Abstract
It is often argued that capital should flow from aging industrialized economies to countries with fast-growing populations. However, institutional failures and the risk of expropriation substantially reduce developing economies’ attractiveness for foreign investors. We analyze the influence of a country’s demographic structure on international investment inflows, using a political economy model in which population growth potentially affects the risk of expropriation. We first explore how redistributive expropriation affects the welfare of different age groups and derive the government’s incentive to expropriate. We then analyze how the relative size of different generations influences the feasible volume of foreign investment.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Cole and English (1991) also discuss the possibility that the risk of expropriation can be reduced by increasing FDI. In that case, larger capital imports make the long-run cost more likely to outweigh the short-run gain of seizing foreign capital.
In a similar vein, Harms (2002) links the risk of expropriation to a conflict between old and young agents. However, that paper does not consider the effect of an alternating demographic structure. Moreover, the return to capital is constant, and international investment is driven by the goal to diversify country-specific risk.
It would, of course, be desirable to endogenize the population growth rate by relating it to a country’s prosperity and the volume of foreign investment. In this paper, however, our main goal is to analyze how an exogenous variation of n influences the risk of expropriation and the volume of FDI.
Note that this constraint reflects the assumption that there is no rivalry in consumption between young workers and their descendants.
The absence of international loans could, e.g., be rationalized by invoking agents’ inability to commit to a repayment of foreign loans and the resulting default risk.
In what follows, we will use the superscript H to denote variables that refer to domestic firms.
Note that, due to our assumption of a 100% depreciation rate, FDI in period t + j coincides with the capital stock in period t + j + 1. We will therefore use the two terms interchangeably.
The Appendix with this and all other proofs is available to authorized users as Electronic supplementary material on the journal’s homepage.
Note that, due to our assumption of a 100% rate of depreciation, there is no capital stock to be redistributed.
Note that there is no heterogeneity within generations. Hence, if we related the government’s decision to the median voter’s preferred policy, only the young generation would determine the policy outcome in a world with positive population growth. While this would simplify the analysis, it would eliminate the intergenerational distributional conflict which is at the heart of our model.
Note that the specification in Eq. 22 does not limit the model’s applicability to countries whose governments maximize their political support, but also allows to consider countries which are ruled by “myopic kleptocrats”. Suppose that a share ϕ of the proceeds from expropriation is evenly distributed among the population while the rest is kept by the ruler. Taking ϕ as exogenous for simplicity, the ruler chooses between expropriation and nonexpropriation to maximize the sum of his own utility from consumption (\(\ln c_{t+j}^{G}\)) and of his political support as represented by Eq. 22. Defining ν and (1 − ν) as the respective weights, the modified objective function would be written as \(V_{t+j} = \nu \ln c_{t+j}^{G} + (1-\nu) \left( N_{t+j} \right)^{\rho} \left[ \left( \frac{1}{1+n} \right)^{\rho}\ln c_{t+j}^{o} + U^y_{t+j} \right]\). It is intuitively clear that raising ν tilts the attractiveness of expropriation towards the old generation’s preferences. It thus has a similar effect as reducing ρ, i.e., the effective weight of young workers. Due to this analogy and since deciding on the size of the parameters ν and ϕ would be arbitrary we continue working with the specification in Eq. 22.
Hence, unlike Cole and English (1991), Thomas and Worrall (1994), Aguiar et al. (2009), and Aguiar and Amador (2009), we do not consider strategies that relate the current choices to the entire history of the game. Krusell et al. (1997) and, more recently, Klein et al. (2008) offer a discussion of Markov equilibria in dynamic models with endogenous policy. Forni (2005) applies this concept to an analysis of social security contributions.
The details are given in Appendix A.3 where Eqs. 31–33 describe consumption levels as a function of factor prices and transfers.
Of course, if we allowed ξ t + j + 1 to vary between 0 and 1, this strong result would not hold. In that case, foreigners might choose to set up firms in period t + j + 1 despite their anticipation of a “partial” expropriation, and the future value of ξ would possibly influence the government’s choice in period t + j.
Given the government’s binary choice and our assumption that it expropriates foreign firms if (and only if) this yields a strictly positive gain in political support, it is intuitive that expropriation never occurs in equilibrium: foreign investors would refrain from setting up firms in the domestic economy if they anticipated the total loss of their revenues. This, however, would leave the government indifferent between expropriation and nonexpropriation. While this reasoning excludes equilibrium in equilibrium, we will show below that the complete absence of foreign firms may be the only outcome that is compatible with a nonexpropriation equilibrium.
This can be seen in Eq. 49 in the Appendix.
If Assumption 1 is not satisfied, the logic behind this argument may be reversed: with a lower value of \(\left(1/(1+n)\right)^{\rho}\), young workers’ resistance against expropriation receives a lower weight relative to old workers’ support. As a consequence, the fact that the positive return effect increases in Ω may dominate and, for a given value of b t + j , the incentive to expropriate may increase in Ω. Note, however, that Assumption 1 defines a sufficient condition for the result established in Lemma 4. Hence this result may emerge even if Assumption 1 is violated.
In a classic paper, Barro et al. (1995) also demonstrate that, in the presence of credit constraints, capital accumulation in an economy that is de jure open to international capital flows resembles the dynamics of the closed-economy neoclassical growth model. In their model, however, the incentive to expropriate is taken as exogenous and a borrowing constraint results from the host country’s inability to use human capital as collateral.
Given the importance of α and A H/A F for the existence of a nonexpropriation equilibrium, we experimented with a wide range of other parameter constellations, keeping the values of n and β constant. It turned out that, for α ∈ {0.3, 0.6 }, a strictly positive volume of FDI is feasible for most values of A H/A F between 0 and 0.5. Conversely, nonexpropriation is only compatible with b t + j = 0 if α assumes very low (≤ 0.2) or very high values (≥ 0.9). Since neither α = 0.2 nor α = 0.9 are plausible, we claim that our results are not very sensitive to the choice of parameter values.
World Bank (2008) documents that, while FDI in low-income countries has picked up recently, the cross-country average of FDI net inflows relative to GDP between 1991 and 2006 was 1.97%.
Indeed, Alfaro et al. (2010) show that, in contrast to government aid flows and sovereign lending, the allocation puzzle does not hold with private capital flows.
To see this more clearly, we write domestic GDP as \(\widetilde{A}_{t+j} K_{t+j}^{\alpha} L_{t+j}^{1-\alpha}\) where \(K_{t+j} \equiv K^H_{t+j} + K^F_{t+j}\) is the total domestic capital stock, L t + j is the entire labor force, and \(\widetilde{A}_{t+j} \equiv A^H [(1+\Omega b_{t+j})/(1+b_{t+j})]^{\alpha}\) is a composite measure of TFP. The latter expression increases in the relative size of the foreign capital stock (b t + j ). Performing a standard growth-accounting exercise in such an economy, one would thus find a positive correlation between the growth of \(\widetilde{A}\) and FDI.
References
Aguiar M, Amador M (2009) Growth in the shadow of expropriation. NBER Working Paper 15194, NBER, Cambridge
Aguiar M, Amador M, Gopinath G (2009) Investment cycles and sovereign debt overhang. Rev Econ Stud 76(1):1–31
Alfaro L, Kalemli-Ozcan S, Volosovych V (2008) Why doesn’t capital flow from rich to poor countries? An empirical investigation. The Review of Economics and Statistics 90(2):347–368
Alfaro L, Kalemli-Ozcan S, Volosovych V (2010) International capital allocation, sovereign borrowing, and growth. Working Paper Harvard Business School, Boston
Amador M (2008) Sovereign debt and the tragedy of the commons. Unpublished Working Paper Stanford University, Stanford
Azzimonti M, Sarte PDG (2007) Barriers to foreign direct investment under political instability. Econ Q 93(3):287–315
Barro RJ, Mankiw GN, Sala-i-Martin X (1995) Capital mobility in neoclassical models of growth. Am Econ Rev 85(1):103–115
Bitzer J, Kerekes M (2008) Does foreign direct investment transfer technology across borders? New evidence. Econ Lett 100(3):355–358
Börsch-Supan A, Ludwig A, Winter J (2006) Aging, pension reform, capital flows: a multi-country simulation model. Economica 73(292):625–658
Brooks R (2003) Population aging and global capital flows in a parallel universe. IMF Staff Pap 50(2):200–221
Bulow JI, Rogoff K (1989) Sovereign debt: is to forgive to forget? Am Econ Rev 79(1):43–50
Cole HL, English WB (1991) Expropriation and direct investment. J Int Econ 30(3–4):201–227
Dreher A, Méon PG, Schneider F (2007) The devil is in the shadow: Do institutions affect income and productivity or only official income and official productivity. KOF Working paper 07-179, KOF Swiss Economic Institute, ETH Zürich
Eaton J, Fernandez R (1995) Sovereign debt. In: Grossman GM, Rogoff K (eds) Handbook of international economics, vol 3, chap 39, 1st edn. Elsevier, New York. pp 2031–2077
Eaton J, Gersovitz M (1984) A theory of expropriation and deviations from perfect capital mobility. Econ J 94(373):16–40
Forni L (2005) Social security as Markov equilibrium in OLG models. Rev Econ Dyn 8(1):178–194
Gollin D (2002) Getting Income Shares Right. J Polit Econ 110(2):458–474
Gourinchas PO, Jeanne O (2009) Capital Flows to developing countries: the allocation puzzle. Peterson Institute for International Economics Working Paper 09-12, IIE, Danvers
Hall RE, Jones CI (1999) Why do some countries produce so much more output per worker than others? Q J Econ 114(1):83–116
Harms P (2002) Poverty and Political Risk. Rev Int Econ 10(2):250–262
Haskel JE, Pereira SC, Slaughter MJ (2007) Does inward foreign direct investment boost the productivity of domestic firms? Rev Econ Stat 89(3):482–496
IMF (2004) How will demographic change affect the global economy? In: World economic outlook September 2004. International Monetary Fund, chap III, Washington. pp 137–180
Klein P, Krusell P, Rios-Rull JV (2008) Time-consistent public policy. Rev Econ Stud 75(3):789–808
Krusell P, Quadrini V, Rios-Rull JV (1997) Politico-economic equilibrium and economic growth. J Econ Dyn Control 21(1):243–272
Köse MA, Prasad ES, Terrones ME (2009) Does openness to international financial flows raise productivity growth? J Int Money Financ 28(4):554–580
Lucas RE (1990) Why doesn’t capital flow from rich to poor countries? Am Econ Rev 80(2):92–96
OECD (2008) International Migration Outlook: SOPEMI 2008. Paris
Reisen H (2000) Pensions, savings and capital flows: from ageing to emerging markets. Edward Elgar Publishing, Cheltenham
Solow RM (1956) A contribution to the theory of economic growth. Q J Econ 70(1):65–94
Sturzenegger F, Zettelmeyer J (2007) Debt defaults and lessons from a decade of crises. The MIT Press, Cambridge
Swan TW (1956) Economic growth and capital accumulation. Econ Rec 32(2):334–361
Thomas J, Worrall T (1994) Foreign direct investment and the risk of expropriation. Rev Econ Stud 61(1):81–108
United Nations Population Division (2008) World population prospects: the 2008 revision population database. New York
te Velde DW, Morrissey O (2003) Do workers in Africa get a wage premium if employed in firms owned by foreigners? J Afr Econ 12(1):41–73
World Bank (2008) Global development finance: the role of international banking. The World Bank Group, Washington, DC
Acknowledgements
This research project was sponsored by the German Research Foundation (DFG) whose financial support is gratefully acknowledged. We are indebted to two anonymous referees, whose comments and suggestions have helped to substantially improve the paper. Of course, we alone are responsible for all remaining errors.
Author information
Authors and Affiliations
Corresponding author
Additional information
Responsible editor: Alessandro Cigno
Electronic Supplementary Material
Below is the link to the electronic supplementary material.
Rights and permissions
About this article
Cite this article
Harms, P., an de Meulen, P. The demographics of expropriation risk. J Popul Econ 25, 809–832 (2012). https://doi.org/10.1007/s00148-011-0375-7
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s00148-011-0375-7