Transparency, Risk, and FDI

Abstract

A central theme in the foreign direct investment (FDI) literature is that political risk deters investment. The empirical record, however, is mixed. multinational corporations (MNCs) continue to invest in high-risk countries. We argue it is not merely about the level of risk, but rather firms’ ability to quantify risk. When MNCs can confidently assess both the nature and the degree of the threats present, they can take appropriate measures to hedge against them. This should increase their willingness to invest, even in higher risk environments. We contend that the ability to accurately quantify risk is a function of political transparency. Among opaque countries, we expect risk to exert a deterring effect on FDI, as commonly theorized. Among more transparent countries, however, we expect that risk is a less salient concern for MNCs. We test this argument using firm-level data on the foreign operations of some of the world’s largest multinationals between 1995 and 2008. The evidence supports the argument. Risk has a strong negative effect on the likelihood of investment at lower levels of transparency, but the magnitude of this effect weakens at higher levels of transparency. This pattern is consistent across multiple types of political risk, and is most pronounced in nonextractive (relative to extractive) industries.

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