This paper develops a theoretical model of direct foreign investment to analyze the changing role of regulatory policies in developing countries in the presence of globalization. The main result is that deregulation is an optimal response to globalization, at least in countries that face a FDI constraint due to credibility problems. The model focuses on the hazards that increased regulations generate for foreign investors as the government gains additional instruments to appropriate the surpluses and quasi-rents of foreign direct investment (FDI) projects. A host of examples from MENA countries offered in the paper illustrate this point. This factor limits FDI in a country to projects with very high surpluses. The government would not be motivated to ease regulations if the rents that it loses to the existing foreign investors exceeds the surpluses that can be obtained as a result of reduced inefficiency and additional investment. This helps explain why many developing countries, especially those dependent on natural resources such as MENA countries, have instituted restrictive regulatory systems in the past. Globalization has changed this trade-off in favor of deregulation by reducing the surpluses of the existing projects and by giving rise to many new productive projects. The paper argues that deregulation can also reduce the role of institutional weaknesses that erode investor confidence in developing countries and help the government build greater policy credibility.
