The Association between Political Instability and Flow of Foreign Direct Investment

Author(s): Kamal Fatehi-Sedeh and M. Hossein Safizadeh

Source: Management International Review, Vol. 29, No. 4 (4th Quarter, 1989), pp. 4-13
Published by: Springer
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ARTICLES

K. Fatehi-Sedeh/M. H. Safizadeh*

The Association Between Political

Instability and Flow of Foreign Direct
Investment 1

The growing importance and necessity of foreign direct investment (FDI) for achieving
economic development in developed and developing nations has generated interest in
foreign investment decisions of multinational corporations (MNCs). Specifically, factors
which prompt MNCs to increase or decrease FDI in individual countries have intrigued
and evaded researchers for many years. The findings of survey-based studies indicate that
MNCs consider the sociopolitical stability of the host country as one of the most
important considerations in allocating funds to foreign projects. Such concern is due to
the belief that the absence of sociopolitical stability in a country is likely to make foreign
investments subject to the vagaries of forces beyond the investors' control.
Although political instability is not the only factor that can impair the interests of MNCs,
the results of survey based studies suggest an increase in the perceived level of political
risk of investing in a country when symptoms of sociopolitical instability such as riots,
demonstrations, strikes, assassinations, and the like emerge. During the past two
decades, numerous empirical studies have been undertaken to ascertain the degree to
which MNCs heed symptoms of sociopolitical instability in analyzing investment oppor-
tunities in foreign countries. In contrast to common expectations, however, these studies
have not been consistent in discovering an inverse association between the flow of FDI
and measures of sociopolitical instability.
Some of the problems which might have contributed to inconsistencies in the results of
the past research have been addressed by Brewer [8], Kobrin [24], and Levis [26], among
others. In supplementing their works, this paper presents a detailed discussion of the
problems which have likely contaminated the findings of cross-national studies. The
ensuing discussions are divided into four parts. The first part reviews pertinent studies
reported in the literature. The second part explores the reasons behind the inconsistencies
in the past research in showing the expected association between political instability and
FDI. The third part presents the results of the empirical investigation of some of our
suggestions. A new definition of political risk, along with recommendations for conduct-
ing future research, are offered in the last part.

* Kamal Fatehi-Sedeh, Ph.D., Associate Professor of Management, Barton School of Business, The
Wichita State University, Wichita, KS, Dr. M. Hossein Safizadeh, Associate Professor, Department
of Operations and Strategic Management, School of Business Management, Boston College, Chest-
nut Hill, MA, U.S.A. Manuscript received August 1987, revised May 1988.

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Review of Literature

The studies that have explored the influence of political instability on FDI fall into two
categories. The first category consists of studies that collected data via contacting multi-
national corporations and inquiring about their investment policies in the developing
nations, particularly about their strategies for dealing with political risk. In this category,
Aharoni [2], Basi [6], Bass, McGregor and Walters [7], using mail surveys, all concluded
that political risk is a major consideration in foreign investment decisions, albeit, accord-
ing to Aharoni, the evaluation of political risk is based on generalizations and impres-
sionistic knowledge of a developing nation. Similar findings were reported by Keegan
[22]. His findings indicated that the executives responsible for international operations
of multinational companies rely very little on systematic environmental scanning meth-
ods.
Similar to the previous studies, Root [30, 31] used a mail survey to uncover international
executives' attitudes towards investment opportunities in Brazil, France, India, Mexico,
and the United Kingdom. The findings indicated that executives' attitudes play a major
role in their evaluation of risk and profitability of the investment opportunities in these
countries.
One notable exception to the studies in this group is that of Piper [29]. According to his
findings, foreign investment decisions, in general, tend to emphasize financial and eco-
nomic variables and de-emphasize social and political variables.
One of the early studies in this group was done by Green [16]. In a cross-national study
of 81 developed and developing nations, Green attempted to identify the nature of the
relationship between political instability and foreign marketing investment. The study
did not find a significant relationship between political instability, as represented by the
Feierabend and Feierabend [13, 14] political instability index, and foreign marketing
investment.
In another study, Green and Cunningham [17] applied regression analysis to the data of
25 developed and less developed countries to determine the variables that influence the
fluctuations of the U.S. manufacturing and total foreign investment. According to their
findings, allocation of United States' manufacturing or total foreign investment is closely
related to market potentials proxied by GNP and population. Another study that has
used regression analysis is that of Levis [26]. Based on the data of 25 developing nations,
he concluded that economic considerations are the prime determinant of the flow of
foreign investment, whereas political factors are the second order determinants.
In contrast to the studies by Green [16] and Green and Cunningham [17], a study by
Kobrin [23] supported the presence of a negative relationship between political instability
and FDI. After controlling for the effect of economic variables on the flow of foreign
investment, Kobrin used the data for 48 nations to see whether the number of U.S.
manufacturing subsidiaries established in each country over the years 1964-1967 can be
explained by two levels (high and low) of the severest form of political conflict labeled
"conspiracy". The statistical results supported his proposition that the association be-
tween political stability and FDI is more likely to be conspicuous when there is an
economically rooted conflict and the government has sufficient administrative capability
to indirectly respond to it.
The association between political stability and FDI is also reported by Agodo [1]. His
investigation was based on a sample of 33 U.S. firms having 46 manufacturing invest-
ments subsidiaries in 20 African countries. The findings showed that no single factor

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alone determines the U.S. private manufacturing investment in Africa, and that political
stability is one of several factors showing strong correlation with the level of U.S.
manufacturing investment on that continent.
While almost all the previously discussed studies in the second group have used correla-
tion and regression analysis, a study by Root and Ahmed [33] employed discriminant
analysis and attempted to identify the determinants of the manufacturing FDI in 70
developing countries. Only one political factor, the number of regular changes in govern-
ment leadership, emerged as a significant discriminator between the developing nations
with differing amounts of FDI in the manufacturing sector.
Schollhammer and Nigh [34] and Nigh [27] in their investigations of the effect of political
events on FDI took a different approach. To them, FDI is not only influenced by political
instability (internal conflict) but it is the result of other factors such as stability of
political system of the host country (internal cooperation), and inter-governmental rela-
tionships that could be cooperative or conflictive in nature, and the market size. Scholl-
hammer and Nigh [34] distinguished between German foreign direct investment (FDI)
in developed and less developed countries and utilized Conflict and Peace Data Bank
[3-5], to measure internal political stability and intergovernmental relationship. Using
regression models, they found that German FDI in less developed countries was affected
(a) negatively by internal political conflict of the host country, (b) positively by cooper-
ative political development between the host country and the German government, and
(c) positively by market size of the host country. Nigh [27], using the same procedure,
examined the effect of political events on the U.S. manufacturing foreign direct invest-
ment (MFDI) decisions for 24 developed and developing countries. His findings indi-
cated that for developing countries, both inter-nation and intra-nation conflict and
cooperation affected U.S. MFDI. In contrast, U.S. MFDI in developed countries ap-
peared to be affected only by inter-nation conflict and cooperation.
While admitting that the differences in methodologies and the variables used in the
analyses account for part of the discrepancies in the results, we feel that most of the past
studies suffer from some fundamental problems which could have distorted their find-
ings. These problems are discussed in the next section.

Pitfalls in the Past Research

The inconsistencies in the past empirical research could be attributed to the following:

1. Part of the problem with the past research is related to the ambiguity of the definition
of political risk and how it relates to instability [35]. Fitzpatrick [15] has evaluated
various definitions of political risk presented in the literature and has clustered them
into four groups. The first two clusters define political risk in terms of political events
or in terms of government or sovereign action resulting in unwanted consequences; the
last two clusters relate the definition of political risk to the environment. The very
presence of four definitions is the quintessence of inconsistency and ambiguity in the
previous work.
2. As political events have been the core of the various definitions of political risk, almost
all of the previous studies have assumed that investors are primarily influenced by
political events in making investment decisions. It is possible that investors are more

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 sensitive to the host government policy changes and decisions than to political events.
Indeed, economic policy instability does not appear to be related to sociopolitical
instability [9, 10, 38].
3. Exclusive reliance on political events for determining perceived political risk has
legitimized the use of composite measures of instability such as the Feierabend and
Feierabend Index [13] as proxy measures of instability in some statistical analyses.
Such indices allow events which are perceived by experts to be more destabilizing to
dominate those which are less so perceived. Perhaps the experts' perceptions about the
degree of instability caused by various political events are not universally valid.
4. Another problem with many of the past studies has been the utilization of static
cross-national data. With regard to the cross-national data, as Desta [12] has noted,
investment climate assessment studies need to take into consideration the unique
characteristics of each country. Due to the differences in location, culture, economic
and political systems, religious factions, history, and the like, similar symptoms of
social unrest in various nations do not imply the same degrees of political instability.
For instance, anti-regime demonstrations in Egypt and the Philippines do not mean
that the political risk of investing in both countries is the same.
Also most studies that have explored the relationship between political events and FDI
have ignored the relevance of the time lag [27, 34]. Since, in most cases there is a time
lag involved before an investor can react to the signs of political instability, a "single
period", static analysis is unable to capture the effects of political instability on the
flow of FDI.
5. Evaluation of the risk of any investment project without considering the expected
return on investment would be incomplete. In other words, a multinational corpora-
tion may continue to invest in a politically unstable country because the expected
return on investment, or the incentives offered by the host government, justifies
accepting the risk involved. Indeed, Green and Smith [18] have discovered a significant
relationship between overall investment profitability and political instability.

Empirical Investigation

To provide support for some of the claims made regarding problems with the past
research, potential causes behind the fluctuations in the U.S. Manufacturing FDI (U.S.
MFDI) were empirically investigated. Using multiple regression analysis, the U.S. MFDI
served as the dependent variable and the frequencies of sociopolitical instability symp-
toms, rather than any composite indices, served as the independent variables (see
Table 1). The values of the independent variables were furnished by Inter-University
Consortium for Political and Social Research (ICPSR). The values of the dependent
variable, U.S. MFDI, were taken from government statistics [37]. Data availability
limited the analysis to the years 1950-1982 and to the following fifteen countries:
Argentina, Brazil, Chile, Columbia, India, Indonesia, Iran, Jamaica, Liberia, Mexico,
Nigeria, Panama, Peru, Philippines, and Venezuela.
To assess the delayed impact of sociopolitical instability on the U.S. MFDI, the indepen-
dent variables were lagged 1-3 years and, three step-wise regression analyses were
applied to the data of each country. The use of step-wise regression analysis and the fact
that only three or fewer variables entered each regression model extirpated our concerns
about a multicollinearity problem.

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In the case of Jamaica, none of the three regression models produced statistically signif-
icant results. (During the period under investigation the flow of U.S. investment into
Jamaica hovered near two million dollars.) For the remaining countries, however, at least
one regression model produced significant results. Table 1 presents the results.
In lieu of discussing the findings for each country separately, more will be gained if we
focus on deciphering the overall implications of the results. Accordingly, four general
inferences conveyed by the results are discussed below.

1. Except Venezuela (which had only one significant model, lag 1) Chile, India, Liberia,
and Nigeria (each of which had two significant models) all three models for the
remaining nine countries were significant. Moreover, in most cases the same variables
are significant in the three models for each country. This seems to suggest that the
symptoms of sociopolitical instability by and large have had lasting effects on the U.S.
MFDI decisions. For Chile, the findings show that it has taken two or more years
before the level of investment has been reduced in reaction to "executive renewals".
For India, Liberia, and Nigeria the flow of U.S. MFDI appears to have increased in
the two years following the emergence of instability symptoms. In the case of Nigeria,
the uncertainty related to the outcome of elections appears to have had a short-term,
one year, negative effect on the flow of manufacturing investment.
2. A rather surprising part of the findings relates to the positive coefficients obtained for
some of the sociopolitical instability variables. Indeed, the regression coefficients are
exclusively positive for four variables representing "protest demonstration", "success-
ful assassinations", "political strikes", and "political executions". Some of the positive
coefficients may simply indicate a spurious relationship. For example, the upward
trend in U.S. MFDI and the emerged instability symptoms may have both been related
to the economic growth of the countries involved. (Past studies have reported a
positive correlation between the flow of FDI and GNP and population. Additionally,
rapid economic developments have been found to have the potential of engendering
social unrest and instability [28]. Indeed, had our objective been to explain total
fluctuations in U.S. FDI, we should have included factors such as GDP and popula-
tion as independent variables in our model. But, because our interest centered on the
negative associations alone, inclusion of such variables was deemed unnecessary.)
Notwithstanding the above reasoning, a possible explanation for the positive coeffi-
cients of "political executions" is that the executions may have been perceived to
weaken or eliminate a menacing opposition and have boosted investors' confidence.
Regarding "protest demonstrations" and "political strikes", the U.S. MFDI may have
increased not as a result of these events, but because of the actions taken by the
government in reaction to them. An alternative explanation is that the very occurrence
of these events and the government's tolerance of them may have conveyed a sense of
stability and confidence about the regime. A positive coefficient for "successful assas-
sinations" is however more difficult to explain. Again, one plausible explanation is
that the government's actions subsequent to these events may have exuded confidence
in the stability of the regime and its policies.
Three variables, namely, "armed attacks", "regular executive transfers", and "relax-
ation of sanctions" have produced positive and negative coefficients for different
countries. Such discrepancies in signs support the argument that the same symptoms
of instability do not imply the same degree of risk in different countries. Only five
variables, namely, "riots", "executive renewals", "executive adjustments", "imposi-
tion of political sanctions", and "death from domestic violence" have produced exclu-

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 sively negative coefficients. In particular, "executive adjustments" and "imposition of
political sanctions" were most frequently related to reductions in the flow of U.S. FDI.
3. The presence of both positive and negative regression coefficients for different instabil-
ity variables in some of the regression models may seem perplexing. In other words,
it may appear that U.S. MFDI is increasing because of some events and decreasing
because of others. But this apparent inconsistency is due to the fact that the variables
which have turned out significant in each model do not necessarily assume values for
the same years. To wit, since the same instability symptoms may not recur every year,
not all the variables have values for every year in the data set. Consequently, the
positive and negative coefficients do not correspond to the same periods. Again, the
positive coefficients may have been caused by spurious relationships.
4. That most of the models produced significant results, and that positive and negative
coefficients were obtained for the same or different instability variables demonstrate
the importance of analyzing the relationship between U.S. MFDI and political insta-
bility at the individual country level. In fact, the aggregate analysis for the fifteen
countries failed to produce significant results.

Conclusion and Recommendations for Future Research

The analysis of political risk and its link to the flow of FDI comprise a relatively new
field. Political events of recent years have precipitated interest in the research and
contributions to this field. The past research, in addition to shedding light on various
aspects of political risk, has made important contributions to the design of future
research experiments. This paper has purported to elaborate on the implications of the
past studies for carrying out future research. This study has led us to make the following
recommendations regarding future research.

1. There should be a clear understanding of political risk and how it is supposed to be

linked to political instability. There is a need for clarity and consistency in definition,
specificity in frame of reference and concision in conceptual structure. To that end we
suggest the following definition:
Political risk is defined as negative perceptions emanating from internal instability, intergovern-
mental relationships, anticipated or unanticipated government actions, or government disconti-
nuities all brought about by social, economic, or political imperatives existing in a country's inter-
nal or relevant external environment.

According to Fitzpatrick [15], political risk as a concept should encompass every

possible risk to international business contained in its political environment. The
existing definitions of political risk focus on the concept of political risk from two
different perspectives [24]. One group views political risk in terms of government or
sovereign actions. The second group identifies political risk as occurrences of political
events or constraints imposed upon the firm. The definition offered here comprises
both perspectives.
2. Since the link between political instability and political risk is not direct and universal,
the relationship between the two should only be examined on a country by country
basis. Moreover, since the match between the nature of foreign investment and socio-
economic developmental aspirations of a polity could influence the level of risk for that

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 particular investment [12], the association between political instability and FDI should
limit its focus to one industry. This suggestion echoes Kobrin et al.'s [25] concern that,
"it is difficult, if not impossible, to systematically aggregate and compare subjective
impressions across either projects or countries."
3. In order to truly gauge the degree of political instability in a country, one should go
beyond the examination of the nature and frequency of the symptoms of political
instability. Such symptoms alone may offer a distorted picture of reality. Factors such
as income inequality, social welfare, history, location, experience with democracy, the
relationship with superpowers, the countries' infrastructure, membership in World
institutions such as International Monetary Fund, and other related factors should be
carefully examined. It is indeed wise to follow TschoegFs [36] recommendation which
involves the application of social structural method that is a standard in sociocultural
anthropology. Furthermore, even events outside a country, particularly, in its' con-
tiguous environment [11], can carry significance regarding its internal stability. For
example, the Soviet Union's invasion of Afghanistan might have made foreign in-
vestors apprehensive of investing in neighboring Pakistan. This phenomenon was
observed in Latin America in the early 1960's, after the Cuban revolution [19]. But,
according to Kassicieh and Nassar [20, 21], it did not apparently take place in the
Middle East after the Iranian Revolution or the outbreak of Iran-Iraq war.
4. Political stability or lack of it can not be determined for a point in time, rather its
determination should involve the scrutiny of events over a number of years. Moreover,
it may take some time before a foreign investor is able to react to the symptoms of
instability in a country. For these two reasons, we find it plausible to further support
longitudinal research for exploring the relationship between political instability and
FDI.
5. Political risk is the restraining force in the foreign investment decision making p
while return on investment is the driving force. Consequently, when political r
increases, the investors may not decrease or withdraw their funds because of the
pected return on investment. Keeping this in mind, the investigation of the relatio
between political risk and the flow of FDI without accounting for the return on in
ment would be incomplete. Therefore, expected or actual rate of return on invest
should be somehow incorporated into the analysis.

Footnote

1 The data for proxy variables of sociopolitical instability utilized in this paper were made available
by the Inter-University Consortium for Political and Social Research. The data were originally
collected by Charles L. Taylor and David L. Jodice. Neither the original source or collectors of
the data nor the Consortium bear any responsibility for the analyses or interpretations presented
here.

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