Journal of Internarional Money and Finance (1994), 13, 400-414

Sovereign risk exposure with potential

liquidation: the performance of alternative
forms of external finance

MARK M. SPIEGEL*
Department of Economics, New York University, New York, NY 10003, USA

This paper develops a model of international investment where direct foreign

investors have the ability to escape discriminatory treatment from the host country
government by liquidating to a domestic entrepreneur. A similar ‘liquidating option’
does not exist for holders of foreign debt obligations, however, because of equal
seniority restrictions. We show that under weak parameter restrictions, the ability
to liquidate implies that the share of FDI in the inward investment portfolio of a
nation will be positively correlated with that nation’s perceived sovereign risk. This
prediction is supported in empirical tests using two indicators of sovereign risk for
52 developing countries. (JEL F21, F23).

The recent payments difficulties experienced by highly indebted countries has

once again called into question the relative desirability of alternative forms of
external finance. This development has been accompanied by a dramatic shift in
the pattern of external finance of the highly-indebted countries (HICs): while
foreign direct investment (FDI) flows have held relatively steady over the 198Os,
private borrowing has decreased rapidly, with net flows often going from south
to north.
Previous models of sovereign risk exposure have typically either depicted
foreign investment as homogeneous or concentrated on one form of foreign
investment. The models characterize the host country decision as balancing the
desire to raise revenues from foreign investment against some penalty for such
behaviour, such as the interruption of trade credits (Bulow and Rogoff, 1989) or
a deterioration in the ability to raise capital internationally (Eaton and Gersovitz,
1981, 1983; Cole and English, 1991). This approach leaves the determinants of
the relative desirability of forms of foreign investment unclear.’
In this paper, we introduce a channel through which changes in political risk
can affect the composition of inward investment in a developing nation. We
introduce a model in which production is externally-financed through both foreign

*Technical assistance from the C.V. Starr Center for Applied Economics is gratefully
acknowledged. Helpful comments were received from Franc0 Peracchi, Andres Velasco, and
attendants of the NYU International Economics Workshop, as well as two anonymous
referees. Antonio Merlo and Yvonne Manu provided excellent research assistance. Remaining
errors are my own.

0261-5606/94/04 0400-15 0 1994 Butterworth-Heinemann Ltd

 MARK M. SPIEGEL 401

borrowing and FDI. A benevolent host country government is precluded from

committing to levels of either partial default on foreign-denominated debt or
taxation of foreign investments ex ante, but the host country can make
commitments to the level of taxation of production under domestic ownership.
We show that the ability to commit to certain tax rates on domestic owners
provides host countries with defacto commitments to foreign investors, so long
as foreign investors have the ability to liquidate their assets to domestic producers.
In equilibrium, this ‘liquidation option’ places a ceiling on the magnitude of
sovereign risk exposure faced by FDI, since the value of assets in place to foreign
producers cannot be driven below their liquidation value, even though liquidation
never takes place in equilibrium. Moreover, since similar commitments on foreign
debt obligations cannot be made because of equal sharing clauses, this introduces
a disparity in the sovereign risk exposure of foreign lending and FDI. Such a
commitment mechanism does not exist for domestic holders of dollar-
denominated government debt, as has been demonstrated empirically by the low
popularity of debt-for-debt swap programs.2
There are a number of historical examples of discriminatory host-country
government policies towards foreign investors. The best known example of
discriminatory policy which induced liquidation is the ‘Mexicanization’ policy
pursued by the Mexican government. In an attempt to encourage foreign investors
to sell their assets to Mexican nationals, the Mexican government has used a
combination of penalties and incentives, including discriminatory taxes, diversion
of government contracts, and the withholding of business operation permits and
import licenses to subsidiaries who delayed surrendering majority ownership to
domestic entrepreneurs (Wright, 1971; Baklanoff, 1975). The Mexicanization
program resulted in the domestic private takeover of Telefonos de Mexico in
1958 and Pan American and Texas Gulf Sulfur in 1967, along with subsidiaries
from a number of other industries (Baklanoff, 1975).
A more recent example can be found in Mexico’s suspension of interest
payments on its dollar-denominated debt in 1982. While equal sharing rules
precluded the Mexican government from suspending payments on dollar-
denominated debt to foreigners without doing the same to domestic
dollar-denominated debt holders, the Mexican Government maintained payment
to primarily domestic holders of Peso-denominated debt. Therefore, the Mexican
Government’s policy was as favorable as possible to domestic investors under
the rules of the Paris Club.
In this paper, we concentrate on the political risk associated with an output
tax of the multinational subsidiary, rather than the risk of outright expropriation,
which has been analyzed by Eaton and Gersovitz (1984). Although outright
expropriations have taken place historically (Williams, 1975), Kobrin (1984)
shows that the more common expropriations have occurred in industries in which
foreign ownership could be supplanted with relatively little loss in productivity,
such as resource extraction. When a productivity loss would result from domestic
operation of a multinational subsidiary, as in the case studied below, the risk
has more often been that of a change in domestic tax policy.
For most multinational subsidiaries, one would expect that some productivity
loss would result from liquidation. Johnson’s (1970) theory of multinational
enterprise stresses that multinationals will experience disadvantages in host
countries relative to potential domestic entrepreneurs, and therefore must have
 402 Sovereign risk exposure with potential liquidation

some ‘firm-specific’ advantages which cannot be costlessly traded to motivate

their existence. Among these might be managerial know-how, brand-name capital,
and economies of scale in managerial operations. Indeed, in the case of the
Mexicanization program, Baklanoff (1975) has argued that the impact of the
program has been poor performance in the development of the Mexican mining
sector relative to other Latin American countries.
Below, I use a model of the multinational firm in which access to
‘entrepreneurial capacity’ is lower under liquidation than under the controls of
the parent firm, as in Eaton and Gersovitz (1984). This implies that liquidation
results in a loss of domestic wages as well as a decline in government revenues
relative to attainable levels under the control of the parent firm. Hence, liquidation
never actually takes place in equilibrium. When combined with the relative
commitment assumptions discussed above, this model shows that under relatively
minor parameter restrictions, the share of foreign direct investment in the inward
investment portfolio is decreasing in the ability of the host country government
to commit to tax rates on foreign investments and levels of debt service. In other
words, increases in the ‘sovereign risk’ associated with foreign investments in a
host country are associated with increases in the share of foreign-direct investment
in a host country’s inward investment portfolio.
To test this hypothesis, I examine the impact of two alternative measures of
political risk: a subjective survey index constructed by Institutional Investor,
which polls portfolio managers on the credit worthiness of developing countries
as foreign borrowers, and objective measures of observed political instability
events, available from Barro (1991). These measures include the number of
assassinations, the frequency of constitutional changes, the number of revolutions
and coups, the number of riots, and the number of strikes.3 Our empirical results
support the predictions of the theory: while investment levels of both foreign
lending and FDI respond negatively to an increase in the riskiness of the host
country, the share of FDI in the inward investment portfolio is increasing in
indicators of host country political risk.

I. A simple model of foreign lending and FDI under sovereign risk

Z.A. Assumptions

Consider a small country endowed only with labor, L, and a domestic level of
‘entrepreneurial capacity’, Hd. This ‘know-how’ parameter is assumed to be a
public good domestically, whose value is independent of the magnitude of its
use. Without loss of generality, I normalize output units so that the value of a
unit of all goods is equal to 1. All production functions are assumed to exhibit
diminishing marginal product and constant returns to scale.
Production takes place in the country by acquiring capital from abroad in one
of two forms: debt-financed production occurs by borrowing debt from abroad,
D, and producing under domestic management according to the production
function :

(1) QD = QD(D, Ld, Hd).

Alternatively, a multinational can locate a subsidiary in the host country. The

 MARK M. SPIEGEL 403

multinational is assumed to produce a different product than the debt-financed

industry, and is assumed to possess a level of firm-specific know-how, Hf, which
exceeds that of the host country. The production function of the multinational
subsidiary satisfies:

(2) QJ = QI(K, Ld, H’),

where K represents the capital
The multinational is assumed
producers. However, the asset
debt-financed industry. Instead,
goods under the management
production function:
invested in the multinational subsidiary.
to have the right to liquidate its asset to domestic
is assumed not to conform to the needs of the
the liquidated subsidiary will produce the same
of domestic entrepreneurs according to the

(3) QJ = Qf(K, Lf, Hd).

We assume that the subsidiary is less productive in the hands of domestic
management:
@a) Q’(K, L’-, I.?“)2 @(K, Lr, Hd).
We also assume that it is preferable to invest borrowed capital in the debt industry
than the FDI industry:

<4b) Qd(& L, Hd) 2 @(K, L, Hd) 1K <D.

The extensive form of the model has three stages: in stage 1, the finance levels
of the multinational and debt industries, K and D, are chosen. Prior to stage 2
E, the magnitude of the government spending shock, is realized. In stage 2,
the host country government announces the schedule of taxation on subsidiary
profits, r, and the level of partial default on foreign debt obligations, R. I assume
that the government has committed to a tax rate on production under domestic
ownership oft, which is kept constant for simplicity.4 In stage 3, the multinational
chooses whether or not to liquidate to domestic entrepreneurs. Lastly, output
levels are chosen in stage 4, determining the wage structure of the host country.

I. B. Equilibrium
To demonstrate sub-game perfection, we work backwards. Equilibrium in the
domestic labor market requires equating the value of marginal products of labor
in the subsidiary and debt-financed industries to the domestic wage rate, w, and
exhausting the domestic labor supply, L. We have three equations in three
unknowns: L,, Ld and w, which yield the solutions:

Ga> Lf = Lf(K, D, L),

<5b) Ld = Ld(K, D, L),

<5c) w = w(K, D, L),
where K and D are determined prior to the stage 3 decision.
In stage 3, the multinational decides whether or not to liquidate.5 The option
to liquidate is an important one for the multinational. At sufficiently high rates
of T, holding t constant, the value of the subsidiary in place will be worth more
to domestic entrepreneurs than the multinational. Define Q as the tax rate which
 404 Sovereign risk exposure with potential liquidation

equalizes the value of the subsidiary under domestic and foreign ownership, Q
satisfies :
(6) ? = 1 - [(l - t)(Q’ - &&)]/[Q, - w&J,
where L,, Qr, and w and t,, Q,, and ti represent the labor hired by the subsidiary,
the output of the subsidiary, and the resulting wage earned by labor when the
subsidiary is under foreign and domestic control respectively. Note that Z is
increasing in the magnitude of the productivity loss since the scrap value of the
asset to the foreign investor is equal to its value to the domestic entrepreneur.
It is the ability to liquidate that limits sovereign risk exposure in this model,
rather than the productivity loss which drives the result in the outright
expropriation model of Eaton and Gersovitz (1984).
In stage 2, the host country government makes its default and taxation
decisions, r and n, taking equations (5a), (5b), (5~) and (6) as given. I assume
that the host country government maximizes the utility of a representative agent,
subject to satisfying a stochastic government expenditure objective G(E). For
simplicity, it is assumed that G(E) is exogenous and does not enter into the
representative agent’s utility function. The government chooses z and 71 to
maximize :
(7) u = u(c) - P(r, n),
subject to
(8) c = Qd + sQ/ + wL/ - G(E) - (1 - n)?D,
where P(z, rr) is an exogenous penalty function P’(X) > 0, P”(X) > 0 (X = r, rc),
and 7 is equal to one plus the contractual rate of interest on debt.
I show in the appendix that the government’s solution to this problem results
in equilibrium r*(D, K, E) and n*(D, K, E), where 7% < 0, rc;l < 0,~: -c 0 and rr$ < 0.
However, the signs of 7k and n% are ambiguous. Both ambiguities arise from
the same source: as inward capital flows increase, the gains from expropriation
increase, but the incentives to expropriate decrease, due to diminished marginal
utility of current consumption. This is similar to the desperation/opportunism
result found by Cole and English (1991). This has been shown in the literature
to allow for multiplicity of equilibria in the presence of capital flight (Eaton, 1987).
Under the assumption that the debtor is credit constrained, we must be in the
parameter space where rci; > 0. However, this still leaves the possibility that 7% -c 0.
For simplicity, I assume the necessary parameter restrictions which preclude this
outcome, but these restrictions are neither necessary for the existence of
equilibrium nor the results which are derived below. The parameter restrictions
corresponding to these assumptions are specified in the appendix.
Define 8 as the value of E at which ‘F*(E) = f. Suppose that E > 8. Assuming free
competition among potential domestic entrepreneurs, a tax which exceeded Q
would result in the liquidation of the asset by equation (6). The multinational
would recover the value of the subsidiary under domestic control which by
definition is equal to that of the subsidiary under foreign control when faced with
a tax rate of Q. It follows that the host country government would never levy a
tax rate greater than Q. The tax rate therefore satisfies:

(9) r=($,, ;:$

whilst the rate of default always equals X*(E).

 MARK M. SPIEGEL 405

The tax rate ceiling, ?, will affect the relative expected magnitudes of 7 and II.
For example, assume that E is uniformly distributed along the interval [E, Z]. The
expected value of T satisfies:
E
(IO) E(T) = P(E < &)t + [ 1 /(E - E_)] 7(E)&
sE
where P(E d 6) = (L - _E)/(E- _E). Alternatively, the expected value of 7csatisfies:

(11) E(n) = [l/(E - e)] ’ n(s)ds.

s,
Consider the impact of a change in the distribution underlying E. For example,
suppose that E(E) is decreased through a reduction in 5. Differentiating (10) and
(11) yields:
LX!Z(rc) ix(z) 1
(12) ----_= [(E(n) - E(7)) - (NE) - 211.
aE_ _
a& (E - _
E)

See Figure 1. Although T(E) has been drawn to be more sensitive to realizations
of E than n(s), the adverse impact of decreasing E is greater for E(n) than E(7).
Increasing the probability of low realizations of E adds poor payoffs to X(E) while
the tax rate on inward FDI cannot rise above Q. Equation (12) indicates that
if the difference between the default percentage in the worst states and Q exceeds
the expected probabilities of default and taxation, a highly likely situation, then
decreases in c will be associated with greater increases in the expected percentage
of default than the expected tax on inward foreign investment.

I.C. Initial investment jlows

Given the expected response functions of the host country government, we can
now examine the impact of a change in E(E) on the magnitude and composition

T(E)
I
I

FIGURE1. Tax and default levels as functions of E.

 406 Sovereign risk exposure with potential liquidation

of inward foreign investment. The multinational corporation is assumed to be

risk neutral. Its profit-maximizing investment decision satisfies:

(13) E[(l - r)Q/K(K, L,, R) - q = 0,

where rrepresents one plus the multinational’s cost of capital.
The host country is assumed to borrow at fixed rate r and be credit constrained
such that creditors earn zero expected profits:

(14) [l - E(rl)]Y = I/,

where rr represents one plus the risk-free rate.
Equations (13) and (14) form a system of two equations in two unknowns:
K and D. In the appendix, we show that under minor parameter restrictions,
D/K* will be increasing in E(E), i.e. that the ratio of debt to FDI in the nation’s
inward investment portfolio will be increasing in the expected level of government
expenditure. Intuitively, a sufficient but not necessary condition is that E(r) is
less sensitive than E(X) to both the composition and magnitude of inward
investment and E(E). E(z) is likely to be less sensitive to changes in the magnitude
of inward investment than E(x) because whilst decreases in inward investment
raise both the incentive to tax and default, the increased incentive to tax also
raises the value of the liquidation option. A similar argument holds for changes
in E(E).

II. Empirical evidence

IZ.A. Data
In the previous section, we demonstrated that the share of debt in the inward
investment portfolio of a nation would be increasing in the perceived riskiness of
that nation, as proxied in our model by the expected level of the government
expenditure shock. In this section, we test this hypothesis using cross-country
evidence concerning political risk and investment flows. We investigate the
sensitivity of investment flows to the political risk of less developed countries as
measured by two alternative indicators of political risk? results of the
Znstitutional Investor country risk survey and historical indicators of political
instability are obtained from the Barro (1991) data set.
The Institutional Investor country risk index data, referred to as RATING
below, were obtained from biannual surveys of one hundred international
investment portfolio managers. These data have been previously used as a political
risk indicator by Melvin and Schlagenhauf (1985). The survey asked managers
to rank countries numerically according to the desirability of their investment
climate. All participants were assured that their responses and participation would
be kept strictly confidential. Moreover, bankers were not allowed to rate their
home countries. The initial survey received 101 responses. The Institutional
Investor weighted the responses, giving more weight to responses from banks
with the largest worldwide lending exposure and the most sophisticated country
analysis systems.
The results of the InstitutionalInvestor survey for the four major Latin American
debtors is shown in Figure 2. The ratings capture well the deterioration in the
economic positions of these countries as a group, as well as country-specific
 MARK M. SPIEGEL 407

80

I I I I I I I I I I
101 ’
1979 I 980 1981 1982 1983 1984 1985 1986 1987 1988 1989

l Argentina + Brazil A Mexico Cl Venezuela

FIGURE 2. Sovereign risk ratings for four large debtors.

developments. For example, the Falklands experience clearly results in Argentina

experiencing a larger decline in its ratings than its counterparts. Data were
compiled on investment flows for 52 developing countries. Data were available
from the Znstitutional Investor country risk survey from 1979 through 1989.’
The event study indicators of political instability obtained from the Barro
(1991) data set include the number of assassinations (ASSASS), the number of
constitutional changes (CONSTCH), the number of revolutions and coups
(REVCOU), the number of riots (RIOT), and the number of strikes (STRIKE).’
Because these events are often infrequent, we used the annual averages over the
sample period.
Univariate regressions were run in pooled cross-sectional time series regressions
with the inclusion of country dummies for Sub-Saharan African countries
(AFRICA), Latin-American countries (LAAMER), and oil-exporting countries
(OIL), as well as the shares of agriculture (AGRI), manufacturing (MANUF),
and service industries (SERV) in country output.’

ZZ.B. Results
Table 1 reports the results of ordinary least squares testing of the impact of
political risk on inward foreign investment flows, using White’s heteroscedasticity
correction method for estimation of standard errors.
The first two columns report the results for total debt flows, official plus private.
It can be seen that the RATING variable is statistically significant at a 5 per
cent confidence level. This implies that safer countries, as measured by the survey
results, receive more inward lending from all sources. However, the event variables
yield mixed results. All of the event variables, with the exception of RIOT which
 TABLE1. Determinants of investment flows: OLS regressions’ (1979-1989).

Dependent
variable Total debt Total debt Pvt. debt Pvt. debt FDI FDI

u - 329.296 840.481 -973.940 686.858 - 18.169 126.511

(820.348) (762.896) (712.401) (661.587) (241.804) (214.492)
RATING 28.841** 32.506** 4.984*
(7.262) (6.422) (2.426)
ASSASS 80.008 - 171.143 141.230
(245.473) (208.444) (84.188)
CONSTCH - 1435.117 -2006.231* 958.910*
(1055.874) (937.318) (323.990)
REVCOU - 139.530 215.142 -827.586**
(332.080) (262.477) (139.146)
RIOT - 341.712* 271.107* 860.051**
(117.045) (93.871) (172.825)
STRIKE 97.475 - 191.473 - 193.368
(595.998) (546.246) (159.961)
AGRI 11.769 - 5.583 6.091 - 15.525* 0.663* 5.254’
(7.477) (8.124) (6.592) (7.505) (1.927) (2.085)
MANUF 59.206** 58.352** 42.703** 45.067** 23.836** -4.826
(12.921) (13.860) (9.577) (10.739) (5.197) (5.140)
SERV - 12.084 - 10.761 - 9.766 - 14.856 - 1.950 - 1.820
(10.398) (10.036) (8.679) (8.664) (2.889) (3.144)
AFRICA - 363.452 - 304.786 243.731 267.423 - 232.077* - 287.368*
(251.016) (257.631) (179.682) (206.156) (116.529) (87.886)
LAAMER 26.241 - 232.563 513.507* - 262.477 -218.275 - 143.931
(285.714) (289.285) (231.421) (260.413) (126.162) (81.209)
OIL 865.662 1315.779** 847.449* 1261.566** - 55.930 37.689
(493.852) (475.865) (421.498) (412.025) (99.967) (89.168)
R= 0.162 0.198 0.179 0.176 0.112 0.321
# Obs 443 438 430 425 389 384
F-Value 12.049 9.584 13.182 8.030 6.881 16.008

aWhite’s heteroscedasticity
correctionused. Total debt flows include both private and official lending,
*Significant at 5 per cent level.
** Significant at 1 per cent level.
 MARK M. SPIEGEL 409

entered significantly with the incorrect sign, were insignificant. The Latin
American and African country variables also entered insignificantly, although
usually with the expected negative sign. Oil exporting countries received higher
debt inflows, significantly when the RATING variable is excluded. Among the
industry variables, one can see that only the share of manufacturing enters
measurably and positively, implying that countries with larger shares of
manufacturing in their output bundles tend to receive larger inward lending flows.
The second two columns have only private inward lending flows as the
dependent variable, adjusting for the possibility that official lenders behave
differently than private lenders. It can be seen that the RATING variable again
enters significantly positive, as would be expected. However, the event variables
again exhibit puzzling results. Constitutional changes now enter significantly
negative, as would be expected, but riots again enter positively and significantly.
The country variable results are similar, with a few exceptions. AFRICA still
fails to enter significantly. However, the Latin American dummy enters positively
and significantly under the specification which includes the RATING variable,
as do oil-exporting nations. Among the industry variables, manufacturing again
enters measurably positive. Agriculture varies in sign, but enters negatively and
significantly when we exclude the RATING variable.
The final two columns report the regression results with FDI as the dependent
variable. Again, the RATING variable enters positively and significantly.
However, the event variables still enter with mixed results. The riot and
constitutional change variables enter significantly and positively, counter to our
expectations. The revolutions and coups variable, on the other hand, enters
significantly with the expected negative sign.
The country variables behave differently in explaining FDI. Both African and
Latin American countries consistently enter negatively, with Africa significant at
a 5 per cent confidence level. The oil-exporting dummy is insignificant. Among
the industry variables, manufacturing again enters positively and significantly
with the inclusion of the RATING variable, but enters insignificantly with the
event variables. Agriculture shares now enter positively and significantly,
indicating that countries with relatively high shares of agriculture were large
recipients of FDI.
Summarizing Table 1, our primary conclusion is that creditworthiness, as
measured by the Institutional Investor survey rating, contributes positively to all
types of investment flows. Everything else being equal, safer countries will receive
more capital than their riskier counterparts. The political instability event
variables, however, yielded mixed results. While constitutional changes and
revolutions and coups were consistently negatively correlated with all different
types of investment flows, other political risk variables, such as riots, were
consistently positive.’ O
Table 2 reports the results of maximum-likelihood two-sided TOBIT
regressions of the impact of our measures of sovereign risk on the share of FDI
in total inward investment flows. l1 Our regression results above suggest that the
RATING variable, which has a significant impact on all types of investment
flows, may be a better proxy for sovereign risk. However, the most striking result
in Table 2 is that the RATING variable consistently enters with the wrong sign,
measurably for the univariate regression. Again, the event variables in Models
4 through 6 yield very mixed results, with riots entering positively, as would be
410 Sovereign risk exposure with potential liquidation

TABLE 2. Share of FDI in total inward investment flows: 2-sided TOBIT regression”
(1979-1989).
Dependent variable: FDI/total inward investment

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

a 0.116 0.156 0.306 0.180 0.243 0.459

(0.046) (0.078) (0.313) (0.048) (0.099) (0.275)
RATING 0.429** 0.301 0.251
(0.124) (0.156) (0.191)
ASSASS - - 0.015 0.025 0.051
(0.060) (0.062) (0.066)
CONSTCH - 0.022 -0.005 0.227
(0.292) (0.351) (0.364)
REVCOU - - -0.291* - 0.280 -0.413**
(0.147) (0.173) (0.181)
RIOT - - 0.169** 0.153** 0.181**
(0.041) (0.045) (0.052)
STRIKE - - 0.085 0.093 0.157
(0.091) (0.098) (0.106)
AGRJ - - 0.349 - - - 0.230
(0.385) (0.348)
MANUF - - -0.154 - - -0.865’
(0.362) (0.438)
SERV - - 0.067 - -0.101
(0.392) (0.393)
AFRICA -0.109 -0.104 - -0.300 -0.133
(0.065) (0.072) (0.273) (0.077)
LAAMER - -0.013 - 0.028 - -0.018 -0.051
(0.057) (0.062) (0.059) (0.069)
OIL - -0.061 0.042 - 0.120 0.105
(0.071) (0.078) (0.079) (0.082)
0 0.405 0.389 0.388 0.387 0.386 0.383
(0.173) (0.017) (0.017) (0.017) (0.017) (0.017)
# Obs 382 382 382 382 382 382

‘Maximum likelihood estimation used. Total inward investment includes private and official lending as
well as inward flows of FDI.
* Significant at 5 per cent level.
** Significant at 1 per cent level.

predicted by the theory, but revolutions and coups entering inconsistently with
the predictions of the theory.
One explanation of the results in Table 2 may be the role played by official
lending in the investment flows of LDCs. Countries experiencing difficulties may
receive official flows to smooth out negative shocks at the same time that their
private sources of finance are drying up. Since the theoretical prediction above
was generated for a model with profit-maximizing lenders, it may be better suited
for explaining the share of FDI in inward private investment flows.
To account for this possibility, we also ran the TOBIT regressions for the
share of FDI in private inward flows. The results are shown in Table 3. The
RATING variable now enters with the positive sign predicted by the theory. The
 MARK M. SPIEGEL 411

TABLE 3. Share of FDI in private inward investment flows: 2-sided TOBIT regression”
(1979-1989).

Dependent
variable Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

u 0.636 0.678 0.690 0.457 0.450 0.527

(0.059) (0.111) (0.444) (0.068) (0.107) (0.414)
RATING -0.421* - 0.426 -0.423 - - -
(0.209) (0.250) (0.289)
ASSASS - - - 0.154 0.169* 0.202*
(0.081) (0.083) (0.088)
CONSTCH - - 0.153 0.395 0.740
(0.384) (0.442) (0.472)
REVCOU - - - 0.341 -0.3941 -0.606*
(0.180) (0.190) (0.223)
RIOT - 0.050 0.031 0.118
(0.069) (0.074) (0.083)
STRIKE - - 0.039 - 0.052 0.067
(0.145) (0.157) (0.164)
AGRI -0.235 - - 0.176
(0.501) (0.492)
MANUF -0.560 - - - 1.526**
(0.576) (0.652)
SERV - - 0.307 - - 0.293
(0.572) (0.579)
AFRICA - -0.181 -0.199 - - 0.073 -0.184
(0.094) (0.101) (0.099) (0.109)
LAAMER - - 0.096 -0.124 - 0.026 - 0.008
(0.090) (0:127)
(8;;;) (0.095) (0.098)
OIL 0.076 0.078 0.071
(0.114) - (0.108) (0.124)
u 0.580 0.564 0.561 0.558 0.558 0.550
(0.033) (0.034) (0.033) (0.034) (0.034) (0.033)
# Obs 356 356 356 356 356 356

‘Maximum likelihood estimation used. Private inward flows include private lending and inward flows of
FDI.
*Significant at 5 per cent level.
**Significant at 1 per cent level.

coefficient estimates are quite stable, and the variable is measurably significant
at the 5 per cent level in the univariate regression and close to 5 per cent
significance in the other specifications. The event variables tend to enter positively,
although the revolutions and coups variable still enters with the wrong sign,
sometimes significantly.
One explanation for the incorrect sign on revolutions and coups may be
obtained from the theory above. This theory relied heavily on the assumption
that host country governments had the ability to make some form of credible
commitment to their domestic citizens. This may not be true under a revolutionary
regime, so the relative superiority of FDI predicted in this model may not emerge.
The country variables tend to enter as expected, although no parameter
estimates are significant at a 5 per cent confidence level. African and Latin
American countries tend to receive lower shares of FDI in their inward investment
portfolios, while oil exporters receive higher shares of FDI. Among the industry
 412 Sovereign risk exposure with potential liquidation

variables, manufacturing shares enter negatively, significantly in Model 6. One

explanation for this surprising result is that high shares of manufacturing,
everything else being equal, imply low shares of extractive activities, in which
FDI tends to play a large role.

III. Conclusion

Two main messages emerge from the results of this paper. The first concerns the
issue of commitment: even if a host country government cannot commit to some
agent, the ability to commit to another agent provides a valuable liquidation
option to a potential investor. In the model derived above, it was shown that
this liquidation option resulted in FDI becoming a relatively more desirable form
of investment as countries became riskier. With the large shifts in investment
patterns subsequent to the debt crisis consistent with this prediction, this argument
warrants further investigation.
The second argument concerns the relationship between sovereign risk and
investment flows. The empirical results demonstrate that the magnitude and
composition of inward foreign investment are heavily influenced by the perception
of credit-worthiness, at least as measured by the survey data. Low country risk
ratings were found to increase the share of foreign direct investment in the private
inward investment portfolio of a host country.
An interesting side issue concerns the role that ‘inappropriateness of technology’
plays in the current model. A large literature exists which argues that multinational
corporations build subsidiary operations which do not make optimal use of
domestic factor endowments. Typically, the argument is that the multinational
subsidiaries are sub-optimally capital-intensive for the labor-rich host countries.
In the model above, inappropriateness of technology may be associated with the
degree of productivity loss which would be experienced in the event of liquidation
by the multinational. However, the multinational maximizes the value of its
liquidation option by limiting the magnitude of the productivity loss associated
with liquidation.lZ The liquidation option therefore appears to give
multinationals an incentive to limit distortions towards ‘inappropriate
technologies’.

Appendix

I. Government solution
Maximization of (7) subject to (8) yields the first-order conditions:

<Al) u,c, - P,= 0,

W9 u,rD-PP,=O.
These yield :

<Al’) 7 =7*(K,D,c),
<AZ') x= n*(K,D,c).
Totally differentiating (Al’) and (A2’) yields:

(A3) 7X = (%,CJJC, + ~,C,,YCPrr - %(G)* - %C,,I< 0,

<A4) 7; = (%C& + w,,YEP,, - d4* - 4c,,l < 0,
if I44 > Iu,,cK4.
 MARK M. SPIEGEL 413

7: = (u,,c,c, + W,,MP~< - %k)2 - w*,l < 0,

77;= (U,,CDsl + u,F)/[P,, - u,,(rD)2] > 0,

nf; = (U,,Ck~D+ u,?)/[P,, - u,,(fD)21 < 0,

a; = (t&c,% + u,f)/[P,, - u,(FD)zl < 0.

II. Ex ante equilibrium

Equations (13) and (14) yield the following comparative static equations:

K, = (lID){CE(7),,,,Q,lC-E(n),l- CE(n)~cr,fl(C1- JWICQ~LGJ - E(7)oQil)),

0, = (VW1 - E(7)lCQL + Q&J - CE(~)KQ/KICE(~)E~XI
+ JW)KE(~)B~~~QK~~.
Taking the difference and simplifying results in:
(A9) K, - 0, = (lID)(CE(7),,,,Q,lCE(a),r - E(n),1
+ W~(rj(QrcCE(7h - E(7)KI - Cl - E(7)lCQtU-f - Gi) - Qhl)>.
It follows that sufficient, but not necessary, conditions for K, - 0, > 0 are:
(AlO) IE(7),,,,l a IWhL
and
<All) lE(n),r - Eel Z F(7), - E(7M.

Notes
1. A possible exception is the literature concerning the impact of employment considerations
on the exposr sovereign risk exposure of foreign direct investment (Brander and Spencer,
1988).
2. For example, in 1987 the Mexican government attempted to swap debt for 20-year zero
coupon bonds which it claimed were ‘senior’. The auction price revealed that the seniority’
pledge had zero market value (Diwan and Spiegel, 1994).
3. These data were widely circulated by Barro in conjunction with his 1991 paper, although
some of the indicators listed were not actually used in the Barro paper. The full data set
is available from the author upon request.
4. This simplifying assumption is unnecessary for the results below. All that is needed is that
domestic producers are treated favorably by the host country government in times of
distress.
5. I am implicitly assuming that this option includes the ability to remove the proceeds of
liquidation from the host country. Imposing a tax on capital movements would not change
the qualitative results derived here, but a tax on capital movements would clearly lower
the value of the liquidation option.
6. Structural indices, such as debt-to-export and debt-to-GDP ratios, have also been shown
to affect both the terms and performance of foreign lending and of foreign bond markets
(Edwards, 1984, 1986).
7. The countries in this study include Algeria, Argentina, Bolivia, Chile, Congo, Costa Rica,
Cyprus, Dominican Republic, Ecuador, Egypt, El Salvador, Ethiopia, Gabon, Greece,
Guatemala, Honduras, India, Ivory Coast, Jamaica, Jordan, Kenya, Korea, Liberia,
Malawi, Mexico, Morocco, Nicaragua, Nigeria, Pakistan, Panama, Paraguay, Peru,
Philippines, Portugal, Senegal, Sierra Leone, Sudan, Syria, Tanzania, Thailand, Trinidad
and Tobago, Tunisia, Turkey, Uganda, Uruguay, Venezuela, Yugoslavia, Zaire, Zambia
and Zimbabwe. Survey data for El Salvador, Guatemala, Honduras and Malawi begin
in 1981, so that observations for the first two years for these countries are treated as missing.
8. The use of recorded events as a proxy for political instability raises some methodological
issues. Using strikes as indicators ofpolitical instability, for example, one would erroneously
conclude from the Barro data set that the UK was more politically unstable than Argentina.
 414 Sovereign risk exposure with potential liquidation

9. The identification of the country coincides with the World Bank tables. Data on industry
shares were also obtained from the World Bank tables. The results without the country
dummies were similar and were provided to the referees. These results are available in an
expanded version of this paper (Spiegel, 1992) and from the author upon request.
10. Some explanations for these results may be that governments respond to political
disturbances with populist policies which require financing through inward flows, or that
riots are prohibited in unstable regimes.
11. The two-sided TOBIT methodology is required because the share variable is by definition
bounded between zero and one. Moreover, a large share of observations (approximately
one quarter) are zero or one, corresponding to periods where countries received either no
FDI or foreign lending. This relatively large amount of censoring of the data implies that
ordinary least squares estimation would not produce consistent parameter estimates.
12. However, if the government had the option of outright expropriation, as in Eaton and
Gersovitz (1984), it may face a trade-off. Increasing the magnitude of the productivity loss
would both lower the value of the liquidation option and lower the probability of outright
expropriation.

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