Politics, Instability, and International Investment Flows

We analyze the role of political instability for the organizational form of foreign investment, whether it takes the form of a majority- or minority-owned investment. We focus on the instability generated by the change of the party in power in a democratic system, rather than on the risk of changes of political regime or expropriation risk associated with this change. In majority-owned establishments, a foreign investor retains the control and enjoys fewer agency problems, while for minority-owned investments or joint ventures domestic partners of a foreign investor can lobby the government for preferential arrangements, such as firm-specific tax breaks. Political instability decreases the payoff to political connections in the future and decreases the attractiveness of minority-owned investments. The implications of our model are supported by empirical tests.