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date: 19 September 2017

Regime Type and FDI: A Transaction Cost Economics Approach to the Debate

Summary and Keywords

A debate exists in international political economy on the relationship between regime type and foreign direct investment (FDI). The central point of contention focuses on whether multinational firms generally prefer to pursue business ventures in more democratic or autocratic countries. A considerable amount of theory has been developed on this topic; however, the arguments in previous studies lack consistency, and researchers have produced mixed empirical findings. A fundamental weakness in this literature is that while FDI has largely been treated conceptually as a homogeneous aggregate, in reality, it features divergent characteristics on multiple dimensions. Three possible dimensions that FDI can be decomposed on are: greenfield vs. brownfield, ownership type (wholly owned vs. joint venture), and horizontal vs. vertical. The most relevant dimensions to the problem at hand are: greenfield vs. brownfield, and horizontal vs. vertical. Five propositions, based on the notion of asset specificity, other investment attributes, and host nation domestic factors, are derived to predict how regime type might affect four types of FDI: vertical-greenfield; vertical-brownfield; horizontal-greenfield; and horizontal-brownfield. Depending on the type of FDI, multinational corporations may have no regime preference, an autocratic preference, or a democratic preference. This research contributes to empirical international relations theory by providing a useful example on how to resolve a scholarly debate, theoretically, and by laying out testable propositions for future empirical research.

Keywords: foreign direct investment, multinational corporation, transaction cost economics, democracy and autocracy, empirical international relations theory, international political economy

Introduction

This article introduces the reader to a debate in international political economy (hereafter “IPE”) on the nexus between regime type and foreign direct investment (hereafter “FDI”) and proposes a new theoretical solution to the debate. The debate centers on whether multinational firms generally prefer to pursue business ventures in more democratic or autocratic countries. A considerable amount of theory has been developed on this topic; however, the arguments in previous studies lack consistency, and researchers have produced mixed empirical findings (Li, Owen, & Mitchell, 2016). This article will briefly review the wealth of arguments on the relationship between regime type and FDI and then explore theoretically how different forms of FDI, typically aggregated in extant research, may cater to different contexts and have varying connections to disparate causal mechanisms. The new theoretical argument invokes the notion of asset specificity, other investment attributes, and host nation domestic factors, to predict how regime type might affect four types of FDI: vertical-greenfield; vertical-brownfield; horizontal-greenfield; and horizontal-brownfield. Depending on the FDI type, multinational firms may have no regime preference, an autocratic preference, or a democratic preference. This article illuminates some possible pathways for future research on this important and controversial topic. Furthermore, this research contributes to empirical international relations theory by providing a useful example on how to resolve a scholarly debate, theoretically, and laying out testable propositions for future empirical research.

Alternative Causal Mechanisms in the Literature

According to the Balance of Payments Manual of International Monetary Fund, FDI refers to the investments from one country to acquire managerial control and ownership in enterprises in another country. In the IPE literature, scholars debate whether FDI is systematically associated with the properties of a political system in a country and how. In a meta-analysis of over 40 published studies, Li, Owen, and Mitchell (2016) highlights a dozen mechanisms that scholars argue could influence the relationship between regime type and FDI. Table 1 below, drawn from Li, Owen, and Mitchell (2016), lists these different mechanisms and their expected effects.

Table 1. Causal Mechanisms and Associated Effects from Democracy

Causal Mechanism

Directional Effect

1

Enhancing property rights protection

+

2

Enhancing policy stability via veto players

+

3

Providing better growth prospects

+

4

Providing more media openness

+

5

Reducing political and economic uncertainty

+

6

Labor-oriented democratic politics

+

1

Stronger antitrust policies

2

More protection for domestic industry

3

Less generous incentive packages for investors

4

Less willingness to defend MNCs from domestic political pressures

5

Relatively less favoritism towards MNCs in resource rich democracies

6

Democratic LDCs unwilling or unable to offer economic freedom

Note: Table 1 is based on a table of causal mechanisms from Li, Owen, and Mitchell (2016). Acronyms: MNC= “Multinational Corporation” and LDC=“Less Developed Country”

Property rights protection is regarded as one of the single most potent factors for attracting FDI, given that the expropriation of fixed assets is a straightforward process for a host government (Li & Resnick, 2003). The respect for the rule of law and private property rights in democracies is thought to originate from at least one of two sources. The first source relates to high political audience costs that democratic leaders may incur for reneging on contracts with foreign investors (Jensen, 2003). Audience costs involve the negative feedback that political leaders receive from their constituents, such as with the mass public. Democracies tend to impose audience costs since they hold frequent elections that can lead to a change in leadership. However, democracies are not the only form of government exposed to audience costs; autocracies typically have their own constituents as well, though many researchers believe that democracies generate more audience costs than autocracies, which typically have narrower constituencies (Weeks, 2008).

The second major source of property rights protection is institutional factors. Institutional factors in democracies, such as checks and balances and veto players, can serve as roadblocks for initiatives to appropriate foreign-held assets (Jensen, 2003; Li & Resnick, 2003; Resnick, 2001). Checks and balances can exist purely at the national level, as well as between national governments and their constituent subnational governments in a federal system. The decentralization of governmental powers in federalist systems has been empirically found to attract FDI (Jensen & McGillivray, 2005). Competition within a government can effectively function as a check on the system.

The number of veto players has been found to be associated with more FDI (Jensen et al., 2012; Zheng, 2011), because veto players can act as a roadblock to change. This deterrent to change creates policy stability in democracies that may be in line with investor preferences (Jensen, 2003; Ahlquist, 2006). By protecting the rights of businesses and individuals through constraining predatory behaviors, democracies often have better growth prospects and lower expropriation risks, helping to attract both horizontal and vertical FDI (Doces, 2010). These institutional factors may effectively function as credible commitments to pro-growth policies.

Democracies traditionally exhibit policies and opportunities that lead to higher levels of accessibility and transparency than autocratic governments. Due to media openness in democracies, those who benefit from FDI are in a position to punish democratically elected leaders who renege on agreements with foreign investors (Choi & Samy, 2008). Through increased transparency, democracies exhibit lower levels of economic and political uncertainty (Choi & Samy, 2008; Choi & James, 2007; Azemar & Desbordes, 2009). This reduction of uncertainty results from various factors, including the freedom of press, transparency in decision-making processes, and regularized elections that prevent succession crises that can occur in autocracies. Less uncertainty and more transparency make democratic economies easier to predict and forecast over the long term, making it possible for them to absorb shocks more effectively.

Finally, democracies may be more willing to embrace FDI because of the empowerment of workers, who benefit from higher wages associated with FDI and can voice their support for policies that favor this form of foreign investment (Jakobsen & Soysa, 2006; Pandya, 2013). However, this may come at the expense of local businesses opposed to FDI. In short, democracy can add clarity to national business environments that can serve all parties.

The arguments discussed above point to a positive link between democracy and FDI. There are, however, arguments that propose a positive link between autocracy and FDI as well. Autocracies may have certain advantages over democracies that are worth serious theoretical consideration. Although policy stability may be an attractive feature of democratic governments, it does not necessarily follow that these stable policies will favor multinational firms. Numerous policy domains may involve an unpleasant environment for foreign businesses. Noteworthy policy areas include antitrust regulation, taxation, regional development, and labor. Unlike autocracies, democracies are significantly more likely to produce, and enforce, antitrust regulations to inhibit firms with substantial market power from interfering in competitive market processes (Li & Resnick, 2003). Democracies may also be more likely than autocratic governments to defend domestic businesses from foreign competitors because domestic groups can lobby their democratic leaders more effectively for protection than those in autocratic ones (Li & Resnick, 2003). When it comes to offering generous incentive packages to foreign investors, democratic governments are likely to confront more opposition than their autocratic counterparts (Li & Resnick, 2003; Zheng, 2011). Furthermore, autocracies are more likely to be in a position to manipulate the outcome of labor disputes in favor of foreign firms (O’Donnell, 1988; Resnick, 2001).

Although these autocratic advantages may be relevant to governments at all income levels, multinational firms may view autocracies differently based on their economic status. Autocracies in less developed countries (hereafter “LDCs”) may enjoy further advantages over democratic regimes in otherwise equal LDCs. Foreign investors may especially prefer autocratic LDCs endowed with abundant natural resources (Asiedu & Lien, 2011). Foreign firms in extractive industries may prefer to avoid democratic regimes in LDCs, which are often associated with government instability that creates economic instability. Due to the relatively longer duration of leadership in autocratic LDCs, investors in extractive industries will likely be able to establish more enduring relationships with officials who grant them access to natural resources. An important takeaway from this discussion is that the context surrounding regime type might be necessary when considering regime preferences by foreign investors.

Up to this point we have discussed the different mechanisms that might link regime type and FDI. However, one glaring weakness with the existing literature is that different arguments do not distinguish between the different types of FDI. It is conceivable that causal mechanisms might apply to different types of FDI in different ways or to varying degrees.

Decomposing FDI

Foreign investment can come in a variety of forms, but a strong emphasis in the IPE literature has been on FDI. As its name implies, FDI refers to bilateral cross-border investment, and it is primarily FDI’s fixed asset component that is not mobile. For the most part, the IPE literature has treated FDI as a homogeneous aggregate, but FDI can be unpacked on various dimensions. The first dimension of FDI involves whether a multinational corporation (hereafter “MNC”) elects to build a new business enterprise or buy an existing one. A second dimension of FDI involves the level of equity ownership in a MNC’s foreign affiliates, such as whether they are wholly owned or joint ventures. The third dimension of FDI relates to how a MNC’s affiliate is incorporated into its global operations: vertically or horizontally. All options possess strengths and weaknesses that a respective MNC will need to consider, and the implementation process by the MNC is known as its entry mode strategy (Delios & Beamish, 1999).

The decision to build is referred to as “greenfield investment,” and this category of FDI constitutes one possible entry mode strategy for MNCs. Greenfield offers MNCs the opportunity to start from scratch and build a business to their own specifications (Meyer & Estrin, 2001). Such an operation may entail purchasing real estate, building facilities, hiring a comprehensive group of staff, and so forth. Although this decision presents MNCs with the opportunity to start a business fresh and fully customize local operations, it comes with certain difficulties. For example, MNCs may not be familiar with the overall business environment (e.g., licenses, permits, and procedures) and consumer culture; furthermore, they will often start with literally no market share if they intend to compete with local businesses (Delios & Beamish, 1999; Meyer & Estrin, 2001). Therefore, MNCs will have to undergo some level of acculturation and establish a variety of economic and political networks to successfully operate in a new economic environment, all of which may take time to develop (Hansen & Gwozdz, 2015; Henisz, 2000; Inkpen & Beamish, 1997; Meyer, Estrin, Bhaumik, & Peng, 2009). This can help to explain the higher success rate of new ventures by those firms that have previously operated in foreign countries (Barkema, Bell, & Pennings, 1996).

The decision to buy is often referred to as “brownfield investment,” and this encompasses mergers and acquisitions. This type of investment offers MNCs certain opportunities to absorb existing assets, distribution networks, and knowledge about the local economy in the acquisition target. Most brownfield investment will entail at least partial investment in a business that will lead to some level of managerial control, which is frequently defined as having a 10% or greater stake (Krugman, Obstfeld, & Melitz, 2011). Yet countries frequently define control in different ways that are specified in their tax codes. A high level of managerial control can be exercised even when a firm has only a minority stake in a business enterprise. As an example, French car maker Renault purchased only a one-third share in the equity of Japanese car maker Nissan in 1999. Renault had no intention of selling their vehicles in the Japanese market, but they were able to leverage their influence through their minority equity stake and replace the CEO with one of their star executives. Ultimately, brownfield investment is not about acquiring ownership per se but about acquiring a substantial level of managerial control over another firm (Head & Ries, 2008).

FDI can be further dissected into business enterprises that have divergent levels of equity ownership. Many subsidiaries are wholly owned, but this is not always the case. Depending on the proportion of equity held, a MNC can also be a minority, equal, or majority partner in a foreign enterprise (Delios & Beamish, 1999), and this type of partnered enterprise is known as a joint venture (hereafter “JV”). JV involves the creation of a new business enterprise through contributions by two or more related or unrelated firms from the same or different countries, or taking out a stake in an existing enterprise (Kogut, 1988), which is sometimes referred to as an alliance. The proportion of stock owned in a JV often determines the level of control by each party involved (Chalos & O’Connor, 2004). JVs afford foreign MNCs the opportunity to tap into the networks of their partners and potentially share tangible and intangible assets (Kogut, 1988). Examples of JVs include the numerous joint operations in Texas’ Eagle Ford Shale Region between American and Chinese energy companies. Many JVs emphasize resource extraction, but this business model has a high level of versatility. The decision to participate in a JV will depend on the product being developed and the level of contractual security in the country receiving investment (Kogut, 1988).

A third dimension along which to decompose FDI involves the organizational purpose of the new venture within the global structure of an MNC. When a MNC engages in cross-border investment to reduce costs, expand production and markets, and maximize profit, its foreign investment may be categorized into two types: horizontal and vertical FDI. Horizontal FDI involves the spread of a parent firm’s existing functions to a new host country, often targeting the latter’s market (Meyer & Estrin, 2001). Such investment is often made to get around such entry barriers as import controls and tariffs. Horizontal FDI allows a foreign enterprise to skirt trade barriers that a foreign firm would otherwise be subject to. In contrast, vertical FDI is associated with “comparative advantage” and involves exploiting abundant factors in a host country (Krugman, Obstfeld, & Melitz, 2011). It serves to reduce costs for an MNC’s global value chain by taking advantage of cheaper factor endowments in different host countries. Goods associated with vertical FDI are often intermediate, given that they are part of the production supply chain, and they are reexported to other countries that host affiliated business enterprises. Obviously, horizontal and vertical FDI generate different sets of benefits and serve different purposes.

The superiority of different types of FDI remains a point of debate. Brownfield investment is regarded by some development scholars as the least desirable form of FDI because it simply replaces domestic ownership by foreign ownership (Ashraf et al., 2016; Harms & Méon, 2011). As an example, if a foreign retailer buys out a domestic one to expand its global presence, this form of horizontal investment only leads to a change in ownership. However, brownfield investment still offers opportunities for the enhancement of economic growth, not the least of which involves the freeing up of domestic capital for alternative use. Meanwhile, foreign investors may bring with them intangible assets (e.g., intellectual property, managerial know-how, brand name) that are lacking in the host.

Greenfield investment, especially of the vertical kind, is regarded as the ideal form of investment, since it may bring in both tangible and intangible assets—producing the most technological spillovers and creating new economic activity (Caves, 1974; De Mello, 1997). Rather than simply creating an appendage of a multinational corporation, greenfield investment often leads to branches or subsidiaries that form valuable components of global supply chains, bringing less developed economies further into the fold of more advanced ones. As an example, U.S. car manufacturers may move part of the production process associated with their vehicles to a maquiladora in Mexico to take advantage of the latter’s more abundant cheap labor. In addition, greenfield investment is arguably not perceived as being in direct competition with domestic businesses (Aitken & Harrison, 1999), preventing protectionist sentiment. As a result, numerous countries offer pecuniary incentives to attract greenfield FDI (Blomström & Mucchielli, 2003). Some past research has found empirical evidence in favor of greenfield investment being the foremost form of growth-enhancing FDI (Harms & Méon, 2011). However, more recent research has challenged the conventional wisdom that it is the preeminent form of development-enhancing FDI, based on alternative macroeconomic indicators (Ashraf et al., 2016). Although the superiority of different types of FDI is still a point of contention in the wider literature on foreign investment, there has not been a sufficient amount of research into the variations of FDI in IPE.

One final form of investment worth mentioning in the context of this literature is foreign portfolio investment. In foreign portfolio investment, institutional investors focus on more liquid securities, such as equities and debt instruments. As an example, a financial manager of a pension fund may purchase one-hundred billion dollars’ worth of bonds from a developing country in hopes that the high yield on these securities will generate worthwhile revenues. Portfolio investment has a shorter time horizon than FDI, leading to different concerns with investors. The key difference between FDI and portfolio investment revolves around a particular characteristic, known as liquidity, which refers to how easily an asset can be disposed of. This form of investment does not involve taking a controlling interest in a foreign enterprise, and portfolio investors simply choose to passively invest in other countries. As a result, portfolio investment does not fall within the traditional category of FDI, since it forgoes control.

It is important to note that FDI is not a substitute for foreign portfolio investment, and some scholars have suggested portfolio investment and FDI complement one another in the development process (Alfaro et al., 2004). However, FDI has been more closely linked with the real economy and development activities (Durham, 2004) and thus a greater emphasis has been placed on it in the wider literature as well as in this article.

Finally, as we decompose FDI along the relevant dimensions discussed above, it is important to clarify the relative importance of the three dimensions. All attributes of foreign investment are important. No stone should be left unturned when we explore investor preferences and investment attributes. However, when it comes to a conceptual analysis on the nexus of democracy and variation in FDI, we are going to aim for parsimony. In accordance with this objective, we assume that subsidiaries are controlled by a parent firm and that these subsidiaries respect the principal-agent relationship specified in their charters. This simplification deemphasizes JVs in this chapter.

This simplification is useful and plausible. A critical strand of the literature in strategic management, using elite interviews and data analysis, has found evidence that variation in equity ownership of JVs is highly influenced by social factors between participating firms, such as inter-organizational trust (Madhok, 2006; Verbeke & Greidanus, 2009). In short, a past history of successful JVs between the same firms may influence the level of equity ownership in a JV (Park & Ungson, 1997). Furthermore, a variety of other factors have been found to be highly influential in determining variation in equity ownership of JVs, such as diverging business cultures (Madhok, 2006; Park & Ungson, 1997). Finally, even though professionals operating in the field should know how to properly structure JVs to best maximize control, a majority of joint ventures ended in unexpected dissolution in the late 20th century (Kogut, 1988; Madhok, 2006; Park & Ungson, 1997). Because of these reasons, the joint venture vs. sole-ownership distinction is not critical for our analysis and thus is not taken into consideration for the problem at hand.

Effects of Regime Type on Unpacked FDI

How should we reconsider the arguments on democracy and investment flows when we unpack FDI? The theoretical mechanisms associated with democracy in the IPE literature may not influence the different dimensions of FDI in the same way. This article considers how extant arguments apply to the link between regime type and different types of FDI. The focus is on two of the three dimensions along which FDI can be decomposed: vertical vs. horizontal and greenfield vs. brownfield. Combinations of these two dimensions generate four different types of FDI: vertical-greenfield; horizontal-greenfield; vertical-brownfield; and horizontal-brownfield. All four combinations of FDI undoubtedly exist somewhere in the world, but certain combinations are likely to be more prevalent than others; different FDI types share some common features and yet also have their distinct attributes. These premises become the basis of our theoretical exploration and thus will be dealt with first below.

MNCs are complex governance institutions, and a strong theoretical framework that helps to explain their organizational behaviors is widely known as transaction cost economics (hereafter “TCE”) (Coase, 1937; Williamson, 1981; Williamson, 1985; Williamson, 1995; Williamson, 1996; Williamson, 2002). TCE helps to illuminate how corporations strategize their expansions through the different possible modes of entry. Before the advent of TCE, corporate behavior used to be viewed by many researchers as a black box and frequently characterized as little more than a “production function” (Williamson, 1985, p. 18), or a type of mechanistic formula that receives inputs and produces outputs. This overly simplistic view has given way to the more nuanced and sophisticated TCE perspective that encapsulates the types of corporate strategy in the literature on business management. We will apply some key elements of TCE to shed light on the relationship between democracy and different types of FDI.

The most important theoretical component of TCE that determines organizational structure is known as asset specificity (Williamson, 1985, p. 30). As suggested by the terminology, asset specificity refers to how specific, or specialized, a set of assets are to a business enterprise and whether or not they can be easily repurposed. An alternative way to think about this is how easily an asset can be reassigned to an alternative economic use. As an example, a fleet of commercial trucks can be easily reassigned to a number of different purposes, but specialized machinery designed to produce thin-film aluminum nitride substrates for high thermal electronics cannot be. According to TCE, more generalized assets and processes do not require a significant level of control over production. In fact, if the production process uses assets that are too general, it would probably be more efficient and cost effective to rely on the market with a large number of potential suppliers. In contrast, increasing complexity in a firm’s assets will lead to a need for further control over production. This is due to the high likelihood of economic opportunism of profit maximizing suppliers in the market and its resultant hold-up problem (Williamson, 1985).

Therefore, when asset specificity is sufficiently high, a firm will want to internalize production entirely through investment in a controlled subsidiary. Contracting out an important business process with high asset specificity will put a firm at a serious disadvantage vis-à-vis its suppliers, making it a potential hostage (Tan, Lyman, & Wisner, 2002). Even the share of equity ownership in a new enterprise is often positively correlated with its level of asset specificity (Delios & Beamish, 1999; Hennart, 1991). The need for vertical integration can become even more important in order to operate lean and minimize waste in supply chain management (Monczka & Morgan, 1996). Consequently, some scholars assume that vertical FDI typically comes in the form of greenfield investment with a substantial level of control over affiliates (Dikova & van Witteloostuijn, 2007; Hennart & Park, 1993).

Vertical and horizontal investments display certain patterns that have been observed by researchers. For starters, there are relatively higher levels of asset specificity associated with the intermediate goods that travel within global supply chains (Andersson & Fredriksson, 2000). For this reason, the literature has found evidence that vertical investment is more likely to be greenfield since it maximizes control over these specialized assets (Hennart & Park, 1993). In contrast, horizontal FDI often involves direct competition between firms, implying that there are substitute goods available in a market. The presence of substitute goods suggests that the assets are more common and generalized. Some scholars further suggest that on average, brownfield investment tends to be horizontal, as it often involves lower asset specificity and a relatively reduced need for control (Dikova & van Witteloostuijn, 2007; Delios & Beamish, 1999). Nevertheless, all four combinations of FDI are possible, and this article will investigate in greater depth how each type of investment interacts with the causal mechanisms suggested in the literature.

The Democratic Advantage from Positive Effects of Democracy

Before we move on, it is useful to provide some further clarification on the positive effect mechanisms of democracy, because they appear to be the most salient in the literature. Although there are both positive and negative causal mechanisms associated with democracies, many of those positive mechanisms promote all forms of FDl and thus create a set of democracy-specific advantages over autocratic governments. These advantages largely relate to stability and credibility in certain government economic policies.

Strong property rights protection in democracies is always a major policy attribute that MNCs prefer (Li & Resnick, 2003). However, property rights protection may prove to be more important with some modes of entry than others, which will be expanded upon in later sections of this article. Another important attribute of democratic regimes that consistently helps to attract FDI relates to policy stability through veto players (Jensen et al., 2012; Zheng, 2011). Policy stability is positively correlated with the number of policy veto players in a country (Tsebelis, 1995; Tsebelis, 2002); and democracies are known to have more veto players on average. Moreover, media openness also helps to attract FDI by making the public policy process more transparent and reducing uncertainty (Azemar & Desbordes, 2009; Choi & Samy, 2008). Business enterprises are averse to uncertainty, and they may refrain from investment in the presence of uncertainty about policy areas that they care about (Canes-Wrone & Park, 2012). In addition, democracies may have better growth prospects to make them attractive to both horizontal and vertical FDI (Doces, 2010). Finally, if labor benefits from higher wages paid by MNCs and thus support FDI, the median voter in democracy, who tends to be a worker, is more likely to support FDI and lobby for lower barriers to entry for MNCs (Jakobsen & de Soysa, 2006).

All in all, these causal mechanisms emphasize the importance of business-friendly policies, stability in public policy, and the creation of a hospitable atmosphere for FDI. Naturally, FDI of all combinations will find their way to countries that provide a business-friendly context for investment, and these positive facets of democracy do precisely that. Through the rest of the article, we will refer to this business-friendly context as the “democratic advantage.”

Two important caveats are worth noting. Although all foreign investors will benefit from the democratic advantage, the level of sensitivity to these benefits may vary across the four different types of FDI. In addition, the effects of the different negative causal mechanisms will also vary, most likely even more widely, among the different types of FDI. Given the significant variations, we will explore the democracy-FDI link for each type of investment individually. Ultimately, a MNC will have to engage in some sort of cost-benefit analysis to determine their optimal mode of entry. However, we believe that TCE can provide a strong theoretical basis for how such a calculation might occur.

Vertical-Greenfield Investment

The positive causal mechanisms associated with the democratic advantage will certainly be perceived as beneficial to those MNCs that are searching for a country to host vertical-greenfield investment. However, we propose that vertical-greenfield FDI will only moderately benefit from this package of positive mechanisms because of asset specificity and other features of this investment type.

Vertical-greenfield FDI is a component of a MNC’s supply chain. This high level of specialization will be associated with a high level of asset specificity that comes with an innate level of security (Frieden, 1994). Assets that cannot be easily liquidated or reassigned to a different purpose have substantially less value to another political or economic actor, and this difficulty in repurposing assets is what leads to increased security. As an example, a wholly owned subsidiary that makes wings for specific commercial aircraft is not a good target for expropriation by the host country. The subsidiary is not economically and operationally viable if it is nationalized and has to operate outside the global supply chain of the parent company.

This is not to say that these assets cannot become a potential bargaining chip with foreign political actors, since international politicking cannot be eliminated by global corporate supply chains—a critical insight of the Obsolescing Bargaining Model (Vernon, 1971). However, a MNC would be wise to call a host government’s bluff on nationalizing assets that would otherwise be largely worthless and simultaneously decrease the positive economic benefits associated with the firm’s activities. In this situation, obsolescing bargaining loses its theoretical relevance and evolves into a process of continual policy bargaining (Eden, Lenway, & Schuler, 2005). Furthermore, indirect expropriation through taxation can also be mitigated because a MNC can easily use accounting techniques like transfer pricing to shift income on paper (Hennart, 2010). Ultimately, a subsidiary that reports low profits on paper and does not have marketable assets is not a valuable target of expropriation, directly or indirectly.

In spite of such resilience even in the face of inferior property rights protection, vertical-greenfield investment will benefit, as most investment does, from certainty in policy, politics, and the broader economy. The capacity to have certainty in policy can mitigate perceived business risk, and this predictability makes choosing investment targets easier. Greater policy certainty, often associated with democracies, makes shareholders and executives more likely to commit to investing within democracies (Canes-Wrone & Park, 2012).

Sustainable economic growth, often associated with democracies, however, may not be as important to the profit-maximization of vertical-greenfield investors as to other types of FDI. For one reason, economic growth may push up the cost of labor and resources, reducing the profit margins of different firms. As an example, robust economic growth in the People’s Republic of China has seen an exodus of contract manufacturers to countries with relatively cheaper labor, such as Vietnam, Indonesia, and Bangladesh. Furthermore, the host country is probably not part of the MNC’s target market. If economic growth leads to increasing levels of purchasing power in a host country, this may lead to an increase in the price of industrial inputs. As a result, the causal effect of economic growth on vertical-greenfield FDI may prove to be counterproductive.

With respect to the various negative mechanisms of democracy, vertical-greenfield investment may have the capacity to mitigate many of these influences. Most importantly, vertical-greenfield investment will be shielded from antitrust regulation since this type of investment will not try to compete with local businesses and acquire industry market share in a foreign economy (Kwoka & White, 2008). Vertical-greenfield investment can effectively address government regulatory issues in this area because its features should not rouse the concerns of local businesses or disrupt market competition.

Similarly, vertical-greenfield investment will be shielded from the negative mechanisms associated with domestic protectionism. Since vertical-greenfield investment is less likely to seize market share from domestic enterprises in the host country, it will not be perceived as a threat by local businesses. Vertical-greenfield investment is simply part of a MNC’s supply chain. In all likelihood, vertical-greenfield investment may be celebrated as an expansion of the existing regional market that local businesses can sell products to and absorb productivity-enhancing spillovers from (Caves, 1974; De Mello, 1997). This increased connectivity between the MNCs and domestic firms will give a foreign MNC access to business partners that can further protect their investment (Johns & Wellhausen, 2016), and insulate MNCs from domestic political pressures. As a result, some of the negative causal mechanisms of democracy in relation to domestic protectionism tend to be mitigated by the subtle attributes of vertical-greenfield investment.

The primary concern of MNCs with vertical-greenfield investment may turn out to be simple factor endowments, such as cheaper labor and access to industrial inputs (Asiedu & Lien, 2011). Labor interests expect higher wage rates from foreign firms (Jakobsen & de Soysa, 2006), and labor costs are less likely to be repressed in democracies than in autocracies (O’Donnell, 1988; Resnick, 2001). And emerging market economies in democracies may not be able to provide sufficient economic freedom to attract foreign investors (Asiedu & Lien, 2011), which may further influence the cost of labor and materials in the host country. In contrast, autocracies are not as inhibited when it comes to offering financial incentives to foreign investors, potentially offsetting future losses in the event of expropriation. With respect to affordable labor, autocratic governments may bend organized labor to the benefit of a MNC by providing a more placated and cost-effective workforce (O’Donnell, 1988; Resnick, 2001). One salient example of this is the widely reported abuse of workers and poor working conditions at Taiwanese-owned Foxconn factories—the sole manufacturer of iPhones for a long time.

In sum, the theoretical discussion above suggests that the expectation regarding the link between regime type and vertical-greenfield FDI is not clear and unambiguous. On the one hand, less policy uncertainty in democracy, irrelevance of anti-trust regulation, and muted domestic opposition all make democracies more attractive to this type of investment. On the other hand, the reduced relevance of stronger democratic property rights protection, economic growth prospects, and the more likely use of labor repression and investment incentives in non-democracies, all make autocracies more attractive instead. All-in-all, the net effect of regime type on vertical-greenfield FDI becomes fairly ambiguous.

Proposition 1: MNCs are indifferent to regime type when engaging in vertical-greenfield FDI.

Vertical-Brownfield Investment

The different causal mechanisms from the literature will influence vertical-brownfield investment in ways that closely parallel vertical-greenfield investment. Vertical-brownfield investors will also be concerned with cost-reduction, reduced risk from stability on various policy fronts, and they will also have decreased sensitivity to property rights protection and host economic growth prospects. However, there are two theoretical deviations from vertical-greenfield investment that originate in antitrust policy and domestic protectionism.

The most important distinction between vertical-brownfield FDI and its greenfield cousin is that the former involves the potential acquisition of entire supply chains, potentially encountering antitrust regulation. Given that vertical investment displays higher levels of asset specificity, the likelihood that a firm will find a suitable acquisition target is usually low since the assets of interest have to be integrated into a preexisting supply chain. As a result, the rare instances of vertical-brownfield FDI will likely involve the acquisition of an entire supply chain, possibly stretching out over multiple countries; or it may be a byproduct of a merger of two MNCs. Because such a merger or acquisition often changes the pre-existing level of market competition and structure, antitrust regulation in the host country becomes relevant.

One important theoretical mechanism that distinguishes vertical-brownfield FDI from vertical-greenfield with respect to regime type is that democracies tend to have stronger anti-trust regulation than autocracies. More specifically, in democracies, vertical-brownfield will be subject to a host country’s antitrust regulatory regime (Kwoka & White, 2008). Yet, whether host antitrust regulation is a hurdle or not may depend on the prior presence of the MNC in the host: if the acquiring firm does not have operations in the host country and no market share, then antitrust regulation is not relevant; if the acquiring firm already has operations in the host, antitrust regulation could be relevant.

Compounding antitrust regulation may be additional issues involving labor and tax authorities in democracies. In the event that the acquiring firm has preexisting operations in the host country, it may attempt to consolidate the subsidiaries to reduce overhead costs after the acquisition (Conybeare, 2004). Layoffs from consolidation may lead to a backlash from the general population in the host country, and this may undermine the hospitality associated with the democratic advantage through multiple channels. First, organized labor may lobby elected officials to prevent the sale (Owen, 2013). Second, host country governments may become concerned about lost tax revenues. If a preexisting enterprise is combined with a newly acquired one, it could lead to tax base erosion in the host country due to lost income and payroll taxes. This tax base erosion may undermine welfare programs many voters in democracies depend upon. As a result, a foreign firm looking to acquire a business in a democratic host may face pressures from domestic protectionism and government bureaucrats. When the democratic advantage begins to weaken, autocracies may become more suitable targets for vertical-brownfield FDI.

Autocratic governments may not feel the same political pressures as democratic regimes do. Autocratic governments are often resistant to the preferences of organized labor (O’Donnell, 1988; Resnick, 2001). Furthermore, autocratic governments may not avidly implement and enforce antitrust policy for numerous reasons. First, the government is only accountable to a narrow ruling coalition and this will not necessarily include all domestic industries (Linz, 2000; Weeks, 2008). Second, policymakers in autocratic governments are likely to be more concerned with rent extraction from industry than competitive market practices. Third, the government is principally concerned with enriching the ruling coalition (Olson, 1993). Unless vertical-brownfield investment undermines the well-being of the ruling coalition, there may not be an institutional response to deter this category of FDI.

In sum, the theoretical mechanisms for vertical-brownfield FDI are very similar to vertical-greenfield, but they are less ambiguous when the foreign firm has preexisting operations in the host country. In the absence of any preexisting operations in the host, the causal links between regime type and vertical-brownfield FDI largely converge to those for vertical-greenfield FDI. However, in the presence of preexisting operations in the host, vertical-brownfield FDI may reduce market competition, cause business consolidation, and produce layoffs and loss of tax revenue. These effects will likely heighten antitrust regulation, increase domestic protectionism, and weaken public support for FDI in democracies, but not in autocracies. Hence, with preexisting operations in the host, vertical-brownfield FDI is more likely to favor autocratic investment destinations than democratic ones.

Proposition 2: MNCs are indifferent to regime type when engaging in vertical-brownfield FDI in countries where they do not already have operations.

Proposition 3: MNCs prefer more autocratic countries when engaging in vertical-brownfield FDI in countries where they already have operations.

Horizontal-Greenfield Investment

Due to its lower level of asset specificity, horizontal-greenfield FDI represents a substantially different mode of entry than either type of vertical investment that we have discussed. One central issue turns on asset specificity. Low asset specificity leads to assets that host governments can much more easily expropriate, such as automotive assembly line equipment. As a result, property rights protection and credible economic policies that are associated with the democratic advantage become significantly more important with this category of investment. In addition, because of the lack of a prior market presence, horizontal-greenfield investment avoids problems with antitrust policy (Kwoka & White, 2008). Thus, democratic regimes often appear to be the best candidates for this category of investment.

However, horizontal-greenfield FDI will encounter several problems with democratic hosts. When a MNC engages in horizontal-greenfield investment, starting from scratch, it may be perceived as an intrusive foreign competitor in the host country, fostering domestic protectionism (Ashraf et al., 2016; Li & Resnick, 2003; Pandya, 2013). In addition, competing domestic industries can more effectively lobby politicians in a democracy, using their policy access to create a hostile business atmosphere for horizontal-greenfield investors (Li & Resnick, 2003). In contrast, a horizontal-greenfield FDI affiliate does not have access to political and business networks that may prove critical to its economic survival (Hansen & Gwozdz, 2015; Henisz, 2000; Inkpen & Beamish, 1997; Meyer et al., 2009), making it vulnerable to the collusion of domestic economic actors with political leaders. In effect, political and economic actors in a foreign country may close ranks around the foreign MNC. When considering whether to engage in horizontal-greenfield FDI in a democracy, MNCs will need to consider seriously the magnitude of domestic opposition.

With respect to autocracies, domestic protectionism is not an issue unless there is a grievance from some member of the ruling coalition. However, MNCs face three large problems when evaluating these regimes for horizontal-greenfield FDI: political access, property rights protection, and lackluster economic growth. In contrast to democratic regimes, newly formed political and business networks may have little impact on autocratic governments. Autocracies must please narrower constituencies to maintain power (Weeks, 2008), and only the largest MNCs may have influence. In short, MNCs may often have to operate in a political environment that could be hostile on multiple dimensions. Moreover, slower economic growth under an autocratic government (Doces, 2010) may lead to lower profits over the long term.

In sum, relative to democracies, autocracies may be less profitable destinations for horizontal investment of all types and lack the necessary level of property rights protection to boot. If a MNC has to choose between an autocratic and a democratic country to engage in horizontal-greenfield investment, choosing a democracy is likely to be a better strategy for the firm. However, the benefits associated with the democratic advantage will be partially offset by policies and actions associated with strong domestic protectionism in these countries.

Proposition 4: MNCs have a weak preference for more democratic countries when engaging in horizontal-greenfield FDI.

Horizontal-Brownfield Investment

Horizontal-brownfield investment possesses the same level of low asset specificity as all forms of horizontal investment. Once again, this low level of asset specificity exposes horizontal-brownfield FDI to a heightened risk of expropriation that reinforces the importance of the positive causal mechanisms associated with the democratic advantage. Moreover, horizontal-brownfield FDI has some potential strengths in addressing issues related to the various forms of domestic protectionism in democratic nations.

The process of buying a foreign firm may invite less local hostility through the preexisting goodwill associated with the acquired firm (Estrin, Hughes, & Todd, 1997). As an example, in 1997, Walmart acquired two faltering retail chains in Germany: Wertkauf and Interspar. Many brownfield investments involve transposing the parent company’s business model onto the new subsidiary (Meyer & Estrin, 2001), and that is exactly what Walmart attempted to do (Kahn, 1999). However, German laws prevented Walmart’s initiative to pursue a low-margin American strategy, and Walmart later exited the German market (Fernie, Hahn, Gerhard, Pioch, & Arnold, 2006). In spite of this strategic blunder, Walmart had benefited from the brand equity of the acquired firms and was able to acquire and maintain market share in Germany for a time. Horizontal-brownfield investment can effectively help MNCs to gain goodwill in host countries.

Horizontal-brownfield investment may also allow a foreign MNC to further ameliorate problems associated with domestic protectionism via preexisting connections. After acquiring a host firm, the MNC can inherit the established political and business connections that can continue to insulate the business from policies associated with domestic protectionism and those that inhibit market efficiency. Preexisting access to political networks in a democracy may make it easier for the firm to lobby politicians for policies that are advantageous to the MNC. Moreover, preexisting access to local business networks may help to neutralize local firms from coordinating against the new arrival. Ultimately, horizontal-brownfield FDI may shield a MNC from protectionism associated with democracy; but this category of FDI will still have to operate according to the same government policies that other firms follow in the host country, and it will be subject to a strict regulatory review in accordance with a host country’s antitrust policies (Kwoka & White, 2008).

Antitrust policies in democracies can be a problematic area for horizontal-brownfield FDI, harming the flow of this type of investment. Horizontal-brownfield investment will almost always be subject to a strenuous review by government regulatory bodies to ensure that the acquisition will not lead to a monopoly or a monopsony (Li & Resnick, 2003). MNCs are commonly perceived by authorities as having monopolistic tendencies and being anticompetitive (e.g., Graham, 1996; Korten, 2001; Vernon, 1998). Furthermore, research has found that antitrust policy has produced a negative impact in foreign countries on inbound FDI by American MNCs (Evenett, 2002). Clearly, antitrust policy is a major hurdle for MNCs, but it is not insurmountable. There are numerous examples of major horizontal-brownfield FDI across different democracies, such as the one-hundred billion dollars acquisition of beverage giant, SABMiller, by Anheuser-Busch InBev SA in 2016. Economic globalization may be redefining how regulators perceive market share in democracies, leaving less room than before for autocratic regimes with respect to horizontal-brownfield investment.

Proposition 5: MNCs have a strong preference for more democratic countries when engaging in horizontal-brownfield FDI.

Summary of Theoretical Expectations

The theoretical discussion in the previous section has led to five propositions about regime type and different types of FDI. Table 2 below provides a summary of these expectations. Asset specificity is the key to understanding the top half of Table 2 and the relevant signs, whereas antitrust regulation and domestic pressures account for variations in the bottom half of the table.

As noted in Table 2, most positive causal mechanisms of democracy are influential across each type of FDI. In short, all combinations of FDI benefit from the democratic advantage under most circumstances. However, some of the positive mechanisms display double-positive signs to indicate the greater importance of the relevant mechanisms to those types of investment. More specifically, horizontal-greenfield and horizontal-brownfield FDI have lower asset specificity and reap greater returns from these positive causal mechanisms, hence the double-positive signs. Vertical-greenfield and vertical-brownfield FDI have higher asset specificity and receive positive, though relatively fewer, benefits from operating in more democratic environments, as illustrated by the negligible effect of growth prospects and the effect of property rights ranging from zero to some positive value. Also note how labor support, denoted by labor-oriented democratic politics, could vary for vertical-brownfield FDI.

Table 2. Effects of Regime Type on Different Combinations of FDI

Vertical

Horizontal

Causal Mechanism

Greenfield

Brownfield

Greenfield

Brownfield

1

Enhancing property rights protection

[0, +]

[0, +]

++

++

2

Enhancing policy stability via veto players

+

+

++

++

3

Providing better growth prospects

0

0

++

++

4

Providing more media openness

+

+

+

+

5

Reducing political and economic uncertainty

+

+

++

++

6

Labor-oriented democratic politics

+

+, 0

+

+

1

Stronger antitrust policies

0

0, −

0

2

Protectionism for domestic industry

0

0, −

0

3

Less generous incentive packages for investors

4

Less willingness to defend MNCs from domestic political pressures

0

5

Relatively less favoritism towards MNCs in resource rich democracies

0

6

Democratic LDCs unwilling or unable to offer economic freedom

0

Expected Preferences of FDI Investors

Democracy

Democracy

Democracy

Democracy

~

~

>>

Autocracy

Autocracy;

Autocracy

Autocracy

Autocracy

>

Democracy

Note: “++” indicates a strong positive effect of democracy; “+” indicates a positive effect of democracy; “−” indicates a negative effect of democracy; “0” implies regime type is irrelevant; “[0, +]” indicates a weakly positive effect; “+, 0 or 0, −” indicates two alternative effects; “~” indicates indifference; “>” indicates a preference; “≥” indicates a weak preference; and “>>” indicates a strong preference.

The negative causal mechanisms of democracy apply to the four FDI types differently. Antitrust regulation is important to the decision to build or buy. Yet vertical-greenfield and horizontal-greenfield FDI do not involve mergers and acquisitions, so these forms of investment are often not subject to antitrust review. The opposite can be said of brownfield FDI with preexisting operations in the host country. Both types of brownfield FDI do involve taking control of a host business enterprise and expanding their market share of the host economy. With respect to antitrust policy, government regulators can effectively block brownfield FDI, but this may be contingent on political as well as economic factors.

Domestic protectionism is a product of both investment attributes and political factors related to many of the other negative mechanisms in Table 2. All types of FDI may be subject to some level of protectionism, with three exceptions. In the first two exceptions, vertical-greenfield FDI does not pose any threat to the existing host domestic industry, and vertical-brownfield FDI, without preexisting operations in the host, does not cause any consolidation and layoffs, preventing retaliation from various actors in the host nation. In the third exception, horizontal-brownfield investment may be able to co-opt local businesses and take advantage of their political networks, thus neutralizing any domestic opposition. In contrast, vertical-brownfield FDI, with preexisting operations in the host, and horizontal-greenfield FDI may face greater opposition in more democratic countries.

Therefore, the cross-cutting causal mechanisms in Table 2 lead to a variety of outcomes, as depicted in the five theoretical propositions. Based on our theoretical framework, we have surmised that vertical-brownfield FDI, without preexisting operations in the host, and vertical-greenfield FDI are indifferent to regime type; in contrast, other forms of FDI investors have regime preferences. Firms engaging in vertical-brownfield FDI, with preexisting operations in the host, prefer autocracy over democracy, horizontal-greenfield investors weakly prefer democracy to autocracy, and horizontal-brownfield investors strongly prefer democracy to autocracy. Depending on the context, MNCs may have no regime preference, an autocratic preference, or a democratic preference when expanding their operations.

Conclusion

This article addresses the debate over the link between regime type and FDI theoretically. It first briefly reviewed the causal mechanisms in the literature, drawing on Li, Owen, and Mitchell (2016). A case was made that one solution to the situation of competing arguments and mixed evidence is to decompose aggregated but heterogeneous FDI into relatively distinct conceptual categories. A systematic account was then provided for how FDI can be decomposed primarily along two dimensions: greenfield vs. brownfield, and horizontal vs. vertical. Based on the notion of asset specificity, other investment attributes, and host domestic factors, five propositions were deduced on how regime type might affect four types of FDI.

Does the conceptual theory in this article close the book on which regime type is superior for attracting FDI? No. However, presented here is a coherent theoretical framework that reconciles competing arguments by specifying the conditions under which each mechanism is likely to be more or less important. Hence, as sharper predictions are made about which type of FDI is more or less likely to exhibit a regime type effect, this exercise provides a theoretical advance in the right direction.

The natural next step for researchers is to take this article’s theoretical predictions to task and subject them to empirical testing. Evidence is required in order to evaluate the empirical validity of these propositions. Propositions that are rejected by evidence shall be jettisoned or revised; propositions that are supported by evidence shall be kept and become the basis for further theoretical development.

Contributing to empirical international relations theory, this article offers one perspective on how to resolve scholarly debates on important questions: develop a more refined theoretical framework that reconciles existing arguments and generates sharper predictions than the existing literature, and then subject those predictions to empirical testing. The outcome is a more solid body of knowledge and a better understanding of problems of interest for both scholars and policymakers in international relations.

Acknowledgments

The authors would like to thank Erica Owen and William Thompson for their excellent feedback on an earlier draft of this article.

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