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Institutional and Political Risk of Foreign Direct Investment

The given literature review will primarily focus on the topic of institutional risk and political risk on Inward FDI of developing or emerging economies. Although both institutional and political risks are relevant in the context of developed nations, they are more concerned and critical in regard to developing ones since societal and structural instability can be a major source of risks in regard to inward foreign direct investments. The research of a multitude of sources is indicative of the fact that there is a reciprocal relationship between these two risks and inward FDI, where the latter reduces the formers, and the formers incentive the latter. The problem of the influence of political risks on international business, including on FDI flows, has been the subject of close attention of both business representatives and academics over the past forty years. Nevertheless, the results of various studies of the relationship between political risk and FDI are far from unambiguous. It is possible that the influence of political factors on the volume of FDI is not sustainable, and, in general, there is not always a significant relationship between political indicators and the volume of FDI.

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In order to conduct a comprehensive analysis of the relationship between FDI and institutional and political risks among developing nations, it is of paramount importance to assess several such countries. For example, in the case of India, it is stated that inward FDI stimulates the overall economy of the nation by making it more productive in regards to total factor productivity, whereas the factor brings a number of benefits, which can be reflected in a reduction of the risks associated with the investments (Choi & Baek, 2017). Another research also supports the given relationship between institutional and political risks in developing nations, where, for example, in the Middle East and North African (MENA) nations, inward FDI results in a “significant positive influence of financial development on overseas investors’ investment decision. The empirically established FDI determining factors such as market size, development level, trade liberalization, macroeconomic stability, trade agreements, bilateral investment treaties and infrastructure & skilled labor availability, were also taken into consideration” (Shah, 2016, p. 93). In other words, developing nations evidently contain some form of risks, but FDI has a direct impact on the reduction of these risks, which generates a positive feedback loop of a gradual and continuous improvement of the nation’s institutions and political structures.

A similar case can be observed in many other major and economically significant countries. For instance, in China, it is stated that “regulations and FDI move together in the long‐run, and there is dependable evidence of asymmetry” (Ullah et al., 2020, p. 1). In other words, the research suggests that there is a correlational relationship between FDI leading to improvements in political and institutional risks, which facilitate a more favorable environment for future investments. Unlike developed nations with industrialized economies and social stability, developing nations are initially more likely to be unable to ensure reduced risks, but foreign direct investments catalyze and jumpstart the risk reduction process, which favors the subsequent FDIs. A study claims that “inward FDIs have a booming effect on the domestic credit in emerging market economies while the trade openness exhibits crowding-out effects. Institutions help moderate these effects of inward FDIs and trade openness on the domestic credit suggesting a particular policy” (Nguyen et al., 2018, p. 75). In other words, the described reciprocity is supported even further where inward FDI results in institutional stabilization and more trade openness, which are important for risk reduction. Therefore, one can claim such a relationship is indicative of the fact that FDI is tightly connected to institutional and political risks. Thus, on the one hand, countries with developing economies are characterized by investment attractiveness and a significant total volume of FDI. On the other hand, the presence of political risk can be considered the main barrier to foreign investment. Since FDI is one of the crucial resources for modernizing developing countries, it is necessary to identify the reasons for the receipt of significant volumes of FDI in some countries and the lack of them in others.

Although the current literature primarily addresses the interdependencies of FDI and institutional and political risks, the one-directional influence of these risks is also supported by the fact that the observations from developed nations are applicable to developing countries as well. A study conducted on all nations along with China’s Belt & Road Initiative, which are mainly developing nations, shows that “political risks, economic risks, and resource risks occupy the main determinant position during the overseas renewable energy investment” (Wu et al., 2019, p. 1). Therefore, it is safe to state that FDI levels and attractiveness are directly determined by political and institutional risks, which means that both developed and developing nations’ inward FDI is tied to the defined risk elements. Although the provided study mainly addresses renewable energy-related FDIs, it is representative of the general risk dependencies of the investment activities.

The problem of political risks acquires special relevance since the world economic crisis has made changes in the functioning of the national economies of the regimes, increasing the role of the state in them. This largely politicized the external environment of business, as a result of which national economic regimes in both developing and developed countries began to be characterized as state capitalism. It can be noted that political risk remains the main threat when investing in developing economies, prevailing over other possible dangers. These can involve macroeconomic instability, limited market and infrastructure opportunities, corruption, difficulties in accessing finance, increased government control, and problems with the availability of skilled labor.

Moreover, the pattern of inward foreign direct investment is not equivalent on the basis of two nations’ interactions. For example, a study suggests that inward FDIs are favorable or more effective in the case of developing-to-developing FDI rather than a developed-to-developing framework (Hu et al., 2021). In other words, the Chinese, as a developing nation, is less impacted by institutional and political risks in its investment in nations of African continents than a developed nation doing so. In addition, it is important to note that different estimation strategies need to be incorporated in regard to FDIs in developing nations (Yang, 2018). It is possible that such a difference is manifested in the notion of a more relatable environmental factor involved in the analysis because investments from developing nations, such as China, have fewer low-risk alternatives and a better understanding of underlying institutional and political risks, whereas an opportunity cost for FDIs of developed nations is higher.

The independent variables characterize the level of political risk, and it is possible to associate political risk with government decisions that are unfavorable to business. In addition, it is possible that political risk is identified with various political events, political processes, and phenomena, as well as the characteristics of the state, government, and the political system as a whole. In general, political risk cannot be measured directly. Its individual components are sometimes amenable to simple quantitative measurement, for example, the risk of expropriation can be operationalized by simply counting cases over a certain amount of time in individual countries. However, political risk, due to the multifaceted nature of this concept, can be quite fully represented by a set of indicators reflecting various aspects of the political environment, while each of the indicators is formed by generalizing primary expert assessments.

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References

Choi, Y., & Baek, J. (2017). Does FDI really matter to economic growth in India? Economies, 5(2), 20-29. Web.

Hu, D., You, K., & Esiyok, B. (2021). Foreign direct investment among developing markets and its technological impact on host: Evidence from spatial analysis of Chinese investment in Africa. Technological Forecasting and Social Change, 166, 120593. Web.

Nguyen, C. P., Schinckus, C., Su, T. D., & Chong, F. (2018). Institutions, inward foreign direct investment, trade openness and credit level in emerging market economies. Review of Development Finance, 8(2), 75-88. Web.

Shah, M. H. (2016). Financial development and foreign direct investment: The case of the Middle East and North African (MENA) developing nations. Journal of Management, 1(2), 93-109. Web.

Ullah, A., Zhao, X., Kamal, M. A., & Zheng, J. (2020). Environmental regulations and inward FDI in China: Fresh evidence from the asymmetric autoregressive distributed lag approach. International Journal of Finance & Economics, 1, 1-17. Web.

Wu, Y., Wang, J., Ji, S., & Song, Z. (2019). Renewable energy investment risk assessment for nations along with China’s Belt & Road Initiative: An ANP-cloud model method. Energy, 190, 1-19. Web.

Yang, J. (2018). Subnational institutions and location choice of emerging market firms. Journal of International Management, 24(4), 317-332. Web.

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StudyCorgi. (2022, August 16). Institutional and Political Risk of Foreign Direct Investment. Retrieved from https://studycorgi.com/institutional-and-political-risk-of-foreign-direct-investment/

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