FDI Inflows Under Expropriation Risk: Can Pro-Business Policies Overcome Investor Aversion?

Abstract

Risk of expropriation in developing countries is an impediment to attracting foreign direct investment (FDI). This risk is often closely tied to the institutional setup of governance in host countries. While reforming institutions to reduce the risk of asset requisition requires political consent and long-term effort, the acute need for investment in developing nations demands urgent solutions. Developing countries attempt to overcome the adverse effects of this risk by introducing pro- business policies such as domestic and capital control tax incentives. This paper examines the scope of such a policy mix to pull in FDI in this context. Using a continuous-time stochastic framework that accommodates multiple variables and their interconnections, it concludes that reducing the cost of doing business has only limited efficacy under restricted conditions. Institutional reform that inspires investor confidence thus cannot be avoided.