Determinants of foreign direct investment

Several factors determine foreign direct investments, including considerations of how much value such investments might have and the confidence that there will be no losses. These considerations are often contextualized as risks, and they mainly include financial and/or political risks.Footnote ¹¹ Higher levels of political and economic threats create a disincentive for foreign firms as they produce added costs to doing business in such a country.Footnote ¹² More recently, reputational risk has received increased attention for its growing potency in determining investment behavior, including reputational risks related to human rights and environmental concerns.Footnote ¹³ Scholars have categorized risks differently, but, generally speaking, economic and political risks tend to be the prime categories of factors found to influence FDI flow. The higher the risk in a country, the lower the amount of FDI it will host.

Economic risks deal with the economic performance of the host country, including risks associated with inflation, participation in international arrangements to resolve FDI disputes, and access to international credit.Footnote ¹⁴ Moreover, some works find that economic risk assessment tends to be the strongest predictor of inward FDI stock. Economic forces in a host country can weigh negatively on the fortunes of a foreign investor.Footnote ¹⁵

There is usually an interplay between economic and political risks in determining whether to invest or how much to invest in a host country. Political risks include the likelihood that the FDI host nation will take political actions or experience political problems that will affect FDI fortunes.Footnote ¹⁶ They also include more detailed considerations like the transparency of institutions, the ability of firms to influence government policy, the stability of government policy, and the government's ability to expropriate FDI assets.Footnote ¹⁷ Ekpenyong and Umoren point to the need to consider a more extensive range of factors that could influence political risk, defining political risk as events that have a destabilizing effect on the ability of enterprises to function in a polity.Footnote ¹⁸ This includes political violence, inconsistency in political alignment, and shifts in the power balance among political parties. One can summarize political risks as involving changes in political forces and events, where the assessment of the host country is conditioned on uncertainty about the actions of government, political institutions, minority groups, and even separatist movements.Footnote ¹⁹ Sometimes, aside from the usual institutional characteristics that predict risk in the host country, investors depend on surveys by political risk analysts, risk insurance brokers, and business leaders to gauge a country's political risk.Footnote ²⁰ Once investments have been made, the investors are at the mercy of the host government. Political instability and the fear of expropriation can alter the interests of foreign investors and motivate their reluctance to move their capital into a potential host country.Footnote ²¹

Much research shows that political risks significantly affect investments when it comes to developing countries. It has been established that foreign firms and, by extension, foreign investors prefer their host countries to be free of armed violence and tend to show a preference for institutional arrangements that reduce the likelihood of unpredictable policies and risks.Footnote ²² These factors may include the level of protection of property rights and the rule of lawFootnote ²³ and the host country's judicial system. Justice institutions are argued to be of particular importance for foreign firms from countries where these rights are well established or where the judicial system, for instance, enjoys independence from government interference.Footnote ²⁴ In a study of French firms, Corcos et al. argue that stable justice institutions are essential factors considered even in trade within firms.Footnote ²⁵ They represent a significant predictor of intrafirm trade, a significant component of FDI.

Researchers have historically debated the importance of political risks in FDI flow.Footnote ²⁶ Not everyone agrees that these factors matter when it comes to the flow of inward FDI. Research has pointed to how economic factors such as market size, access to credit, and so on, tend to be the strongest predictors of FDI flow, explaining the gap in the amount of FDI hosted in industrialized countries compared to developing countries.Footnote ²⁷ Some economic-focused research has found that political factors, such as government failure, do not influence FDI.Footnote ²⁸ Others have argued that political considerations are second-order determinants of FDI as economic considerations remain the prime explanations for foreign direct investments.Footnote ²⁹ In a study of FDI in Africa, Asiedu finds that while the usual economic factors like natural resources, market size, and inflation remain prime predictors of FDI, political and legal institutions and policies in the host government have similar effects, with corruption and political instability dissuading foreign investment.Footnote ³⁰

Research has shown that political risks are stronger predictors of FDI flow in emerging economies than in industrialized countries and that such risks have increased in recent years.Footnote ³¹ Lucas points to political risk as the primary reason for the FDI gap between industrialized and developing countries, despite the potential for significant marginal returns in developing countries.Footnote ³² Regionally focused research on FDI flows to the Middle East and North African countries has also found political risk factors to be significant determinants of differences in FDI attractiveness across countries.Footnote ³³ Some have called for a more conditional approach to political risks, such as political violence. Li, Murshed, and Tanna point out that while economic factors are the strongest predictors of FDI flows, the impact of political factors is uneven across sectors, as FDI flows to extractive sectors are most unlikely to be affected by armed conflicts.Footnote ³⁴

The costs of divesting from a host country can dissuade investors from involving themselves in countries with domestic issues like political violence. However, although divestment comes with some costs to investors,Footnote ³⁵ doing business in conflict-torn countries may come at a higher financial or even reputational cost. Material costs can be incurred as a result of attacks on infrastructure in these countries.Footnote ³⁶ Investors can also face criticism from the international community for doing business with a country that is in active civil conflict.Footnote ³⁷

Evidence of the state losing ground as well as legitimacy is detrimental to investor confidence. With uncertainty regarding the government's capabilities, a potential loss of future investment opportunities if the rebels win, and any risk of conflict renewal,Footnote ³⁸ foreign businesses are pressured to reassess their decision to remain in the host country. Most of this research assumes the need for foreign investors to find a safe investing environment. However, this precondition is challenged when investors engage in risky investment behavior. For example, Kolstad and Wiig write that increasing Chinese investments have been finding their way into unstable and natural resource-rich African countries, further destabilizing these regions.Footnote ³⁹ However, by understanding that risks are constantly juxtaposed with benefits in investment decisions, one can get a clear picture of how the relationship between risks and investments is conditioned on potential benefits.Footnote ⁴⁰

While foreign firms face risks in nonconflict states, such risks are particularly prevalent in war-torn countries and conditioned by conflict-specific factors. In cases of civil war, we argue that one particular conflict characteristic that foreign investors should consider when determining a state's risk is the military strength of the government compared to the rebel movements it is at war with. This conflict feature can impact a foreign firm's confidence in the strength of the government it partners with. Next, we theorize how the balance of power between rebels and a government affects the investment decisions made by foreign businesses in a conflict state.

The risks associated with increasing rebel capabilities for foreign investors

FDI can serve as a crucial avenue for development and postconflict recovery in high-risk countries. Extensive research has demonstrated that foreign investments contribute to economic growth, both directly and indirectly. Countries grappling with armed conflict often require economic growth as they rebuild in the aftermath of turmoil, leading them to incentivize and attract foreign investors.Footnote ⁴¹ However, growth in the military capability of rebel groups could mean more intense conflict, which is linked to reduced economic growth. This could be through pathways that reduce public and private investment in the country experiencing conflict.Footnote ⁴² It is important to consider the extent to which these dynamics affect FDI.

The extant literature on FDI shows mixed findings on the relationship between armed conflict and FDI. Many works point out that foreign investors face significant risks in areas impacted by conflict and violence.Footnote ⁴³ However, there is evidence that these concerns can be alleviated by strong state capacity, stable institutions, and military expenditure.Footnote ⁴⁴ While studies have shown that the unique attributes of the state are important for explaining FDI,Footnote ⁴⁵ research has yet to consider the role of rebels in shaping the views held by foreign investors regarding the strength and stability of a government during conflict. Rebel groups vary in terms of their characteristics, including their military strength relative to the government, which can impact the conflict and war outcomes.Footnote ⁴⁶ As stated by Clayton, “the absolute strength of a belligerent is less important than their strength in relation to their opponent.”Footnote ⁴⁷ While we agree that government strength matters to foreign investors, we rely on the literature on FDI and civil conflict and argue that foreign investors consider whether the government is militarily stronger relative to the rebels that it is in conflict with and not just the overall military strength of a government. The power dynamics between warring parties can affect the environment of the conflict country and as a result, impact the investment choices of foreign firms.

The reduction in FDI levels can occur through two pathways. First, it can happen as a result of relatively higher rates of divestment, as foreign firms withdraw their investments from a country. Divestment can be driven by a variety of factors, such as increased risks, political instability, unfavorable economic conditions, or concerns about the business environment. Research has shown that a deconstruction of firm-level decisions on disinvestment and decisions about how much to invest are not equally affected by political risks.Footnote ⁴⁸ Unlike the decision to invest, withdrawing investment is more complex; foreign firms are at the mercy of the host government, and they are forced to be less responsive to political changes. Divestment could mean the loss of capital for some of these firms as FDI is less movable.Footnote ⁴⁹ Firms that have already invested in the country might find it more difficult to exit the host government as a response to the political climate, and they tend to have a higher tolerance for political risks. However, they are still more likely to withdraw investment as political risks increase.Footnote ⁵⁰

Second, lower FDI levels can also result from relatively lower rates of new investment, as foreign firms become hesitant to make further investments in a particular country. This hesitation can stem from factors such as uncertain economic prospects, unfavorable government policies, regulatory barriers, or lack of confidence in the business climate. Countries may be forced to reevaluate their decision to enter a host country that presents risks and uncertainties. This is the more sensitive pathway as the current political situation is considered.Footnote ⁵¹ Foreign investors thus assess the features of a potential market and make investment decisions based on the host country's climate, understanding that withdrawals will be difficult once investments are made. Amid an uncertain political environment in a potential host state, investors may be reluctant to move capital there. This may result in a reduction in the level of FDI.

In our theory, we consider both pathways—divestment and reduced new investment—as potential factors contributing to the lower levels of FDI observed. By examining these two pathways, we aim to comprehensively understand how the balance of power in conflict influences FDI and its variations across conflict zones. The reduction in the volume of FDI could result from a reduction in the amount of new foreign investments coming into the host government. It could also be a result of an increase in the exit or withdrawal of foreign investors or firms from a host country. It is thus important to address how the power dynamics of the conflict affect the decision to withdraw investment, as well the incentives to invest in a host country that is already experiencing armed conflict.Footnote ⁵²

As pointed out by Li and Resnick, firms withdraw from areas where the costs of investment are high because of the risks they face.Footnote ⁵³ We propose that the military capabilities of rebels relative to the government can create several concerns for foreign firms if the balance of power is tilted away from the government. First, rebel organizations that have a military advantage over the government can reveal the state's weakness in preventing its opponent from mobilizing and expanding its territorial control.Footnote ⁵⁴ A shift in the balance of power between rebels and government forces in favor of rebels benefits the latter in that the rebels are able to gain control over territory, resources, and access to new recruits.Footnote ⁵⁵ However, such shifts also suggest that state capacity is diminishing. As the literature has highlighted, a decline in government strength can send a negative signal to investors, influencing their decisions as to whether they should continue investing in the country.Footnote ⁵⁶ While conflict itself creates a risky environment for foreign firms,Footnote ⁵⁷ a government that is militarily weak relative to its enemy may create additional political and economic risks for investors, including enforcement of contracts and property rights.Footnote ⁵⁸ Although a state's military power can help minimize these risks, this can change if a government faces strong rebels. Such governments must redirect their resources to deter the opposition from becoming even stronger, making it more difficult for investors to remain in the country.

Second, rebels with higher military capabilities relative to the government can pose security issues for investors. Governments that are challenged by rebels that have a military advantage are forced to allocate their available resources to fight their opponent. As a consequence, this affects their capacity to provide protection for local populations and businesses, including foreign firms and the individuals they employ, leaving them exposed to violence. Not only does this impact the personal security of investors and their workers, but it can also influence production and the ability of a foreign firm to make a profit.Footnote ⁵⁹ Though some businesses may have the capacity to use their own capital to attain private security, not all investors have the means to do so. A decline in security measures by the state for foreign firms results in unexpected costs for investors and takes away from any earnings they may have gained while operating in the country.

Furthermore, the relative strength of a rebel group can influence the outcome of a conflict. States in conflict that have strong militaries are expected to pursue military victory as opposed to negotiating a deal with their opponent.Footnote ⁶⁰ Stronger insurgents, on the other hand, are able to survive the costs of continued fighting and, as a result, threaten a government's ability to stay in power.Footnote ⁶¹ This can raise the costs of the conflict and lead to more violence and destruction of infrastructure.Footnote ⁶² While governments that face rebels with higher military capabilities are more likely to agree to mediationFootnote ⁶³ and offer concessionsFootnote ⁶⁴ to avoid a possible rebel victory, the bargaining position of stronger rebels can prolong conflict as they try to obtain additional concessions or further increase their power capabilities to defeat the government.Footnote ⁶⁵ With little clarity as to how the conflict will end, foreign firms can become discouraged from maintaining their investments in the state.

Additionally, as noted by Lee, “foreign investors are both backward-looking and forward-looking.”Footnote ⁶⁶ We therefore expect that increasing rebel strength and a potential rebel victory can raise concerns over future contract commitments for investors. Although it is difficult for investors to predict shifts in the fighting capabilities of conflict actors, any advancements in rebel military strength can put foreign investors in a difficult position. While a foreign firm may be familiar with the government in power and its business expectations and policies, the policy preferences of rebel groups will be less clear to foreign investors. If rebels were to defeat the government and win the conflict, it would be unknown to investors whether future contracts with the state would resume or remain credible given the likelihood of the state's institutions and policies changing.Footnote ⁶⁷ To avoid having their capital and property affected if rebels were to achieve military victory, a foreign investor may find it beneficial to reduce their investments from a country on their own before they are forced out if the rebels are uninterested in maintaining ties with them.

Lastly, another factor that foreign investors consider when determining whether they should continue their investment in a country where rebels have stronger military capabilities relative to the government is the possibility of conflict reoccurrence.Footnote ⁶⁸ While findings on the relationship between conflict outcomes and postconflict stability are mixed,Footnote ⁶⁹ some studies show that conflict reoccurrence is less likely if government forces achieve victory in comparison to a rebel defeat.Footnote ⁷⁰ In situations in which conflict renewal is likely to occur, the confidence of firms in seeing any possible future stability may be affected.Footnote ⁷¹ As a response, they may try to withdraw from the country to avoid getting entangled in the dynamics and consequences of a renewed conflict that could be more violent and costly than the previous one.

Our analysis considers the level of FDI inflow in the host country, and it does not differentiate between the withdrawal of FDI and the inflow of new investments. However, based on the mechanisms for both pathways considered earlier, we propose the following hypothesis:

Research design

In this study, we seek to examine the effect of the relative military capabilities of rebel movements to government forces on FDI in intrastate conflicts. To determine the appropriate cases to use in our sample, we rely on data from the Uppsala Conflict Data Program (UCDP) Dyadic dataset v. 20.1.Footnote ⁷² Looking at civil wars during the period 1989–2009, our sample includes a total of 625 country-year cases.Footnote ⁷³

Empirical analysis and discussion

Examining all civil conflicts that occurred between 1989 and 2009, we test the effect of relative rebel capabilities on foreign investment.Footnote ⁹¹ We estimate two models: one baseline model without control variables, to avoid introducing any bias (Model 1),Footnote ⁹² and a model that includes the control variables discussed in the previous section (Model 2). The results for these models are presented in Table 1. As shown in Table 1, our Relative Rebel Strength variable is negative and achieves statistical significance in both Models 1 and 2. In looking at the results of Model 1, our baseline model, the results indicate that a 1 percent increase in Relative Rebel Strength is associated with a 1.024 percent decrease in FDI inflows. As shown in Model 2, the effect that the relative strength of rebel groups has on FDI inflows becomes slightly smaller once we include our control variables in the model. Nevertheless, the findings show that foreign investors react to the military strength of rebel movements. Specifically, the coefficient for Relative Rebel Strength suggests that a 1 percent increase in rebel capabilities relative to the government results in a 0.853 percent decrease in FDI inflows. These findings yield support for our theoretical expectations that conflict-affected countries receive less investment from foreign firms as the military strength of rebels relative to government forces becomes stronger. Increasing rebel capabilities creates uncertainty for investors regarding the stability of the conflict environment and conflict outcomes and thus, discourages them from making investments in the state.

Table 1. Effect of relative rebel military capabilities on FDI

Note: Standard errors in parentheses.

* p < .1; ** p < .05; *** p < .01.

Using the results of Model 2, we calculate the predicted amounts of FDI inflow across different levels of relative rebel capabilities to illustrate the substantive effects of the balance of power between government forces and rebels on FDI.Footnote ⁹³ These values are presented in Figure 1. As shown in the graph, when rebels are at parity with government forces (level 0), FDI inflows in the country are $3,639,948. However, in situations in which rebel movements are much stronger than the government (level 2), states receive $660,333 in FDI, a decrease of $2,979,615. This suggests that advances in military strength by rebels over state forces has reducing effects on foreign investments coming into a country.

Figure 1. Predicted FDI inflows across different levels of relative rebel capabilities.

Note: number of cases within parentheses*

Turning to the control variables included in Model 2, Size of Conflict Zone surprisingly has a positive and significant coefficient, suggesting that foreign investors are not necessarily deterred from countries where large amounts of territory are impacted by conflict. Larger conflict zones may be linked to larger countries having more territory. Further research will have to deconstruct what the expansion of conflict areas could mean for FDI and investors’ assessments of the country experiencing conflict. The duration of conflict also has a positive and significant relationship with FDI inflows. As found by and Buhaug, Gates, and Lujala and by Cunningham, Gleditsch, and Salehyan, weaker rebels are associated with longer conflicts.Footnote ⁹⁴ An argument can be made that foreign firms continue to operate in countries experiencing longer wars if rebels are weak. With respect to the country-specific variables we account for in our analysis, Troop Quality is positive and significant. As anticipated, investors are drawn to countries that have better equipped militaries which can be used to provide protection for them and their assets. Another factor that is positive and achieves statistical significance is Judicial Quality. Consistent with findings in extant literature on FDI, these results suggest that states that practice judicial independence are able to signal the presence of stronger political institutions and as a result, receive more foreign investment.

Robustness checks

There is a significant debate in the literature on FDI regarding measurement of foreign investment in a country.Footnote ⁹⁵ To address concerns regarding the appropriate measure of FDI to use and confirm the robustness of our findings, we estimate additional models using alternative measures of FDI. We first consider FDI as a percentage of a country's GDP and present the results in Table 2. Consistent with the findings of our main analyses, Relative Rebel Strength has a negative coefficient and holds statistical significance. An additional model is conducted using FDI stocks as the dependent variable. As portrayed in Table 3, this alternative measurement of FDI is in the negative direction and significant, providing additional confidence in our argument that the relative power capabilities of warring parties influence how attractive a country is to foreign firms.Footnote ⁹⁶

Table 2. Effect of relative rebel military capabilities on FDI (using FDI/GDP)

Note: Standard errors in parentheses.

* p < .1; ** p < .05; *** p < .01.

Table 3. Effect of relative rebel military capabilities on FDI (using FDI stocks)

Note: Standard errors in parentheses.

* p < .1; ** p < .05; *** p < .01.