New - ETA Chair memo n°2


In this paper we study the problem faced by firms that invest in foreign countries characterized by weak governance. Our focus is on extortion relying on the threat of expropriation or of bureaucratic harassment. We characterize an optimal extortion mechanism using Myerson’s optimal auction paradigm. We study the determinants of the quality of governance and whether and how the insurance of FDI improves upon it. We find that political risk insurance does not always improve upon all governance indicators. In particular, it may increase the risk of expropriation. However, we characterize a large variety of circumstances under which governance in the host country unambiguously improves: the risk of power abuse (extortion or bureaucratic harassment), the magnitude of the extortion bribes (to avoid abuses) and the bureaucrats’ revenue from corruption decrease with better insurance coverage of foreign firms.
This research has been supported by MIGA (Mutual Investment Guarantee Agency, World Bank Group)