Explaining missing capital flows: The case of foreign direct investment

A persistent puzzle in political economy is the lack of capital flows to developing countries. I ask the following: Does an increase in the level of democracy attract foreign direct investment inflows for developing countries? This paper explains this puzzle by relying on a theory of factor endowments that explains that FDI into developing countries has been low because the foreign capital competes with the scarce factor, the domestic capital, which is owned by the policy controlling autocrat. Changes in the international system, such as the end of the Cold War, offer natural experiments to see if external pressure to develop democracy yields increasing FDI for developing countries. To test this theory a dynamic panel data generalized method of moments estimator shows that when the change in democracy is exogenous the change in FDI due to a one point change in democracy is about {dollar}200 million and when it is an endogenous regressor the increase in FDI from a one point change in democracy is about {dollar}975 million.