The Effects of Judicial Strength and Rule of Law on Portfolio Investment in the Developing World^*

Abstract

Objective. Applying existing theories relating to investment risk, this article examines the effects of judicial strength and adherence to the rule of law on portfolio investment in the developing world. We aim to demonstrate that countries with higher levels of judicial strength and rule of law are more able to attract portfolio investment because they provide greater protection of property rights and a better risk environment for investors. Methods. Using time-series data for 79 developing countries for the period 1996-2005, we employ panel-corrected standard errors multivariate regressions to demonstrate that higher levels of judicial strength and rule of law are associated with higher levels of portfolio investment. Results. We find that a one standard deviation increase in overall judicial strength and rule of law results in more than a 50 percent increase in portfolio investment. In separate analyses, we show that a one standard deviation increase in specific measures of judicial independence, impartial courts, and protection of property rights leads to increases in portfolio investment ranging from 27 percent to 184 percent. Conclusion. Judicial strength and adherence to the rule of law are important determinants of portfolio investment in the developing world.The past two decades have witnessed the parallel revival of both democracy and foreign investment in the developing world, a convergence that has led many political economy scholars to argue that democratic reform is a causal agent for increased foreign investment flows into developing countries

The importance of legal systems for portfolio investment in the developing world

“…Previous works dealing with foreign investment have shown how regime type or broad institutional features can provide the types of assurances that induce foreign investment. We present more specific findings on how institutional arrangements and performance can affect foreign investment and do so by building on foundational work of Li and Resnick (2003), Li (2006), Jensen (2006), Biglaiser and Staats (2010) and Staats and Biglaiser (2011). Our work provides a platform for further investigation on the role that legal systems of whatever type play in attracting foreign capital.…”

“…Our assumption about the effect of legal systems on PI also is borne out by Staats and Biglaiser (2011), who find that strong judicial performance and adherence to the rule of law are associated with increased PI inflows. 4 Investors additionally worry about arbitrary governmental decisions and abrupt changes in policy that can cause private property to diminish in value.…”

“…Relatively few studies to date have investigated the determinants of PI (Ahlquist, 2006; Biglaiser et al, 2008; Brennan and Cao, 1997; Staats and Biglaiser, 2011), which is surprising considering that for more than two decades PI has served as a vital foreign capital source, surpassed only by FDI (World Bank, 2008). While there are reasons to believe that PI is subject to many of the same influences as FDI, which we discuss below, PI is generally assumed to be more short term and liquid than FDI and sufficiently different from FDI as to argue for separate investigations of the factors that allow some countries to attract more portfolio flows as compared with other countries.…”

“…Although these works are empirical, their treatment of the interplay between law and foreign investment is mainly theoretical. Biglaiser and Staats (2010) and Staats and Biglaiser (2011, 2012), in turn, have shown empirically that legal factors can help attract foreign capital. 2 Our aim in this paper is to go a step further than prior works by investigating whether it matters for attracting PI that a country has a common law legal system as opposed to civil, Islamic or some mixture of legal systems.…”

“…Taking up that challenge, many studies investigate broad institutional factors, most specifically whether it matters in terms of political risk that the governing regime is democratic or authoritarian (Feng 2001; Huntington, 1968; Jensen 2003, 2006, 2008; Li 2006, 2009; Olson, 1993; Oneal, 1994). Still other studies unpack regime type in order to consider the particular political institutions, processes and alignments that uniquely attract investors by lowering risk (Li and Resnick 2003; Biglaiser and DeRouen 2006; Biglaiser and Staats 2010; Staats and Biglaiser 2011; Jensen and Johnston 2011), providing a climate of receptivity to foreign investment, including financial inducements (Li 2006; Pinto and Pinto 2008; Jensen 2012), or causing some combination of risk lowering and receptivity (Jensen et al 2012).…”