Abstract
We develop a formal model that looks at the mutually endogenous determination of foreign direct investments in the extraction of natural resources, at the decision of host governments to expropriate these investments, and at the level of corruption. Higher investments in resource extraction make expropriation more attractive from the perspective of national governments. A low expropriation risk is in turn an important determinant of international investments and is therefore associated with high levels of resources extraction. Moreover, investments in the resource sector also raise corruption. Our theoretical predictions are confirmed by estimations of a simultaneous equation model in which we endogenize expropriation risk, corruption, and resource extraction.
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Notes
Historically, resource-rich countries participated very little in the gains from their resources (Venn 1986; Yergin 1991). It is not surprising that this often led to fierce conflicts about revenue sharing, waves of expropriation, and to the creation of state-owned companies especially after de-colonization (see Bremmer and Johnston 2009; Hendrix and Noland 2014; Hogan et al. 2010, or Tomz and Wright 2010).
Of course, it could also be that firms are not able to commit to their part of the contract and renege on their investment or tax obligations (Guriev et al. 2011). In fact, charging firms with not fulfilling their obligations is often used as an argument for expropriation. We abstract from this complication here and assume that firms always fulfill their part of the contract.
It should be mentioned that we do not consider state owned enterprises that may also be important players in resource extraction in some countries but only look at international private investors and their risk of expropriation.
Alternatively, one may assume that bureaucrats appropriate a share of expected revenues, e.g. \((\tau -1)E[p]Q\) with E[p] denoting the ex ante expected value of the resource price. Our theoretical results would not change qualitatively using this formulation. Since we match the quantities of extracted resources with the quality of institutions in our empirical analysis, we prefer the formulation here.
As some of the examples mentioned in the introduction show, expropriation in the real world is not that clear-cut and may also occur via renegotiation of revenue sharing agreements or through tax hikes. In such a situation, governments expropriate firms only partially, and no clear-cut line can be drawn between expropriation and taxation. We abstract from this complication and focus on full expropriation only in our model.
Alternatively, and without changing the central findings of our model, one could assume a fixed compensation payment f from the expropriating government to the international firm.
Taking the derivative of the third term in (6) yields \(-f \tilde{p}g( \tilde{p})/Q^2-fk_{i}\frac{\partial (\tilde{p}g(\tilde{p}))}{\partial Q} /Q^{2}+2fk_{i}\tilde{p}g(\tilde{p})/Q^{3}\). In equilibrium \(k_i=Q/n\), such that the derivative can be written as \(-f \tilde{p}g( \tilde{p})/Q^2-f\frac{\partial (\tilde{p}g(\tilde{p}))}{\partial Q} /(nQ)+2f\tilde{p}g(\tilde{p})/(nQ^2)\). For a large enough n, the second and third term in this expression become very small such that the whole derivative is negative.
This can be seen by taking the derivative \(\partial [\cdot ]/\partial \tilde{p}=\tilde{p}g(\tilde{p})\frac{n-2}{n}-\frac{\tilde{p}^{2}g^{\prime }( \tilde{p})}{n}\) in (7). This derivative is positive for \(n>2\) and \(g^{\prime }(\tilde{p})\le 0\). For \(g^{\prime }(\tilde{p})>0\), the derivative is monotonically increasing in n and positive for \(n\rightarrow \infty\). The term \([\cdot ]\) itself is also monotonically increasing in n and positive for \(n\rightarrow \infty\).
According to IMF (2010, 2012) a country is resource-rich if its natural resources contribute to at least 20% of its total fiscal revenues and/or at least 20% of its total exports. Moreover, data in IMF (2012) is averaged from 2006 to 2010 whereas the corresponding data from IMF (2010) is averaged from 2000 to 2007. From both values we calculate a simple unweighted average of the respective indicator.
The minerals included are bauxite, copper, lead, nickel, phosphate, tin, zinc, iron, gold, and silver.
These costs are still country-specific primarily due to the countries’ geographical characteristics.
Theoretical works supporting this line of argument include, e.g., Bartolini and Drazen (1997), Narvaz (2013). Alzer and Dadasov (2013) empirically show that de jure financial openness improves institution quality by reducing expropriation risks, and Levchenko (2013) shows the positive effect of trade integration for institutional quality.
We construct an aggregate index (instead of relying on a single one) in order to reduce measurement errors which might be associated with individual indices and, in particular, to obtain a comprehensive indicator that includes both trade and financial openness.
Note that our theoretical model focuses on the investment decision of foreign investors whereas the data on the extraction volume considers resource extraction by domestic and foreign investors. Since parts of declining foreign investments can be substituted by domestic activities of the state or private investors, the relationship between foreign investment and expropriation risk may be even tighter than the one suggested by our results.
We owe this observation to a referee.
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We are grateful to our referees for very helpful and constructive comments. We would also like to thank Philipp Harms and workshop participants for their suggestions.
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Dadasov, R., Hefeker, C. & Lorz, O. Natural resource extraction, corruption, and expropriation. Rev World Econ 153, 809–832 (2017). https://doi.org/10.1007/s10290-017-0288-y
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DOI: https://doi.org/10.1007/s10290-017-0288-y