Abstract
Expropriation of foreign direct investment (FDI) is more likely to occur in resource extraction compared to other sectors. Despite the higher risk of expropriation in resources, countries viewed as more likely to expropriate (having expropriated in the recent past) also have a disproportionate share of FDI in the resource sector. An incomplete markets model of FDI is developed to account for this puzzle. In one sector of the economy, resources, the government manages a stock of mineral rights. The type of government regime is stochastic, with low penalty regimes facing a relatively low, exogenous cost of expropriating FDI, and the level of country risk is measured by the variation in these costs across different regimes. The key innovation of the model is that the government, before the regime type is known, is able to charge different prices to domestic and foreign investors for mineral rights. Granting cheap access increases FDI and reduces the country’s share of resource rents, increasing the temptation to expropriate in a relatively low penalty regime. In very high-risk countries, subsidizing resource FDI increases the total value of output by raising investment, and the net gains from expropriating in a low penalty regime outweigh the rents foregone under a high penalty one. However, a stochastic resource output price results in relatively low-risk countries restricting FDI inflows to the resource sector instead – “windfall profits” in this sector raise incentives to expropriate when prices are high, yet minimization of the ex ante risk of expropriation is preferred owing to the relatively high penalty for expropriating. These results imply a higher average share of resource-based FDI in countries most likely to expropriate, while resources account for a high share of expropriated assets compared to the sector’s global share of FDI.