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The demographics of expropriation risk

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.

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Notes

  1. See, e.g., Lucas (1990), Reisen (2000), Brooks (2003), IMF (2004), and Börsch-Supan et al. (2006).

  2. For a discussion of this argument in the context of international borrowing and lending, see Bulow and Rogoff (1989) and Amador (2008).

  3. 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.

  4. 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.

  5. 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.

  6. Note that this constraint reflects the assumption that there is no rivalry in consumption between young workers and their descendants.

  7. 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.

  8. In what follows, we will use the superscript H to denote variables that refer to domestic firms.

  9. Note that we abstract from the possibility that the presence of foreign firms raises TFP of domestic firms (see, e.g., Haskel et al. 2007 and Bitzer and Kerekes 2008).

  10. 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.

  11. The Appendix with this and all other proofs is available to authorized users as Electronic supplementary material on the journal’s homepage.

  12. Note that, due to our assumption of a 100% rate of depreciation, there is no capital stock to be redistributed.

  13. 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.

  14. 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.

  15. 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.

  16. The details are given in Appendix A.3 where Eqs. 31–33 describe consumption levels as a function of factor prices and transfers.

  17. 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.

  18. 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.

  19. This can be seen in Eq. 49 in the Appendix.

  20. 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.

  21. 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.

  22. 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.

  23. 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%.

  24. 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.

  25. 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.

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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.

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Correspondence to Philipp Harms.

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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

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Keywords

  • International investment
  • Political economy
  • Demographics

JEL Classification

  • F21
  • D78
  • J10