Foreign Direct Investment and the Risk of Expropriation

Abstract

When an investor, for example a transnational corporation invests abroad it runs the risk that its investment will be expropriated. The host country although it might have a short-term incentive to expropriate has a long-term incentive to foster good relations to attract more investment in the future. This conflict between short-term and long-term incentives determines the type of contracts agreed by transnational corporations and host countries. In a model of the manufacturing industry with a continuous flow of investment it is shown that investment is initially underprovided, increases over time, tending, for certain parameter values, to the efficient level. This version prepared on 19th January, 1990. * The support of the Deutsche Forschungsgemeinschaft through SFB 178 at the Universitat Konstanz is gratefully acknowledged. We thank Keith Cowling for comments on an earlier draft. This paper is circulated for discussion purposes only and its contents should be considered preliminary. HEADNOTE: When an investor, for example a transnational corporation, invests abroad it runs the risk that its investment will be expropriated for the simple reason that international contracts are practically impossible to enforce. Any agreements or contracts then undertaken by the transnational company and the host country must be designed to be self-enforcing. It could be possible for the host country and the transnational corporation to find such self-enforcing agreements if there are future gains from trade. Thus although the host country might have a short-term incentive to expropriate it has a long-term incentive to foster good relations with potential investors to attract more investment in the future. This conflict between short-term and long-term incentives determines the type of investment contracts agreed. This paper extends previous work on the general underprovision of investment when contracts are incomplete or only partially enforceable (see e.g. Grout, 1984) to a dynamic context. It is likewise shown that investment is initially underprovided but it increases over time and for certain parameter values it tends to the efficient level. The expected future discounted returns to the transnational company declines over time, extending Vernon's observation of the obsolecing bargain (Vernon, 1971). The model is also extended to allow for capital accumulation and consideration is given to renegotiation-proof contracts.

Sovereign Theft: Theory and Evidence about Sovereign Default and Expropriation

“…1 This argument has been made in various forms by many authors, including Gersovitz (1981a, 1984), Thomas and Worrall (1994), and Albuquerque (2003).…”

Expropriation risk and FDI in developing countries: Does return of capital dominate return on capital?

“…38 See, among others, Eaton and Gersovitz (1984), Cole and English (1991), Thomas and Worrall (1994), Albuquerque (2003), Aguiar et al (2009), Tomz and Wright (2010), Stroebel and Van Benthem (2013) and Hajzler (2014). 39 When cutting off all future investment cost is the maximum (trigger strategy) punishment that investors can impose, the cost to the host country is decreasing in the representative agent's (or government's) discount factor and increasing in the degree of risk aversion, since there is an insurance motive for accessing international capital markets when the host-country agent is risk averse.…”

“…This implies that government's and investors' strategies are time-invariant and the essential features of the contract can be captured within a static framework. In other models (e.g., Phelan, 2006;Thomas and Worrall, 1994), a two-period model no longer provides a good approximation of equilibrium investment and expropriation dynamics. 41 In Cole and English (1991) and Aguiar et al (2009), the existence of this traditional sector is needed to bound from below the host-country utility in autarky for any degree of relative risk aversion.…”

Hyperbolic discount curves: a reply to Ainslie

“…Such relational contracts arise since it is costly or impossible in many instances to rely on third parties, e.g., courts, to enforce agreements and assess damages resulting from violations. Within economics, multi-period principal-agent models illustrate selfenforcing contracts and have been considered in as diverse contexts as labor markets (Harris and Holmstrom 1982;Shapiro and Stiglitz 1984), credit markets (Bulow and Rogoff 1989;Albuquerque and Hopenhayn 2004), and international trade (Thomas and Worrall 1994).…”