (1997, 371) find that in the post-1969 period, Xconst is the driving force behind the polity2

democracy score. Choi (forthcoming) and Starr (1992) suggest this is because executive

constraints are the most easily identifiable signal of a liberal democracy. Additionally, by using a

single component, we reduce statistical noise generated by including several related

components.6

In order to measure a state’s legal structure and respect for property rights, we use the

Legal Structure and Security of Property Rights measure from the 2011 Economic Freedom of

the World data set (Gwartney, Hall and Lawson 2011).7 This variable ranges from 0-10, with

higher values reflecting an increasingly strong legal structure that enforces property rights.

Property rights data are only available every five years during the period prior to 2000, meaning

data exist for 1970, 1975, 1980, 1985, 1990, 1995, and 2000-2008.8

As was noted earlier, democracy and property rights are conceptually distinct. However,

these terms are often treated as closely related, with some even implying that private property

rights are nested within democracies (c.f. Jensen 2003 or Jakobsen and de Soysa 2006). Within

our data set, it is evident that the correlation between the two is moderately high ( = .44) and is

statistically significant (p < .001). While this raises some collinearity concerns, it should make

finding statistical significance more difficult.

6 Analyses conducted using the 21-point polity2 democracy measure produce similar results. 7 The use of this data is relatively common within the economic and economic policy literature. See, for example,

Burkhard (2002); Knack and Heckelman (2005); Ovaska and Takashima (2006); de Soysa and Vadlammanati

(2011), and Vamvakidis (1998). In addition, employing a meta-analysis of economic freedom, Doucouliagos and

Ulubasoglu (2006) find no statistical significant difference between studies employing these data compared to those produced by the Heritage Foundation, Freedom House, or Scully and Slottje (1991). For a more in-depth discussion

of the how economic freedom is conceptualized and measured, see Gwartney and Hall (2003). Finally, this variable

is conceptually the same as the International Country Risk Guide (ICRG), used by scholars such as Choi (2010) and

Powell and Staton (2009), but is available for a wider time frame. 8 Rather than interpolating data, we rely only on this available data for our results.

16

Like Li and Resnick (2003), we expect that democracy may have both positive and

negative effects on FDI. As Simmons (2000) suggests, firms may avoid democracies with weak

property rights protections. However, we theorize that democracy impacts FDI conditionally

through property rights; democracy increases the effectiveness of property right protections by

promoting contiguity in a property rights regime. While firms prefer states with strong property

right protections, they especially prefer democracies with strong property rights protections.

Continuity within the property rights regime is especially important in times of technological

dynamism. To account for this conditional effect, we include an interaction between Democracy

and Property Rights.

Control Variables

Several variables are included to account for alternative determinants of FDI. These are

government durability, economic size, economic growth, level of economic development,

resource endowments, and physical security. While there are a number of other potentially

confounding factors, most alternative theoretical explanations are accounted for by this set of

control variables.9 Control variables are obtained from the World Development Indicators

(World Bank 2011) unless otherwise noted.

Durability of a regime is obtained from the Polity IV data set (Marshall and Jaggers

2008). Durability is important for investors, as past stability is an indicator of current and future

government stability. MNCs are more likely to invest in countries with consistent policies and

9 Studies in international relations, and political science more generally, suffer from over-specification of variables in empirical models that do not correspond to the theoretical model on which they are based (Kadera and Mitchell

2005; Ray 2003). The inclusion of atheoretical control variables is often grounded in fears of omitted variable bias.

However, Clark (2005) demonstrates that these fears are overstated. Worse, the inclusion of unnecessary control

variables matter substantively because this can mask the relationship of theoretically relevant variables and the

dependent variable (Achen 2005; Greene 2000, 337-338; Ray 2005).

17

governments. It is expected that Durability has a positive impact on FDI. This is logged to

control for skewness.

The size of the economy also has an effect on FDI inflows. Larger markets are likely to

produce higher FDI inflows, since they provide greater probability for future returns. Economic

Size is operationalized as gross domestic product (GDP) in constant 2000 United States dollars.

Economic Size is logged to control for skewness.

GDP Growth rates are used to demonstrate growing economies. High rates of GDP

Growth demonstrate expanding markets. Growth attracts more FDI investment as foreign

investors seek to maximize returns on future markets.

Rural Population represents the level of economic development. It is expected that

populations that are rurally based are less economically developed than those with more urban

development.

Resource endowments are thought to attract FDI. Resource are the sum of mineral, gas,

and oil rents as a percent of GDP. These are logged to control for skewness. Because the

Resource of a country can be equal to zero, a constant is added before logging the value to make

all values positive and non-zero. Since this value is a constant, it has no effect on the estimated

coefficient.

Security is represented by the number of battle deaths within a state’s territorial borders.

This variable accounts for both international and intrastate sources of conflict. The number of

battle deaths is logged to control for skewness. As was the case for the previous variable, a

constant is added to all countries to prevent non-zero values.

Empirical Analysis

18

Table 1 demonstrates the importance of accounting for variation in space and time. The random

intercepts are able to account for a large portion of the variance in the model. This can be seen by

looking at the random effect parameters j and t . These values of these parameters represent

the amount of variation accounted for, or ‘soaked up,’ by including multiple levels in the

statistical model that would otherwise inflate the standard errors of the coefficients. The

individual effects of j and t will be demonstrated visually when looking at the individual

coefficients associated with the marginal effect of property rights for different states over time.

< Table 1 about here >

The first model displays the independent effects of property rights and democracy.

Property rights protections exert a positive impact on FDI while democracy has a negative

influence. However, this ignores any conditional impact of democracy on property rights. This is

investigated in the second model that includes an interactive term between property rights and

democracy. It is important not to simply look at the results and interpret them as we would

additive regression models. This is because interactive terms are multiplicative and non-linear in

nature (Kam and Franzese 2007; Braumoeller 2004). Thus, the interactive and constitutive terms

have no inherent meaning on their own. Instead, the marginal effects should be calculated to

provide substantively meaningful results (Brambor, Clark and Golder 2006).

Figure 2 displays the marginal effect of property right protections on FDI over different

levels of democracy. This means that the effect of property rights is conditional on a state’s level

of democracy. At the lowest value of Democracy, the effect of Property Rights protections

towards attracting FDI is negative and statistically significant. However, this effect becomes

statistically insignificant between Democracy values of approximately 2 and 5 before becoming

positive and statistically significant at values of 6 and 7. This means that marginal effect of

19

property rights is negative in autocracies and positive in democracies; that is, the effect of

property rights changes depending on the level of Democracy. The kernel density estimate on the

right hand side of the plot displays the proportion of observations at each level of democracy.

< Figure 2 about here >

Comparing model 1 to model 2 illustrates the importance of correctly modeling the

structural form of our theoretical relationship in order to properly evaluate the theory outlined

above (Keele 2008). Ignoring the conditional nature of democracy on attracting FDI at different

levels of property right protections leads to very different inferences than assuming a linear

structure. These results shed light on why previous studies have found mixed results regarding

the effect of democracy and FDI. Rather than having an independent and linear effect on FDI,

democracy interacts with property right protections and conditions its influence.

One aspect of the utility of the hierarchical model is evident when considering the

marginal effect of Property Rights on FDI for each country over time. Figure 3 displays the

marginal effect coefficient for each country in every year where data exists; thus, each line

represents a specific country and each dot is an observation point. For ease of interepretation,

these results are displayed at the regional level. It is clear from the figure that the marginal effect

changes over time and by country. While in the Central and North Asia the marginal effect is

predominately negative at all points in time, in the others it tends to start as negative and

becomes positive. In addition, we find that while Europe introduces substantial variation in the

marginal effect of Property Rights, the mean coefficients for each region are roughly the same in

each year, expressing surprising sameness between developed and developing countries.

< Figure 3 about here >

20

It is clear that temporal elements introduce substantial variation that is accounted for by

using a hierarchical modeling approach. Ignoring these sources of variation would inflate the

standard errors associated with variable coefficients and may result in incorrect inferences

regarding the relationship between democracy, property rights and FDI. By acknowledging this

variation, we are able to isolate the impact of our variables of interest.

For instance, by looking closingly at Figure 3, it appears that prior to the late 1990s, the

marginal effect of Property Rights with FDI inflows was negative, while afterwards this effect

becomes increasingly positive for most countries. In addition, the change between years is not

constant, but instead experiences significant variation in both strength and direction over time.

This helps to demonstrate the value of treating each year individually rather than assuming a

common structure between all years.

Finally, the average substantive relationship between property rights and democracy and

their effect on FDI is displayed in Figure 4. The simulations used to calculate the predicted

values of FDI when varying property rights and democracy are based on the values obtained

from the second model of Table 1. As is clear in Figure 4, democracy has a negative effect on

attracting FDI at low levels of property rights protection. As property right protection increase to

the mean, democracy has a positive impact on attracting FDI. At high levels of property right

protection, democracy has an even stronger positive relationship with FDI.

< Figure 4 about here >

Conclusion

The disparate empirical findings in the literature are largely reconciled through our analytical

and empirical approach. Analytically, both those arguing for democracy and autocracy as having

a privileged position for enticing FDI are in some measure correct. However, the effect of

21

property rights protections on FDI is conditioned by the institutional structure and legitimacy

provided by a country’s regime type. Despite claims in the literature that democracy attracts FDI

because of its high levels of property rights protections, we know empirically that democracy

and property rights protections are separate concepts. Yet, the intuition that high levels of

democracy and property rights protections produce high inflows of FDI is accurate. But it is

equally important to recall that democracies with low levels of property rights protections are

less able to attract FDI than their autocratic counterparts. Thus, democracies and autocracies

have advantages depending upon the level of property rights protections provided.

Our empirical approach also represents an advance in the literature on regime type and

FDI. The non-nested hierarchical model allows us to more appropriately account for country-

specific and temporal effects. We can examine the effect of property rights and regime type on

FDI inflows in each country by over-parameterizing the model rather than resorting to a

reference category as is the case with fixed effects models. We can explicitly model time rather

than simply treating it as a nuisance as occurs in PCSE models. Both help us to estimate

standard errors more precisely, resulting in a much more accurate testing of our central

hypothesis. This approach also allows us to avoid well-known problems resulting from pooling

developed and developing countries in the data set, since coefficients for each country can easily

be recovered and displayed to verify trends identified in the statistical analysis and note outliers.

Finally, our use of net inflows of FDI per capita helps to resolve some of the measurement issues

found in the literature, since it reflects actual inflows of FDI and accounts for country size.

In terms of policy, the results of our analysis indicate that neither democracy, nor

property rights protections alone are sufficient to attract FDI. In fact, democracy alone has a

negative effect on FDI inflows. In order for democratic countries to attract FDI, they must be

22

encourages to develop strong property rights protections. Such property rights regimes provide

institutionalized, legitimate means of establishing and modifying property rights as technology

and the economy change over time. Only democracies are capable of ensuring such protections,

and when they do, they are rewarded handsomely through increased FDI inflows.

23

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Table 1. Effect of Democracy and Property Rights on FDI

Property Rights * Democracy

24.17**

(10.56)

Property Rights

87.73***

-36.04

(28.62)

(61.40)

Democracy

-44.27**

-156.32***

(21.68)

(53.55)

Durability

84.54**

71.49*

(36.36)

(36.66)

GDP

22.74

14.00

(30.94)

(30.8)

GDP Growth

3.06

3.81

(7.26)

(7.25)

Rural Population

-8.69***

-8.94***

(2.66)

(2.64)

Resources

-110.88***

-98.52

(36.55)

(36.64)***

Physical Security

-2.93

-4.92

(15.75)

(15.71)

Constant

92.97

749.08

(393.52)

(481.72)

Random Effects Parameters

j

441.35

433.99

t

244.87

245.46

954.53

953.62

Observations

1375

1375

Log-Likelihood

-11472.8

-11470.2

Note: * p < 0.10, ** p < 0.05, *** p < 0.01. Coefficients are displayed above the standard errors, which are

in parentheses. The random effects parameters display the estimated standard error associated with each

non-nested hierarchical group variable, where j is country, t is year and is residual error.

28

0

500

1000

1500

2000

2500

Tota

l F

ore

ign D

irect

Investm

ent

1970 1980 1990 2000 2010Year

Note: Foreign Direct Investment figures are in billions of US dollars.

Figure 1. Aggregated World Foreign Direct Investment Over Time

29

0.0

5.1

.15

.2.2

5

Kern

al D

ensity E

stim

ate

of

Dem

ocra

cy

-200

-100

0

100

200

Marg

inal E

ffect

of

Pro

pert

y R

ights

on F

ore

ign D

irect

Investm

ent

0 2 4 6 8Level of Democracy

Note: Dashed lines give 95% confidence interval. Light dashed-dot line displays the Kernal density estimate.

Figure 2. Marginal Effects of Property Rightson Foreign Direct Investment

30

-10

12

34

1970 1980 1990 2000 2010

Latin America

-10

12

34

1970 1980 1990 2000 2010

Europe

-10

12

34

1970 1980 1990 2000 2010

Africa

-10

12

34

1970 1980 1990 2000 2010

Middle East

-10

12

34

1970 1980 1990 2000 2010

Central & North Asia

-10

12

34

1970 1980 1990 2000 2010

Southeast Asia & Oceania

Ma

rgin

al E

ffe

ct o

f P

rop

ert

y R

igh

ts

on

Fo

reig

n D

ire

ct In

ve

stm

en

t

YearNote: Displayed value is the marginal effect of Property Rights when interacted with Democracy frommodel 2 of Table 1. Displayed coefficents are in thousands.

Figure 3. Marginal Effect of PropertyRights Over Space and Time

31

1000

1500

2000

2500

0 2 4 6 8

Property RightsOne S.D. Below Mean

1000

1500

2000

2500

0 2 4 6 8

Property Rightsat Mean

1000

1500

2000

2500

0 2 4 6 8

Property RightsOne S.D. Above Mean

Fo

reig

n D

ire

ct

Inve

stm

en

t

DemocracyNote: Dashed lines give 95% confidence interval. Durability, GDP, GDP Growth, Rural Population,Resources, and Physical Security held at mean.

Figure 4. Predicted Foreign Direct Investment at VaryingLevels of Democracy and Property Right Protection