The effect of military expenditure on FDI inflows: conflicting vs non-conflicting countries

Foreign Direct Investment (FDI) is seen by policy-makers as a tool to support development, increase productivity and advance technology in developing and emerging economies. However, to attract a decent flow of FDI, a country must maintain peace and stability. A country with higher political instability is more likely to receive lower FDI than a country with lower political instability. As shown in Figure 1 below, Africa, which is the most conflict-prone region in the world, is the smallest receiver of FDI whereas Europe, North America, China and most Asian countries that are safe from major armed conflict, are amongst the highest receivers of FDI in the world.

Figure 1: Stock of Foreign Direct Investment, 2010 (US$ billions). Source: Feenstra and Taylor (2014). Note: The thickest lines represent the largest stock of FDI.

A common policy response to curtail conflict and unrest in a country is to increase military expenditure. The increase in military expenditure, however, entails opportunity costs such as an increase in government expenditure, an increase in tax, an increase in the cost of imports (if the imports include weapons and training), an increase in borrowing and expansion in the money supply. Furthermore, higher military expenditure not only takes away productive investments from physical, economic and financial infrastructure but it also sends a preemptive warning to potential multinational FDI investors to cease investment in the country from the fear of a possible armed conflict. Therefore, in non-conflicting countries increase in military expenditure will deter FDI. On the other hand, if the country is already under military threat, increasing military expenditure to stabilise the economy helps boost foreign investors’ confidence in the prospects of a secure investment return, leading to a higher FDI inflow to the country.

In my paper (co-authored with Nusrate Aziz) titled “Armed Conflict, Military Expenses and FDI Inflow to Developing Countries” published in Defence and Peace Economics we explore whether the adverse effect of increased military expenditure on FDI inflows differs between conflicting and non-conflicting countries using data panel data of 60 developing countries, for the years 1990 to 2013.

The estimated results indicate that an increase in military expenditure without any armed conflict reduces FDI inflow. We posit that the results obtained are such due to the following reasons. Firstly, higher military expenses reduce investment in countries’ physical, economic and financial infrastructure that makes investing in the host country an unfeasible option for foreign investors. Secondly, higher investment in military hardware in a country transmits a negative signal to foreign investors of a risk of unsafe returns on investment due to a potential military threat. An increase in military expenditure in the face of armed conflict, on the other hand, increases FDI inflow. This positive effect emerges due to an increased confidence amongst investors about a safe return from FDI in the conflict-prone area.

We also show that the effect of military expenditure on FDI is time sensitive, i.e. it takes time for military expenditure to affect FDI inflow. FDI inflow in response to higher military expenditure is higher to the country that faces higher armed conflict than the country that faces lower armed conflict. The findings are robust in the case of overall conflict and internal conflict. Our results are also robust to the alternative specification, subsample analysis and estimation using different definitions of long-run.

In light of the findings discussed above, the study suggests policy-makers to abstain from budgeting high expenditures on a country’s defence in the absence of a significant political threat so that FDI flows are encouraged into the country. In case of a significant military threat, however, it is imperative that the government spends a sufficient amount on military resources in order to attract and sustain higher FDI inflow.

To cite this article: Aziz, N., & Khalid, U. (2017). Armed Conflict, Military Expenses and FDI Inflow to Developing Countries. Defence and Peace Economics, 1-14.

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