Paper prepared for presentation at the Workshop on the Politics of Preferential Trade Agreements:
Theory, Measurement, and Empirical Applications, Princeton University, Niehaus Center for Globalization and Governance
Friday, 30 April - Saturday 1 May 2010
* For comments on previous drafts, we thank David Leblang, Michael Munger, Jonathan Wand and participants of presentations at the American Political Science Association Meeting 2007, the Midwest Political Science Association Meeting 2008, and at Stanford University. We thank Nancy Brune, Jose Antonio Cheibub, Freedom House, Witold Henisz, Nathan Jensen, Jon Pevehouse, the Polity Project, UNCTAD and WDI for making data available to us and Raymond Hicks and David Francis for excellent research assistance.
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ABSTRACT : Capital is scarce in most developing countries. Increasingly, direct investment (FDI) into productive assets has come to be seen as a promising avenue for boosting economic development. As a consequence, developing countries compete for FDI by making ex ante promises to foreign investors not to pass laws or regulations--or refrain from other actions--that would diminish the value of the investment ex post. But how credible are such promises? A number of studies in recent years have examined the effect of domestic institutions (veto players, democracy, etc.) on the credibility of commitments by developing country governments toward foreign private economic actors such as foreign investors. In addition, a few studies have examined the effect of international institutions on the credibility of such commitments. We examine the possible interactions of domestic and international institutions in promoting FDI. We show theoretically and empirically that democratic domestic institutions help attract more FDI into developing countries only in the context of economically liberal international institutions.
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1. Introduction
In recent years, many developing countries have sought to increase the amount of foreign
capital invested in their countries, especially long-term capital investments (e.g., Moran 1998).
Countries tend to face a problem when trying to attract such capital, however. While they might
now promise not to take actions that lower the value of such investments, they often cannot
credibly promise to do so in the longer run. Once the investment is made, governments may be
tempted to change the terms of these investments to reap a greater share of the gains for
themselves and/or their country. Potential investors thus face political risks. They must assess
the political investment climate, as well as the economic opportunities offered by different
countries when deciding where to invest. The time inconsistency problem that creates the above
risks is well known to investors/firms, governments, and scholars (e.g., Kobrin 1982, 1984;
Moran 1978; Vernon 1971). It is a problem since it leads to underinvestment. How can
governments reassure potential investors; what can they do to reduce the political risks in order
to induce investors to make these investments?
In an earlier paper (Büthe and Milner 2008), we have found that developing country
governments can use international trade agreements (GATT/WTO and especially PTAs) to make
their commitments to economically liberal policies more credible and thus boost their countries'
attractiveness for foreign direct investors. As an unexpected corollary of that analysis we found
that measures of domestic political institutions, which we had included as controls, were mostly
insignificant. Various measures of political democracy, in particular, were insignificant after
controlling for international institutions.1 This finding seemed to challenge the recent literature
1 The measure of domestic institutional constraints ("veto points") developed by Henisz (2002) became weaker after controlling for international institutions, but remained significant at the 0.1 level in most analyses.
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on FDI that finds democratic countries to have been more successful than non-democratic ones
in attracting inward FDI, even after controlling for market size, level of economic development,
etc. (e.g., Feng 2001; Globerman and Shapiro 2003; Jensen 2003, 2006; Tures 2003). We
cautioned, however, that one should not prematurely conclude from our findings that domestic
institutions do not matter for FDI. Quite to the contrary, we suggested that measures such as
veto points or democracy, while not significant by themselves, might interact with international
institutions or policy measures such as trade openness in affecting FDI (Büthe and Milner 2008:
754n30). The systematic analysis of the interaction between international and domestic
institutions, however, was beyond the scope of the earlier paper.
This paper seeks to address the issue by asking: Is the impact of international institutions
conditioned by domestic regime type? We first discuss the existing literature and develop the
theoretical underpinnings for our expectation that there is an interaction effect between
democracy and international institutions. Then, to get at the question empirically, we conduct
two analyses, focused like Büthe and Milner (2008) on trade agreements. First, we compare
average levels of inward FDI in four sub-samples of our data, splitting the data by PTAs (high
versus low) and democracy (yes versus no), based sequentially on one of three key measures of
democracy used in the literature (i.e., the dichotomous measure of democracy developed by Jose
Cheibub, originally with Alvarez, Limongi and Przeworski (ACLP), the 3-catetory Freedom
House aggregate score of "Freedom," and the aggregate measure of regime type, Polity). This
simple test does not allow us to control for any other factors, but provides an informative first
look at the data based on a minimum of assumptions. We find that there is a clear and in most
cases statistically significant difference in average inward FDI between high- and low-PTA
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country years, and that this difference is more pronounced among democracies than among non-
democracies.
Second, we conduct regression analyses on the full sample, where we include the
measures of international and domestic institutions along with an interaction term, i.e., the
product of our measure of PTAs and three measures of domestic political institutions: the
dichotomous Cheibub democracy measure, the Freedom House index, and Polity (in separate
regressions due to high collinearity between the measures of democracy). We find that political
regime type (democracy) has no statistically significant effect on inward FDI, except when a
country is a party to international trade agreements. Trade agreements boost FDI to a
statistically significant extent, and democracy reinforces this effect.
Our findings lead us to conclude that the effect of international institutions on FDI is
conditioned by domestic institutions. Governments can increase the credibility of their
commitments to investors by signing international agreements, but this effect is stronger when
the commitments are made by governments with democratic political institutions at home.
Indeed, the combination of international trade agreements and democratic politics at home can
substantially increase FDI inflows. Potential investors are doubly reassured that democratic
governments which sign trade liberalization agreements with other countries are more likely to
follow market-friendly policies and to resist the temptation to intervene in ways that degrade the
value of investments. In sum, domestic institutions can reinforce the role of international
institutions as commitment mechanisms for governments who want to attract foreign investment.
Our research contributes to several current debates and has important policy implications.
First, we hope to advance the debate over foreign direct investment. We extend the work done
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recently by scholars on the role of domestic political institutions in affecting FDI (e.g., Jensen, Li
and Resnick). Like others, we show that democracies are different and they have important
effects on economic outcomes, as well as political ones (e.g., Mansfield, Milner, and Rosendorff
2002). We show that a significant amount of the variation in FDI can be explained by political
variables neglected in previous research.
Second, our research contributes to the broader literature on institutions and how they
matter in politics. Here, our findings lend further support to the argument that institutions—
whether domestic or international—affect the credibility of the commitments that governments
make (e.g., Leeds 1999; Martin 2000; Milner 1997; North and Weingast 1989; Simmons 2000a,
2000b). There are good reasons to think that domestic democracy and liberal international
institutions increase the credibility of commitments that governments make to each other. We
find that part of this logic also holds for commitments that governments make vis-à-vis foreign
private actors in the international political economy. Furthermore, we demonstrate that the
impact of international institutions depends in part on domestic ones. Beyond the literature on 2-
level games (Evans, Jacobson, and Putnam 1993; Mayer 1991; Putnam 1988), the interaction of
domestic and international institutions has received little attention in the literature (with a few
exceptions, such as Mattli and Büthe 2003; Snidal and Thompson 2003). Our findings suggest
that it is a promising area for further research. Additionally, we show that participation in
institutions in one issue area can have effects in another—trade institutions affect foreign
investment flows.
Finally, our research has important implications for scholars and practitioners interested
in the politics of economic development and democratization. Most importantly, we find that
democracy magnifies the economic benefits a country can gain from participation in
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international political-economic institutions, such as trade agreements. While it is unlikely that
governments are going to fully democratize (and thus risk losing power completely) to increase
foreign investments, the promise of these additional economic benefits creates incentives for
taking small steps toward greater democracy. The resulting increase in foreign investment
should promote growth, which should in turn enhance the government's political support, which
might explain the relative stability of the "hybrid" political regimes that present a puzzle for
much of the literature on democratization (Diamond 2002; Levitsky and Way 2002). Moreover,
many scholars have pointed out the tension between economic liberalization and globalization on
the one hand and democratic control of public policy on the other. Some even have argued that
economic liberalization must precede democratization for democracy and an open economy to be
compatible. We find that democratic countries can reap greater benefits from economic
liberalization and globalization, which suggests that democracy and an open economy may in
some ways be more compatible when democratization precedes economic liberalization rather
than vice versa.
2. Domestic Institutions and International Commitments
2.1. Existing Literature
The credibility problems that countries face regarding foreign direct investments have
long been known to policy makers and academics (e.g., Vernon 1971) (Moran 1985).
Investment decisions are based on the set of policies a country's government currently has in
place or the set of policies the government may have promised to adopt. Investors use this
information to calculate the potential profitability of their investment. After the investment is
made, however, governments often have incentives to renege on their promises or change
policies, thus reducing the value of the investment. All investors face the risk that the security or
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profitability of their investments will be reduced as an intentional or unintentional consequence
of changes in government policy. All investors therefore should worry about the credibility of a
government’s commitment to any particular set of policies. But foreign investors should worry
in particular: They have often no legitimate voice in the political process that determines the
policies affecting them, which in turn makes them attractive targets of nationalistic political
opportunism. And foreign direct investors face even higher risks since their investments are by
definition less mobile.2 We investigate here how governments can mitigate the political risks
associated with these investments; we are less interested in the economic factors that induce or
repel such flows, although we try to control for these factors.
A recent and growing literature examines the domestic political institutions that countries
can use to overcome the time inconsistency problems they face. Numerous scholars have
investigated the impact of regime type on investment. They have asked whether investors care
how democratic a country is when they make investment allocation decisions. The early
literature on FDI suggested that MNCs were attracted to autocracies by their ability to suppress
labor demands and by the absence of election-induced policy uncertainty (Bornschier and Chase-
Dunn 1985; O'Donnell 1979 (1973)). Other scholars, however, found no significant effects for
regime type (e.g. Oneal 1994) or suggested more complex causal relationships (Kahler 1981).
More recent research has found that democracies attract more foreign direct investment, because
policy in democracies may be more predictable than in autocracies (e.g., Feng 2001; Jensen
2003). Jensen argues that democracies provide three advantages over autocracies when it comes
to FDI. First, democracies provide more information to potential investors because they are
2 The degree of mobility of course varies. It is very low for investments in the extraction of natural resources, which may explain why these investments have long been most at risk of expropriation; services FDI, which has increased greatly in recent years, is much more mobile, but still less mobile than financial investments, assuming equal constraints on taking funds out of a given country.
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more transparent; second, democracies allow for more representation of the interests of investors
so investors can affect the governments of the FDI host countries; and third, democracies create a
more credible environment for market friendly policy because of the higher audience costs that
executives face if they change policies.
Li and Resnick (2003) challenge some of these arguments based on a more differentiated
notion of democracy and its potential effects on FDI. They see democracy as having both
benefits and costs for foreign investors, the main benefit being the better protection of private
property rights. They show that regime type indeed does have mixed effects; only the private
property rights component of democracy is favorable to FDI. Blanton and Blanton (2006) find
little evidence that democracy matters for FDI, but show that human rights treatment by host
countries is important. In sum, mixed evidence exists for the impact of regime type on FDI, and
the causal process by which that effect is exerted is much debated.
Another political mechanism by which political leaders may increase the credibility of
their commitments to investors is through international agreements and treaties. A number of
authors have shown that by signing bilateral investment treaties (BITs) countries can attract FDI
inflows (e.g., Neumayer and Spess 2005; Büthe and Milner 2009), though others have found
more mixed results. In recent work, Büthe and Milner (2008) show that countries that join
preferential trade agreements (PTAs) and the WTO receive more FDI.
Büthe and Milner argue that the indirect political effects of trade agreements are the most
important reasons for this effect. Trade agreements have a positive effect on investors’
assessments of how risky it is to undertake an investment in a given country, they argue, because
signing a trade agreement commits a government directly to economically liberal foreign
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economic policies such as low trade barriers and more indirectly to economically liberal
economic polices at home (both of which foreign investors have been shown to like). Trade
agreements can serve as commitment devices that tie a government’s hands and reduce the
likelihood that it will adopt policies that hurt the value of investments. Governments can
increase the credibility of their current policies by signing trade agreements that commit them to
market friendly policies and make changing those policies more visible and more costly. Trade
agreements serve as “strategic moves” that potentially raise the costs for a country to renege on
its policies toward foreign investors later on (Dixit and Skeath 2004: chap 10). International
trade agreements may also be more credible than pure domestic policy changes since the costs of
breaking trade agreements with international partners may be higher than the costs of domestic
change. The purely economic effects of PTAs are only part of what induces foreign investors; the
political significance of trade agreements as costly and hence credible commitments also matters
to foreign investors and boosts FDI above and beyond the direct economic effects of trade
agreements.
2.2. Interaction of Domestic and International Institutions
In this paper, we explore the interaction between domestic and international institutions
in solving credibility problems for governments. Given the findings in our earlier paper, we
expect that international trade agreements like PTAs and the WTO will have a positive impact on
FDI inflows. We hypothesize that democratic domestic political institutions may multiply this
effect of trade agreements on FDI because signing a trade agreement has in the eyes of foreign
investors greater consequences for democracies than for non-democracies. The specific effect of
international institutions on FDI would thus be conditional on domestic institutions. We
stipulate two reasons for such a conditional effect.
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First, freedom of the press and freedom of expression are a hallmark of (liberal)
democracy. Even if press freedom ratings by Freedom House and Reporters sans Frontiers show
that the extent to which citizens enjoy these freedoms in practice varies considerably among
democracies, the ratings tend to be much higher for democracies than non-democracies.3 Press
freedom ensures more, better and public information about government behavior from an
independent source; freedom of expression ensures that those who are (in danger of being)
harmed by a (planned) policy change have the opportunity to speak up and make their grievances
publicly known. While this additional information, especially the unbiased information provided
by a free press, is surely valued by foreign investors seeking to assess political risks, it may not
lead to significantly increased FDI if the government policies thus revealed are not favorable to
foreign investors. On balance, democracy by itself might therefore not have a significant effect
on FDI. However, if freedom of the press and freedom of expression coincide with trade
agreements that commit governments to economically liberal foreign economic policies (and
liberal economic policies more broadly), then the additional information would make it easier for
any interested party to identify violations of those commitments. By facilitating the detection of
any violation of a country's policy commitments, freedom of the press and expression make it
easier for a country's partners in a trade agreement to punish such violations, which in turn
should increase foreign investors' confidence in these commitments since it makes violation of
the commitments more costly in expectation than when the same commitments are undertaken
by a non-democratic government.
Second, democratic leaders face higher (domestic) audience costs than non-democratic
leaders when they break foreign policy commitments that they have made in public. Autocratic 3 See http://www.freedomhouse.org/template.cfm?page=16 (8/20/2007) and http://www.rsf.org /rubrique.php3?id_rubrique=639 (8/20/2007).
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leaders may be able to violate international agreements with little domestic cost (though they will
still face international costs, which should ensure that trade agreements boost FDI independent of
democracy). Democratic leaders will, in addition, pay a domestic political price—what Fearon
(1994) has called "audience costs"—for reneging on their commitments, which should render
making such commitments more credible and therefore further boost the increased FDI that
democracies experience as a consequence of signing trade agreements.
The basic argument here—derived from the sizeable literature about the effect of
domestic audience costs on international relations—is that when democratic governments make
an international commitment (to a particular policy or course of action) that is visible to domestic
audiences, they increase their own political costs of not pursuing that policy or course of action,
thus making the commitment more credible.4 Our claim is that, as a country grows more
democratic, foreign investors come to consider its commitments to trade liberalization in
particular and liberal economic policies in general as more credible, because of the higher
audience costs such countries face in breaking trade agreements. This argument depends, first,
on publics not approving of their leaders violating international trade agreements once they are 4 Differences in audience costs across regimes types have been invoked to explain why democracies fight less (Fearon 1994; Schultz 2001), why they are more likely to win wars they fight (Lake 1992), why they are unlikely to back down in crises (Smith 1998), why they use international legal arbitration more (Allee and Huth 2006), and why they comply with their international commitments more than nondemocracies (McGillivray and Smith 200?). In general, the microfoundations of these arguments about audience costs have been poorly specified. Is it the public’s concern for the nation’s reputation in world affairs that matters; is it the democratic leader’s concern about how the public sees him (competent or not); or is it the political opposition that makes electoral gains from the leader’s behavior? More recent work has tried to pin down these microfoundations. Tomz, for example, finds some support for the hypothesis that citizens are concerned about the international reputation of their country (Tomz 2007). Gale (2007) has tried to show what happens when the level of audience costs can vary according to the salience of the issue at hand. His results show that treating both the level of the strategic interests and regime type as variables produces better predictions about crisis behavior than audience costs alone. Kernell (1997) and Baum (2004) show that presidents in the US can also try to generate audience costs to enhance their international bargaining positions, but that this can be a double-edged sword. Slantchev (2006), in a more direct attack on these microfoundations, shows theoretically that only an independent media can generate the information necessary for publics to be able to sanction their leaders, and thus only democracies with strong medias are capable of generating audience costs that differ from those of autocracies. In sum, the existing literature presents a number of different explanations for the public's initial preferences for keeping international agreements, but the general logic that unfolds from this assumption is widely shared.
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signed. It also depends, second, on publics in democracies knowing whether these commitments
have been violated; third, on these publics' ability to punish their leaders for such violations; and,
fourth, on foreign investors being able to assess these differential audience costs when making
investment decisions.
While a complete analysis of the causal mechanism is beyond the scope of this paper
(and the logic of the argument suggests that actual violations of trade agreements by democracies
should be quite rare), the existing literature offers at a general level some support for each step in
the causal chain and strong support for some of the steps. First, there is a diverse literature
suggesting that publics disapprove of their governments violating international agreements (e.g.,
Fearon 1994)(McGillivray and Smith). Tomz even finds direct support for this preference on
behalf of the general public in experimental studies and in surveys about economic agreements
(Tomz 2007). Since democratic leaders depend upon broader public support than autocratic
ones, these preferences among the general public should have greater salience in democracies
than in non-democracies. As for the second issue, comparative public opinion research across
political regime types is difficult if not impossible, but existing research shows the general public
in democracies to be well informed about their countries' foreign policies. And since reneging
on international commitments almost always harms some domestic interests, freedom of
expression in democracies makes it very likely that those domestic interests will make the
government's violation of its commitments public, as discussed above. Electoral democracy in
turn guarantees that voters can punish the government if they disapprove of its policies (though
the extent to which this constrains the government will surely depend upon the salience of the
issue and the expected closeness of the next election, see, e.g., Aldrich, Sullivan, and Borgida
1989). On the fourth and final step, there is at least anecdotal evidence to support our argument.
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While the level of explicit political consciousness among business executives tends to be low,
interviews with senior managers in multinationals in the US and Europe, conducted by one of us,
suggest that major foreign direct investment decisions almost always involve a political risk
analysis, and that a country's political and legal system is part of that analysis, along with
specific policies and international legal commitments such as BITs and trade agreements.
In sum, our claim is that, as a country grows more democratic, foreign investors
increasingly come to believe its commitments to trade liberalization in particular and more
liberal economic policies in general, because of the higher (internal) audience costs such
countries face in breaking trade agreements and because of the higher likelihood that breaking
the agreement will be detected by other signatories, who can impose costs externally. So we
expect that democracies that sign PTAs will receive more FDI than democracies that do not sign
them, and that this effect will rise with the number of PTAs they sign. The flip-side of this
argument is that among the countries that sign PTAs, those countries that are more democratic
will receive more FDI than those that are less democratic.
Overall, our argument is that democracy, even if it may not matter for FDI by itself,
combines with a country’s commitment in international trade agreements matters to make a
country more attractive for foreign investors. It is the interaction of these two institutional
factors that makes the difference. This leads us to two central hypotheses:
H1: As the extent of a country’s level of democracy rises, the positive effect of signing PTAs on
its inwards FDI increases. (In a dichotomous setting, the positive effect of signing PTAs on a
country’s FDI inflows will be greater for democracies than for autocracies.)
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H2: As a logical corollary of H1, the positive effect of democracy on a country’s inwards FDI
will be greater for a country the more PTAs it has signed.
3. Empirical Analyses
3.1. Sample and Key Variables
To test the above hypotheses, we conduct statistical analyses of inward foreign direct
investment for a large panel of developing countries. International organizations like the UN
Conference on Trade and Development (UNCTAD) began collecting comprehensive annual data
on foreign direct investment flows into developing countries in the 1970s. The most recent year
for which we have complete data is 2008 (though limited availability of one of the control
variables limits some analysis to 2006). We restrict our sample to non-OECD countries because
there are strong theoretical reasons to believe that FDI into developing countries (LDCs) is a
function of a different set of factors than FDI into advanced industrialized countries.5 Our
sampling frame thus consists of all independent non-OECD countries with a population of more
than 1 million. There have been 132 such countries in existence at some point in time between
1970 and 2008. We have sought to maximize our sample size and are able to analyze data for
123-125 of these 132 countries for our main analyses.
Our dependent variable, inward FDI, is the sum of direct investment undertaken by
foreigners in a given country during a given year, as a percentage of GDP (this variable tends to
be positive but can take negative values in years when foreigners withdraw more direct
investment than they undertake). The data is taken from the online version of UNCTAD's
Handbook of Statistics, the source of the most comprehensive data on FDI (see UNCTAD
5 Blonigen and Wang (2005) show empirically that pooling data from OECD countries and LDCs is problematic.
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2003:231f for details). We use FDI as a percentage of GDP to eliminate the need to deflate our
dependent variable and to make it comparable across countries and across time.
To study the interaction of domestic and international institutions, we focus on three sets
of variables: measures of international trade agreements, measures of domestic political regime
type (democracy), and the interaction between them. Our main measure of trade agreements is
CUMULATIVE PTAs, which records the number of trade agreements (other than GATT/WTO) to
which a country is a party by the end of the given year. This variable is based on a new, more
comprehensive dataset compiled by Helen Milner and Ed Mansfield and differs from the
Pevehouse measure used by Büthe and Milner (2008) in that it covers a larger number of PTA.
For the LDCs in our sample, this variable ranges from 0 to 21.6
We employ three measures of regime type to assess the degree of political democracy at
the domestic level. We consider first a dichotomous measure of electoral democracy created by
Cheibub, which codes a regime as democratic if and only if high political offices are chosen
through fair and free contested elections where alternation of leaders occurs.7 Second, we
employ the widely-used Polity index, which combines data on five aspects of domestic political
institutions that capture the differences between democracies and autocracies: 1.) the
competitiveness of the process for selecting a country’s chief executive, 2.) the openness of this
process, 3.) the extent to which institutional constraints limit a chief executive’s decision-making
authority, 4.) the competitiveness of political participation within a country, and 5.) the degree to
6 Since we have argued that PTAs constitute a commitment to liberal economic policies and increase the informational effects and thus the costliness of breaking the commitment, we expect a positive correlation with FDI. Since we have argued elsewhere that GATT and WTO membership also constitute a costly commitment to liberal economic policies, we include in some of the analyses—as a secondary measure of trade agreements—a dichotomous measure(s) of formal membership in GATT and WTO: GATT/WTO MEMBERSHIP (coded 1 for every year in which a country is a member of GATT or WTO, see www.wto.org/english/thewto_e/gattmem_e.htm, www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm). The correlation with FDI should also be positive. 7 For details see Alvarez et al (1996), Cheibub (2007) Przeworski et al (2000).
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which binding rules govern political participation within it.8 The resulting 21-point score should
be positively correlated with FDI. Third, we use Freedom House's (FH) three-point score.
Based on expert observers’ answers to questions about the electoral process, political
participation and the functioning of government, FH rates each country as free, partly free, or not
free. Note that this measure is coded such that higher numbers are less democratic; hence a
positive correlation between democracy and FDI implies in a regression setting a negative
coefficient for this variable.
None of these measures is perfect, and correlations among them, while above 0.7, are far
from unity, which suggests that they are not in fact measuring the same thing (see Elkins 2000;
Munck and Verkuilen 2002). Yet, they provide reasonable and broadly comparable indicators of
democracy, and they are the standard measures used in the literature. We therefore use all three
measures (separately, given the high correlation) to assess whether our results are robust to
changes in the conceptualization of regime type.
3.2. Empirical Analysis I: Differences in Average Inward FDI
As a very simple first cut, we split the sample between democracies and non-democracies
(the columns in Figures 1-3).9 We also split the sample into country-years with a low number of
PTAs (2 or less) and country-years with a high number of PTAs (3 or more). Since we had no
theoretical reason to expect any particular threshold for the number of PTAs, we used the median
number of PTAs to dichotomize the sample based on this measure, so that the size of the two
8 For details, see http://www.cidcm.umd.edu/inscr/polity/index.htm, Gurr et al. 1989, and Jaggers and Gurr 1995. 9 Since our unit of analysis is the country-year and many countries in the sample experienced regime changes during the time period covered by this analysis, we divide the sample based on observation-level information, i.e., we did not assume that any given country is in one column or the other for the entire period. However, for consistency with our other analyses, we used the 1-year lagged valued for democracy and PTAs. The lag allows for a time delay between these hypothesized explanatory variables (democracy and PTAs) and their stipulated effect on FDI. It also provides some safeguard against reverse causation.
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groups (the rows in Figures 1-3) would be approximately equal. This two-way split of the
sample resulted in the 2x2 tables in Figures 1-3. We then calculated, for each cell, the mean of
FDI (net inwards FDI as a percentage of GDP), as well as the standard deviation.
Our general theoretical argument about PTAs as such suggests that—within each
column—average FDI should be higher in the top cell than in the bottom cell. If democracies
attract more FDI than non-democracies at any given level of PTAs, then—within each row—
average inward FDI should be higher in the cell on the right than in the cell on the left. Our main
focus in this paper, however, is to assess the hypothesis that the effect of PTAs on inward FDI is
conditioned by domestic political institutions and more specifically that democracy boosts the
effect of PTAs on FDI. If this hypothesis holds, we should observe a greater effect of PTAs in
the democracy column than in the non-democracy column.
Democracy (Cheibub)
NO YES
3.17 3.65 HIGH (7.39, 1054) (3.55, 708)
1.38 1.39
PTA
s
LOW (3.62, 1666) (1.99, 553)
Figure 1: Mean annual levels of inward FDI (as a percentage of GDP) by regime type and dichotomized level of PTAs (PTAs split at the median: low = 0 - 2; high = 3 and more). Standard deviation and N for each cell in parentheses.
Figure 1 shows the results when the dichotomous measure is used to differentiate
between democracies and non-democracies. We find that countries (i.e., country-years) with a
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high number of PTAs generally attract more FDI than countries with a low number of PTAs.10
This difference is more pronounced for democracies than for non-democracies—as expected
theoretically: The estimated effect of a country increasing the number of its trade agreements
from a "low" number to a "high" number is an increase in inward FDI equal to almost 2.3% of
GDP for democracies (as measured by Cheibub's measure). By contrast, the estimated increase
for non-democracies is just below 1.8% of GDP. While the difference is highly statistically
significant (p < 0.00005) for both democracies and non-democracies, it is larger and more
significant for democracies. Democracy, on the other, has virtually no effect in a low-PTA
environment, but increases FDI inflows in a high-PTA environment to a substantively (almost
0.5% of GDP) and statistically at least weakly significant extent (p<0.0567).
Figure 2 shows the average levels of FDI for each subgroup in the 2x2 table if the
POLITY measure is used to distinguish between democracies and non-democracies. It has
become customary in much of the literature to require a polity score of 7 or more on the raw (–10
to +10) scale of the Polity index for a country to be considered a democracy.11 We accept this
threshold to create a dichotomous measure of democracy for purposes of Figure 2.
10 More precisely, we find: countries that were parties to a high number of PTAs in the previous year attract more FDI than countries that were parties to a low number of PTAs in the previous year— on average and controlling for democracy. 11 18 or more in the 1 to 21 scale that we use for the interaction terms below.
18
Democracy (Polity > 6)
NO YES
3.04 3.92 HIGH (7.02, 1180) (3.67, 568)
1.40 1.32
PTA
s
LOW (3.50, 1856) (1.94, 340)
Figure 2: Mean annual levels of inward FDI (as a percentage of GDP) by regime type and dichotomized level of PTAs (PTAs split at the median: low = 0 - 2; high = 3 and more). Standard deviation and N for each cell in parentheses.
Here again, among countries with a high number of PTAs, democratic countries attract
more FDI than non-democracies. The difference is large and strongly statistically significant
(p = 0.0025). Among countries with low PTAs, this simple analysis even suggests that
democratic countries receive less FDI, though the difference is statistically completely
insignificant (p = 0.6532) for countries with low PTAs. Also, country(year)s with high PTAs
attract more average inward FDI than country(year)s with low PTAs, both in general and
controlling for democracy. This effect is substantially larger for democracies than for non-
democracies—consistent with the hypothesis advanced above—though statistically significant in
both columns of Table 2 (p < 0.00005).
Finally, we turn in Figure 3 to the democracy measure FREEDOM from Freedom House.
We dichotomize this measure (as customary in the literature) by coding "free" countries
(FREEDOM = 1) as democracies, and by coding "semi-free" and "unfree" countries as non-
democracies. Splitting the sample based on the Freedom House measure of democracy (and
19
consequently inherently limiting the analysis to cover 1973-2008) yields the average levels of
inwards FDI recorded in Figure 3.
Democracy (Freedom House)
NO YES
3.17 4.13 HIGH (6.79, 1295) (3.77, 437)
1.41 1.49
PTA
s
LOW (3.59, 1605) (1.98, 320)
Figure 3: Mean annual levels of inward FDI (as a percentage of GDP) by regime type and dichotomized level of PTAs (PTAs split at the median: low = 0 - 2; high = 3 and more). Standard deviation and N for each cell in parentheses.
As when using the other measures, countries-years with high PTAs here, too, appear to
attract more FDI than country-years with low PTAs, and the difference again is statistically
significant for both democracies and non-democracies (p=0.0002). Democratic countries also
appear to attract generally more FDI, but in the low-PTA environment, the difference is not
statistically significance (p = 0.3481). By contrast, the difference is clearly statistically
significant in the high-PTAs environment (p = 0.0026).
These findings generally support our argument. Most importantly, the greater difference
between the top and the bottom cell in the democracy column than in the non-democracy column
suggests that democracy indeed boosts the effect PTAs on FDI. The findings also suggest that
PTAs have a greater effect than democracy, which only appears to matter in a high-PTA
environment (though the difference across the columns in the lower row is never statistically
significant).
20
While interesting, these findings suffer from several handicaps. Most importantly, this
approach does not allow us to control for other factors that previous research has found to be
significant determinants of FDI, such as market size, economic growth, political violence, or
trade or financial openness. If those factors are not perfectly orthogonal, the above results suffer
from omitted variable bias. Moreover, the findings in the Figures above may reflect spurious
correlation: The number of PTAs, measures of democracy, and FDI have all generally trended
upwards during the time period covered here. More sophisticated statistical techniques are
warranted.
3.3. Empirical Analysis II: Regression Analysis
We have noted above a number of concerns that make us hesitant to draw strong
inferences from the summary of the data in the 2x2 tables. To address these concerns and get
more directly at the interaction between international and domestic institutions, we now turn to
regression analysis. We start from a model of the following general form:
(i)
… where "TA" is a generic measure of trade agreements and "X1it-1 … Xnit-1" represent
any number of control variables. To asses whether the effect of trade agreements on FDI is
conditioned by democracy, we add "DEM," a (for now) generic measure of democracy and an
interaction terms of the general form TA*DEM:12
(ii)
12 We include democracy as the component part of the interaction term.
21
Models of the type shown in equation (i) are essentially restricted versions of models of
the type shown in equation (ii). The latter, however, is itself a restricted version of the fully
unrestricted model in equation (iii), which implies that regime type conditions the entire
structural relationship between the hypothesized explanatory variables and FDI:
(iii)
We should draw inferences from the estimated coefficients for models of type (ii) only if,
on the one hand, model (ii) offers a significant improvement in fit vis-a-vis model (i) and, on the
other hand, model (iii) does not offer a significant further improvement over model (ii). F-tests
may be used to conduct these tests for joint significance of the additional coefficients.
As discussed above, we use three measures of democracy and form interaction terms for
each of them (one at a time to avoid multicollinearity). Thus we first interact CUMULATIVE PTAs
with Cheibub's the dichotomous indicator of democracy to create PTA*CHEIBDEM. In a separate
set of models, we then interact trade agreements with POLITY, the 21-point scale measuring the
extent of democracy, PTA*POLITY.13 In a final set of estimations, we interact trade agreements
with the Freedom House measure of regime type to form PTA*FREEDOM. These interaction terms
are the key variables of interest for assessing hypotheses 1 and 2. Their estimated coefficients
should be positive, except for PTA*FREEDOM, which should have a negative coefficient.
While trade agreements and the interaction terms are the key variables of interest for us,
and while there are good reasons to keep models for panel data as simple as possible, we
recognize that FDI is also affected by other economic and political factors, not yet discussed.
13 Since a raw polity score of zero is not mathematically meaningful (as would be assumed when using it in a multiplicative way), we re-scale polity so that it exhibits no negative values. Instead of ranging from -10 to +10, POLITYpos runs from 1 through 21.
22
Specifically, in keeping with previous work, we control for host MARKET SIZE by including in our
model the log of the country's population. To control for the level of ECONOMIC DEVELOPMENT,
we include the log of per capita GDP in constant (2000) dollars. To control for economic
growth, we use the percentage change in the country's real GDP from the previous year, GDP
GROWTH. Among the political factors, the most important ones identified by previous research as
predictors of FDI are the number of bilateral investment treaties (BITs) to which a country is a
signatory (from UNCTAD 2000); POLITICAL INSTABILITY, the composite measure from Arthur
Banks' dataset of political events that indicate political violence and instability (Banks 1999);
and DOMESTIC POLITICAL CONSTRAINTS, Henisz's preference-weighted measure of the number of
veto players in a national political system (2002:363).14
As the length of the time series for each country is too short to justify the usual
assumptions about asymptotics for analyses within any single country, we pool data from all
developing countries in our sample. Preliminary tests show, however, that neither simple OLS
on the pooled sample nor random effects estimation is appropriate. Since our main theoretical
interest is whether changes in international or domestic institutions affects a given country's
attractiveness to foreign direct investors, we conduct "within" estimations (OLS with country
fixed effects; for a more detailed discussion, see, e.g., ) (Hsiao 2003; Wooldridge 2002). All
explanatory variables are lagged one period; when necessary, they are also detrended to
safeguard against spurious correlation that arises from variables trending together over time (e.g.,
14 This variable indicates the extent of constitutionally mandated institutions that can exercise veto power over decisions as well as the alignment of actors’ preferences between those institutions within each state. The data measures the presence of effective branches of government outside of the executive’s control, the extent to which these branches are controlled. While this is a measure of domestic political institutions and might therefore be considered as an alternative to the measures of democracy, it is not itself a measure of democracy (neither conceptually nor empirically, as it varies greatly among democracies)
23
Davidson and MacKinnon 1993:670-673). Country fixed effects are employed in the detrending
stage; and standard errors are clustered by country.15
3.3.1. Results
Table 1 reports the estimated results when using CHEIBDEM as the measure of
democracy. The first column (model 0) replicates model 4 of Büthe and Milner (2008), albeit
with the new measure of PTAs and several years' of additional data, which increase the size of
sample by 1/3 compared to their model 4, adding more than 800 observations. Our key findings
are consistent with theirs: PTAs boost FDI inflows to a highly statistically significant extent;
GATT/WTO membership also boosts FDI, though the estimated coefficient here is only weakly
significant. The estimated positive effect BITs just misses conventional levels of statistical
significance. Political instability reduced FDI, though it is only weakly statistically significant.
Economic growth boosts FDI; market size and economic development are (after de-trending and
country fixed-effects) insignifcant. The most notable difference is that Henisz' measure of
DOMESTIC POLITICAL CONSTRAINTS is far from statistically significant (with the wrong sign). We
attribute this changes to our use the 2010 update of Henisz' measure, which differs significantly
from the 2002 version used by Büthe and Milner (2008)—the correlation is below 0.6 for the
observations in our sample. Because of the potential for multicollinearity when including
Henisz' measure simultaneously with the measures of democracy, we therefore drop this
insignificant measure from the model.
15 We use the standard errors for within estimators proposed by Arellano (1987), which are robust to both heteroskedasticity and autocorrelation and yield the most conservative inferences (see Kézdi 2004).
24
Table 1 Interactive Effect of Democracy and Trade Agreements: ACLP
Model 0 Model 1 Model 2CHEIBDEM Model 3 CHEIBDEM
cumulative PTAs 0.169*** (.0583)
0.170*** (.0581)
0.162*** (.0576)
0.172*** (.0579)
CHEIBDEM * cumulative PTAs
0.615*** (.229)
0.640 (.281)
CHEIBDEM -0.192 (.231)
-0.136 (.227)
Dom. Political Constraints
–0.345 (.538)
GATT/WTO membership
0.776* (.445)
0.762* (.449)
0.734 (.448)
0.725 (.460)
CHEIBDEM * GATT/ WTO membership
0.751*** (.775)
BITs 0.0205 (.0130)
0.0202 (.0129)
0.0201 (.0128)
0.0203 (.0130)
CHEIBDEM * BITs 0.000971 (.0317)
Political Instability -0.0150* (.0124)
-0.0142 (.0123)
-0.0134 (.0125)
-0.0144 (.0124)
CHEIBDEM * Political Instability
-0.0545* (.0312)
Market Size 0.186 (1.70)
0.202 (1.71)
0.158 (1.68)
0.193 (1.71)
CHEIBDEM * Market Size
–4.23 (3.71)
Economic Development 0.195 (.645)
0.197 (.642)
0.232 (.646)
0.234 (.657)
CHEIBDEM * Economic Development
0.232 (.899)
GDP growth 0.0997** (.0456)
0.0989** (.0451)
0.0986** (.0451)
–0.0955** (.0414)
CHEIBDEM * GDP growth
-0.169 (.105)
constant 2.38*e-10 (1.53.*e-9)
-1.63*e-9 (1.49.*e-9)
0.00711 (.00984)
0.0210 (.0134)
N 3337 3344 3344 3344
R2 +.0411 +.0413 +.0439 +.0474
p>F (F-test, this model against immediately prior model)
n/a n/a 0.0143 0.1657
Note: Robust standard errors in parentheses. * p < 0.1; ** p < 0.05; *** p < 0.01, two-tailed tests. n = 124. All estimates in Stata 10.1.
25
Model 1 then is our baseline model, following the logic of equation (i) above, Model 2
adds to this baseline model the CHEIBDEM measure of democracy and the interaction term with
PTAs. The estimated coefficient for the interaction term is positive and substantively as well as
statistically significant (at better than the .01 level), while the estimated coefficient on the PTAs
as such is virtually unchanged. Substantively, the coefficient suggests that the additional FDI
generated by every additional PTA is more than three times as much for democratic than for non-
democratic developing countries.16 The coefficient for the dichotomous measure of democracy
(CHEIBDEM), by contrast, has the wrong sign (suggesting that democracies as such get less FDI
than non-democracies) but is nowhere near conventional levels of statistical significance. The
model fit is improved, though only modestly. Jointly, the two new variables (CHEIBDEM and
CHEIBDEM*PTAs) are clearly significant (p = 0.0143), but since CHEIBDEM*PTAs was calculated
from the de-trended series, the correlation between CHEIBDEM and the interaction term is actually
very low (below 0.1), which suggests that the t-statistics on the individual coefficients can be
interpreted directly.
The last column of Table 1 shows the results for model 3, which includes interaction
terms between CHEIBDEM and every independent variable in the baseline model (model 1).
While a few of the interactions come up weakly statistically significant here (political constraints
with the wrong sign), most of the interactions are completely insignificant, and the F-test clearly
shows that estimating model 3 is not warranted. In sum, when using the CHEIBDEM measure of
democracy, we find no evidence of democracy by itself attracting FDI inflows, but quite strong
evidence of democracy interactively reinforcing the FDI-boosting effect of international trade
agreements. This effect also appears to be substantively large and statistically significant at 16 Keeping in mind that the dependent variable and most of the explanatory variables for these regressions have been de-trended.
26
conventional levels for GATT/WTO, but not for the other variables in the model. We can
therefore reject model 3 and conclude that it is, above all, the interaction between trade
agreements and domestic regime type (democracy) that matters.
Do these findings hold up when we use other, more fine-grained measures of democracy?
The first two columns of Table 2 present models 1 and 2a for POLITYpos (the 21-point regime type
measure from the Polity project, rescaled to the 1 - 21 interval before calculating the interaction
terms). The thrust of these results is very comparable to the findings for CHEIBDEM: There is no
indication of a statistically significant effect for the regime type variable alone (the insignificant
coefficient has the wrong sign),17 but the positive coefficient for the interaction term of regime
type and PTAs is both substantively and statistically significant (at p = .012). The two variables
are jointly significant at better than the 0.05 level, but this result appears to be again driven
almost entirely by the interaction term. Since the POLITY measure differentiates gradations of
democracy, this finding from country-fixed-effects regressions clearly supports the general
version of our hypothesis 1: As a country's level of democracy rises, the positive effect of
signing PTAs on its FDI inflows increases. Adding an interaction with GATT/WTO also yields
a positive coefficient, but that coefficient is only weakly statistical significant (p = 0.088); model
3 is again clearly not warranted (results not shown; available upon request).
17 Ironically, the positive effect of political constraints on FDI increases when we move from model 1 to model 2. This may be interpreted as PolCon picking up the aspect of democracy most desired by foreign investors.
27
Table 2 Interactive Effects: Alternative Measures of Democracy
Model 1polity sample Model 2Polity Model 1freedomsample Model 2Freedom
cumulative PTAs 0.144** (.0569)
0.132** (.0569)
0.170*** (.0842)
0.156*** (.0599)
(Politypos or Freedom) * cuml. PTAs
0.0442** (.0176)
-0.272** (.114)
Politypos -0.00413 (.0182)
Freedom -0.318* (.162)
GATT/WTO membership
0.813* (.445)
0.792* (.441)
0.685 (.490)
0.692 (.484)
BITs 0.0171 (.0124)
0.0170 (.0122)
0.0109 (.0135)
0.0121 (.0128)
Political Instability -0.0101 (.0120)
-0.00913 (.0123)
-0.0173 (.0148)
-0.0140 (.0147)
Market Size 0.110 (1.72)
0.178 (1.68)
0.521 (2.22)
0.839 (2.15)
Economic Development 0.142 (.654)
0.201 (.635)
0.787 (.884)
-0.823 (.852)
GDP growth 0.112** (.0458)
0.111** (.0460)
0.101** (.0485)
0.102** (.0483)
constant –2.59*e-9 (2.32*e-9)
0.0126 (.0117)
-2.07*e-10 (1.41*e-)
0.0131 (.00974)
N 3317 3317 3072 3072
n 123 123 122 122
time period covered 1970-2006 1970-2006 1973-2006 1973-2006
R2 +.0443 +.0469 +.0404 +.0433
F-test Model 2 vs. 1 p > F = .0383 p > F = .0193
Note: Robust standards errors in parentheses. * p < 0.1; ** p < 0.05; *** p < 0.01, two-tailed tests. All estimates in Stata 10.1 R2 not fully comparable across models due to changes in sample size.
The estimated coefficients for the models using the Freedom House measure of
democracy lend further support to this finding: The interaction term of PTAs and Freedom is
clearly statistically significant, but the negative coefficient here (given the encoding of this
democracy measure) again suggests substantively that PTAs boost inward FDI much more
28
strongly for democracies than for non-democracies.18 In an alternative version of model 2, in
which only the interaction term with GATT/WTO is added (not shown), that interaction term
also is significant, although the indicator variable for GATT/WTO membership alone in these
models misses the conventional threshold for statistical significance (p = 0.167), and there is
again no indication that model 3 is warranted.
In the analyses above, we examined the effect of PTAs on FDI flows in the context of
other economic and political factors that previous analyses have shown to explain FDI flows, and
we interacted our PTA measure with the three measures of regime type. Our expectation was
that the estimated coefficient for the interaction term should be positive (except for the inversely
encoded Freedom House measure, where it should be negative). The coefficients estimated for
the interaction terms bear out these expectations and substantively suggest for all measures of
democracy that the FDI-boosting effect of PTAs is stronger the more democratic a country is.
We have also found a substantively similar but more uncertain effect for the multilateral trade
agreement, GATT/WTO.
4. Conclusions
In this paper we have asked how political factors affect flows of direct foreign investment
into developing countries. We have argued that governments face time inconsistency problems,
which may reduce inward FDI because potential investors worry about the credibility of implicit
or explicit promises not to take measure that would devalue the investments, but that
governments can overcome or reduce these problems and thus increase inward FDI with the help
of domestic and international institutions that tie the hands of governments so that it is more
18 In this case, even the coefficient for the democracy measure by itself has the "correct" sign (suggesting a positive effect of democracy on FDI), but it is so far from conventional levels of statistical significance that we are ready to put much stock into that finding.
29
costly to renege on their promises later on. In an earlier paper we showed that international trade
agreements and institutions can help perform this function. Signing preferential trade
agreements or joining the WTO helped countries attract foreign investment. In this paper, we
show that this effect persists even when a more comprehensive set of PTAs is taken into account
and the time series are extended, increasing the sample size by 1/3. Furthermore, we extend the
prior research and show that domestic institutions matter as well. The impact of trade
agreements on FDI is increased when countries are more democratic. Democracy at home can
be used in combination with international institutions to enable governments to enhance the
credibility of their positions. Although we do not find an effect for domestic regime type by
itself, we do show that in combination with international trade agreements, democracy indeed
matters.
These findings have interesting implications for the current literature and future research.
First, research in both security studies and IPE has during the last two decades examined
domestic political institutions and specifically regime type as an explanatory variable for a range
of phenomena in world politics. Few, however, have systematically examined the interaction
between domestic and international institutions. Our findings that domestic institutions
condition the effect of international institutions suggests that this interaction is a fruitful avenue
for future research.
Second, recent research has suggested that governments can use international institutions
to boost the credibility of commitments that they make to each other. Our finding that
governments of developing countries can increase inward FDI by committing themselves to
economically liberal policies through PTAs suggests that governments also can use international
30
institutions to boost the credibility of their commitments vis-à-vis private actors in the
international political economy.
Third and finally, our findings have important policy implication for those who seek to
improve the investment climate and thus increase investment and economic growth in
developing countries. As North and others have emphasized, institutions can be constructed to
help leaders attract investment and thereby increase economic growth. We show not only that
international trade institutions can perform this role, but also that their effect may be increased
by having more democratic political institutions at home.
31
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