The Impact of Political Risk on Foreign Direct Investment

Abstract

Even though other forms of risk, such as economic risk and financial risk have been studied quite extensively, political risk has not received much attention owing primarily to lack of data. Among other components of country risk, political risk is more critical in importance and more multifaceted in impact, becoming more prominent especially in developing countries. It’s that reason why our first task is to include the political risk and some of its components that are found to be significant in the empirical studies in the evaluation of FDI, and not only the level of political risk but also its changes over time. Regarding the effects of political risk on FDI inflow, this paper shows the multitude of ways by which the different expressions of political risk may influence both positively and negatively the value of investment opportunities and the decisions of firms to invest. This paper looks at the effect of political risk on FDI by using a systematic approach of factor analysis, in reducing the number of variables into their underlying factors and then generating factor scores. Then it uses a panel regression approach combined with factor analysis to examine the relationship, and which particular aspect of political risk contributes more towards deterring FDI inflow. Similar to most studies in the empirical literature on FDI flows, the logarithm for investment flows and the independent variables is used.

“Capital is a coward. It doesn’t go where it perceives danger” –Anonymous investor in Zimbabwe, 10 May 2010