Political parties and foreign direct investment inflows among developing countries

Party Systems Matter for FDI Inflows 

Investors care about the domestic governing environment of host countries as it reveals information directly relevant to the risks threatening their investments. Policymakers of host countries, particularly those in the developing world, typically have a hard time credibly signaling their commitment to reduce such risks as it is ultimately their private information. Studies on foreign direct investment (FDI) imply that good governance alleviates this commitment problem and, subsequently, renders national economies conducive to foreign capital inflow. 

While this line of research significantly advances our understanding of how potential investors assess political risks of host countries, we suggest that the analytic utility of quality of governance indicators is limited as these indicators are predicated on relatively subjective and opaque coding decisions. In our recently published article in Political Studies we propose that the FDI literature can benefit from utilizing a core institutional trait of democratic politics, party systems of host countries in general and effective number of political parties (ENPP) in particular, to explain variations in FDI inflows among developing democracies. 

Parties serve as political representatives, are involved in policy-making, and consequently play an important role in influencing FDI inflows. For potential investors, how many actors hold the reins of power is an important consideration and ENPP is indicative of the number of actors who can influence policies at critical junctures of legislative processes. Moreover, unlike the performative indicators of quality of governance, ENPP is easily observable and not subject to arbitrary coding decisions. 

The Argument

In particular, we argue that effective number of political parties (ENPP) offers investors information on two important subjects, namely, 1) the likelihood of their investment unduly expropriated (expropriation risk) as well as 2) the extent of political representation as it relates to policy stability (representation). We posit a positive relationship between the effective number of political parties (ENPP) and the level of foreign direct investment inflow given that a high ENPP is indicative of a secure investment environment with low expropriation risk and a better represented society that signals greater policy stability. 

First, political parties function as one of the most effective veto players in legislative processes. The number of political parties in this sense indicates the plausibility of a sudden policy change. Very low ENPP indicates high discretion of a small number of parties at adopting and implementing economic policies. This perception of high policy discretion bestowed upon the majority party reduces the government’s credibility on its commitment to maintain a favorable investment environment (such as low risk of expropriating private property). Such policy unpredictability is likely to be a cause of concern for investors. 

Second, very low ENPPs connote low levels of representation. Parties function as competitive agents of societal actors and provide an opportunity for societal preferences to influence legislation. Hence, the number of political parties is a useful indicator of the diversity of societal interests (not) effectively represented in legislation, providing investors with general insights into the economic policy making of a host country. Presence of few political parties in the parliament may lead to the exclusion of diverse political groups from public policymaking, brewing grievance that may escalate into drastic political changes, particularly in developing countries’ contexts. The possibilities of such grievance-driven political changes shy away investors as the alteration of political climates renders the return to their investment unpredictable. Overall, investors may view too little (low ENPP) representation with caution as it could threaten policy stability. 

In contrast, expropriation risks stemming from policy discretion is relatively low in countries with higher ENPPs given the procedural difficulties in implementing drastic policy changes with a larger number of influential actors in the legislature. In principle, any policy proposals will need to be discussed among multiple groups in the legislature before policy changes can be made, thereby reducing the likelihood of reckless decisions. Higher ENPP may alleviate the risks associated with impulsive policy changes. In other words, higher ENPPs can signal to potential investors the presence of a favorable investment environment. 

A country with high ENPP is also more representative in nature, where alternative views within society have a platform to influence policy-making within the confines of the legislature. Events that may feed violence and sudden changes in the government are less likely in countries with high ENPPs than in those with low ENPPs. This signals to the investors predictability and stability of government policies. 

We invoke two country cases as illustrative examples of our argument. The dominant position of the Democratic Party of Albania in the 1990s, for instance, was a drag to the investment inflow into Albania despite the government’s pro-market reforms. Likewise, without his monopolistic political position and the political turmoil that ensued, Chavez could not have driven away foreign investment so precipitously from Venezuela in the early 2000s.

We test the relationship between ENPP and FDI inflows on a sample of 56 developing democracies from 1985 to 2011. The result of our empirical analysis lends strong support to our argument and is found robust to alternative empirical scenarios.

Concluding Thoughts

Our research highlights the domestic determinants of FDI inflows among developing democracies. We underline the fact that parties are the major agents of policy making in modern democratic politics. Their central role of aggregating and mobilizing collective policy preferences is the centerpiece of everyday politics, particularly in policy-making, policy implementation, and monitoring. Thus, the nature of party systems of a host country can be an important source of information to potential investors about the political environment. 

The study has important policy implications that may be of interest to potential host countries, especially in the developing world: where information about policymaking is scarce, ENPP offers investors a fairly useful gauge of how politics might affect their investment. 

Read the full article published in Political Studies here.

Nisha M Bellinger is Assistant Professor of Political Science in the School of Public Service at Boise State University. Her research focuses on political economic themes. She is the author of Governing Human Well-Being: Domestic and International Determinants (Palgrave Macmillan 2018), and her research appears in journals such as European Political Science Review, International Political Science Review, and Journal of Politics, among others.

Byunghwan Son is Assistant Professor of Global Affairs at George Mason University (Fairfax, USA). His work appears in journals such as Journal of Politics, Journal of Peace Research, and International Political Science Review, among others.