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Foreign Direct Investment and the Risk of Expropriation
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1994
Year
EconomicsTransnational CorporationTransnational Company DeclineInternational FinanceInternational Capital MarketTransnational CompanyTradeInternational InvestmentManagementBusinessCommercial PolicyPolitical RiskInternational RiskOptimal ContractingInternational BusinessFinanceForeign Direct Investment
Investors face expropriation risk because international contracts are unenforceable, so host countries must design self‑enforcing agreements that balance short‑term expropriation incentives against long‑term investment attraction, shaping contract types. The study extends prior work on investment underprovision under incomplete contracts to a dynamic setting. The model incorporates capital accumulation and examines renegotiation‑proof contracts. Investment is initially underprovided but rises over time, reaching efficient levels for certain parameter values.
When an investor, for example a transnational corporation, invests abroad it runs the risk that its investment will be expropriated for the simple reason that international contracts are practically impossible to enforce. Any agreements or contracts then undertaken by the transnational company and the host country must be designed to be self-enforcing. It could be possible for the host country and the transnational corporation to find such self-enforcing agreements if there are future gains from trade. Thus although the host country might have a short-term incentive to expropriate, it has a long-term incentive to foster good relations with potential investors to attract more investment in the future. This conflict between short-term and long-term incentives determines the type of investment contracts agreed. This paper extends previous work on the general underprovision of investment when contracts are incomplete or only partially enforceable (see e.g. Grout (1984)) to a dynamic context. It is likewise shown that investment is initially underprovided but it increases over time and for certain parameter values it tends to the efficient level. The expected future discounted returns to the transnational company decline over time, extending Vernon's observation of the obsolescing bargain (Vernon (1971)). The model is also extended to allow for capital accumulation and consideration is given to renegotiation-proof contracts.