Research

Political risk and coordination failure are two leading causes of low investment and growth in low- and middle-income countries. The international community devotes substantial resources to addressing these challenges. We show that these problems are intertwined: political risk induces coordination failure. We then propose a subsidy program to eliminate politically induced miscoordination. Our program—Guaranteed Return with Profit- and Loss-Sharing (GPLS)—offers a minimum return to investors while clawing back returns above a specified maximum. The design screens out investors who would have invested even without subsidies and induces participation from more hesitant investors at minimal cost. Optimally designed GPLS programs significantly reduce costs relative to natural alternatives, such as guaranteed return schemes (e.g., fixed annual payments of $x$ per cent) or Guaranteed Return with Profit-Sharing (GPS) programs. Such optimal subsidies represent a major step toward feasible and sustainable international interventions to coordinate development under political risk.

Governments are increasingly restricting foreign investments on “national security” grounds, yet we lack a clear framework for how governments manage their exposure to foreign firms when geopolitical conditions can deteriorate abruptly. This paper develops a dynamic model in which a host government values foreign investment, because it raises economic output, but also faces the risk that some firms are strategic: during “peace,” a strategic firm can quietly build latent capabilities (e.g., data access, supply-chain dependence) that becomes harmful if relations turn hostile. A geopolitical shock can trigger hostility, so policy must balance the economic gains from greater exposure to foreign firms against the possibility of future weaponization. I characterize the government’s optimal exposure path and the firm’s incentives to build capabilities, and show why governments may restrict access to foreign firms even before hostility arrives. In particular, the equilibrium exposure path features a distinctive bang-bang segment in which the government cuts access back down to the minimum for a period even before hostility arrives. Lowering access slows the buildup of strategic firm’s capacity and leaves the government in a better position if relations turn hostile.

To what extent does global economic exchange deter conflict between countries? This paper re-examines the pacifying effect of economic ties by examining investment behavior in the presence of geopolitical risks. While investments can deter conflict by raising its opportunity cost, the risk of war also affects firms’ willingness to invest. The central finding is that deterrence depends not on the total volume of investment but on how capital is distributed across firms. When capital is concentrated in a few large investors, an individual commitment can be pivotal in tipping a government toward peace. By contrast, when the same amount of capital is dispersed across many smaller firms, individual contributions have negligible influence on government decision. In both cases, firms must coordinate to deter conflict, but the coordination problem increases greatly when capital is dispersed across many investors, limiting the pacifying effect of investments.