One would think that acts of terrorism would have a negative impact on Foreign
Direct Investment (FDI) flows to affected countries. Common sense dictates that
the loss of foreign investor confidence following acts of terrorism would prompt
large outflows of capital in affected countries, and that once a country is
branded a terrorist target, it would attract reduced levels of FDI. Some academic
studies have demonstrated that sometimes this is in fact the case. However,
foreign investor sentiment is not always dictated by common sense. The lure
of profit and desire to establish trade partnerships is often a stronger motivational
force than perceived political risk is a disincentive to invest.
Although the growth of global terrorism is indeed on the minds of some corporate
decision makers when contemplating whether or not to invest abroad, it has not,
apparently, prevented many of them from deciding to invest in the post-9/11
developing world. According to the United Nations Conference on Trade and Development
(UNCTAD)1, FDI flows to the developing world surged 200 percent between 2000 and 2004,
up from 18 percent to 36 percent of global FDI. During the same period, FDI
flows to developed countries plunged 27
percent, from 81 percent to 59 percent of global FDI. In every category of developed countries cited, the inward FDI
trend is down significantly, while in every developing country category, the inward
FDI trend is sharply higher. Although the
vast majority of terrorist attacks take place in developing countries,2 the FDI trend is clear.
Further to this point, the United Nations (UN) has put together a ranking
of inward FDI for 2001-20033 which measures the
amount of FDI countries receive relative to their economic size (calculated
as the ratio of a country's share of global FDI inflows to its share of global
GDP) with some surprising results. Third, fifth, and seventh on the list are
Azerbaijan, Angola, and The Gambia, respectively. Investment in oil and gas
exploration and development accounts for much of the investor interest in these
countries. Interestingly, of the top 20 performers, only 3 were developed countries.
Germany was ranked 102nd, the United States 112th, and Japan 132nd, out of 140
total.
Does this mean that perceived terrorism risk negatively effects FDI decision
making? That undoubtedly depends, of course, on where one intends to invest.
Clearly, a company considering investing in Iraq would have far greater concerns
about terrorism than one investing in Canada. Interviews and surveys of executives
in multinational corporations in the 1960s and 1970s4 found political events to be one of the most important factors influencing foreign
investment decisions. This was no doubt due in large part to the Cold War and
the perception that "regime change" could have stark implications for foreign
operations.
It appears that times have changed, however. Consulting firm A.T. Kearney
produces an annual publication, The FDI Confidence
Index, in which it polls top decision makers in the world's largest 1,000
companies and asks their opinions on a range of FDI-related issues. The conclusions
are also surprising. In 2003 corporate leaders' top pick for global event most
likely to influence their investment decision was recovery of the U.S. economy.
Terrorism and security concerns were tied with the Middle East conflict for
number 7 on the list of 11 concerns.5
In 2004, with the U.S. economy on the rebound, its recovery was still the
top pick, but down from 84 percent to 60 percent of respondents' concerns. The
list of decision maker concerns had grown from 11 to 15, with terrorism and
security staying stationary at number 7, this time tied with concerns about
rising interest rates.6 Although the A.T. Kearney
studies do not focus on specific countries, it is worth noting that in each
instance, economic concerns outweighed political concerns by a large margin.
In addition to recovery of the U.S. economy, the other top four concerns in
2004 were the impact of global or regional trade initiatives, the threat of
global deflation, and the depreciation of the U.S. dollar. On this basis, it
does not appear that terrorism per se has a heavy influence on FDI decision
making.
Empirical studies examining the link between perceived political risk, terrorism,
and FDI flows have yielded contradictory results. Some have found linkages,
while others have not. Those that have found linkages tended to be older studies.
Some of the newer studies challenge the previous results. Some empirical studies
have tended to put more emphasis on macroeconomic variables as explanatory factors
in FDI flows, while others stress the importance of political variables. In
practice and in theory, it appears difficult to make a clear-cut distinction
between political and economic variables as definitive sources of influence,
and it is reasonable to conclude that FDI decisions in developing countries
are determined both by political and economic factors.7
A Harvard study8 states that higher levels of
terrorism risk are associated with lower levels of net FDI. In an integrated
world economy, where investors are able to diversify their investments, terrorism
may induce large movements of capital across countries. Another academic study9 takes this a step further and examines the impact of terrorist attacks on capital
markets. The authors researched the U.S. capital markets' response to 14 terrorist/military
attacks from 1915 to 2001 and concluded that the U.S. capital markets recover
faster to such events now than they did a century ago. This is largely attributed
to a stable banking/financial sector that provides adequate liquidity in times
of crisis and thereby promotes market stability.
In their largest decline, the U.S. markets dropped 21 percent over an 11-day
period when Germany invaded France in 1940 and took 795 days to recover to their
pre-event level. After 9/11, the markets dropped just 8 percent over an 11-day
period and took just 40 days to recover. Other financial markets were not as
resilient. For example, over the 11-day period following 9/11, Norway's stock
market dropped 25 percent and took 107 days to recover. One possible reason
for the favorable U.S. performance is that the Fed took steps to provide liquidity
throughout the banking and financial sector. This serves to emphasize that post-event
investor perceptions can to a limited degree be managed by effective government
response.
In a recent study done at Pennsylvania State University10 (PSU), the effect of economic globalization on transnational terrorist incidents
was examined statistically using a sample of 112 countries during the period
1975 to 1997. The strong results show that FDI, trade, and portfolio investment
have no direct positive effect on the number of transnational terrorist incidents
among countries, and that the economic development of a given country and its
trading partners reduce the number of terrorist incidents in a given country.
To the extent that FDI and trade promote economic development, they have an
indirect negative effect on transnational terrorism. Perhaps the decision makers
polled in the A.T. Kearney studies knew intuitively what the PSU study proved
statistically—that economic development is a deterrent to terrorism.
A related recent study done at PSU11 probed
whether democratic forms of government reduce the number of terrorist attacks.
In this case, 119 countries were examined between 1975 and 1997. Contrary to
some earlier academic studies on this subject, which promote the idea that terrorist
groups are more often found in countries with democratic forms of government
than authoritarian forms of government, the author found that some aspects of
democracy—such as higher electoral participation, which produces a high degree
of satisfaction among a general population—tend to reduce the number of transnational
terrorist incidents, while other aspects of democracy—such as a system of strong
checks and balances and the ability to restrict press freedoms—often serve to
increase the number of such incidents.
The argument made in both PSU studies makes sense and are backed up by statistics,
yet they do not address the fact that many countries with vastly different histories
and forms of government have experienced long-term terrorism12 on their soil (for example, Colombia, Israel, Turkey, Nepal, India, Pakistan,
the Philippines, Spain, the United Kingdom, Saudi Arabia, and Algeria). The
same is true of countries with "new" terrorism problems (such as the United
States and Thailand). More often than not, it appears that countries with significant
terrorist acts tend to have democratic forms of government. Terrorism does not
appear to occur with great frequency in countries with authoritarian or communist
forms of government, which lends credence to the earlier academic studies. In
the complicated world of terrorism, undoubtedly, both sets of arguments are
true and neither is true.
The same PSU author produced another interesting empirical recent study examining
the impact of political violence (PV) on FDI.13 The study posits that terrorist incidents do not produce any statistically significant
effect on the likelihood that a country will be chosen as an investment destination,
or on the amount of FDI it receives. Further, it states that unanticipated acts
of terrorism do not generate any changes in investor behavior, either in terms
of investment location choice or the amount of investment.
However, a study done on the impact of terrorism and FDI in Spain and Greece14 arrived at a completely different conclusion—that acts of terrorism had a significant
and persistent negative impact on net FDI. They concluded that 1 year's worth
of terrorism discouraged net FDI by 13.5 percent annually in Spain and 11.9
percent annually in Greece. On this basis, it was concluded that smaller countries
that face a persistent threat of terrorism may incur economic costs in the form
of reduced investment and economic growth.
Related to this, the same authors of the previously cited Harvard study produced
a case study on the economic costs of the Basque conflict15 and concluded that there is evidence of negative economic impact associated
with terrorism in the Basque portion of Spain. On average, the conflict resulted
in a 10 percent gap between per capita GDP of a comparable region without terrorism
over a 2-decade period. Moreover, changes in per capita GDP were shown to be
associated with the level of terrorist activity. The authors also demonstrate
that once a ceasefire came into effect in 1998-1999, Basque stocks outperformed
non-Basque stocks. When the cease-fire ended, non-Basque stocks outperformed
Basque stocks.
An interesting corollary is the research done by the Asian Development Bank
(ADB) when it created a terrorism insurance facility for investors in Pakistan.
ADB learned that in nearly every instance, acts of terrorism in Pakistan were
directed at government and/or military targets, and that commercial loss (if
any) was nearly always the result of collateral damage. A survey of local insurance
companies in Pakistan revealed that the incidence of commercial loss due to
acts of terrorism was almost zero. This is in sharp contrast to the image of
Pakistan that prevails in the global media, where it is portrayed as a poor
place to invest because of perceived terrorism risk. Yet 9/11 produced more
than $50 billion in commercial losses in the United States, and it remains one
of the top FDI destinations. This demonstrates just how flawed common perceptions
of risk can be.
Perceptions of terrorism risk have a great deal of influence on some investment
decisions, and very little on others. Among the factors that influence decision
makers are the economic health of the investment destination, the difficulty
associated with doing business in a given country, the existence of rule of
law and good corporate governance, the existence of corporate and government
connections, and of course the cost of production. Investors may also distinguish
between "perceptions" of the existence of a terrorism threat in a given FDI
destination and "acts" of terrorism, or between "domestic" acts of terrorism
and "international" acts of terrorism. However, one factor often not considered
when contemplating making a cross-border investment is consumer behavior, and
its linkage to the political process. Perceptions are important here, as well.
Predicting consumer behavior correctly can be as important in determining the
success of an investment as predicting whether terrorism will have an impact
on operational capability.
For example, one would think that the rise in hostility toward the United
States by a variety of Europeans in response to the Iraq War would result in
fewer European sales of goods by American companies. Interestingly, one of the
first detailed empirical studies on consumer behavior post-200316 notes that although up to 20 percent of European consumers do consciously avoid
purchasing American-made products, sales by American companies in 2000-2001
and 2003-2004 grew at least as quickly as those of their European rivals in
Europe. In the case of Coca-Cola, McDonald's, and Nike, European sales grew
85 percent, 40 percent, and 53 percent, respectively, for the period. Apparently,
Europeans make a distinction between the actions of the U.S. government and
the products of American companies.
Short-term corporate costs directly or indirectly linked to acts of terrorism
can be substantial, but the potential long-term costs of terrorist threats to
national economies can be devastating. A study by Australia's Department of
Foreign Affairs and Trade17 has found that developing
countries stand to lose the most because of their dependence on FDI and export-led
growth. The developing economies of East and Southeast Asia are deemed to be
the most vulnerable. The study estimates that economic growth in the region
could decline by 3 percent after 5 years of ongoing terror threats and by 6
percent over 10 years.18 The attacks of 9/11 are
estimated to have cost the United States some $660 billion through 2005 and
have significantly reduced global investment levels.19 The IMF has estimated that the loss of U.S. output from terrorism-related costs
could be as high as .75 percent of GDP, or $75 billion per year in the future.20
This article began by asking the question "does perceived terrorism risk
negatively effect FDI decisions?" We have seen that there is no single answer
to this question and that it is dependent on numerous variables. The empirical
evidence answers the question both in the affirmative and the negative, and
persuasive arguments have been made on both sides. Similarly, some theorists
maintain that democratic political systems are a breeding ground for terrorism,
while others claim just the opposite. And some earlier studies concluded that
corporate executives consider political and terrorism risk to be among the most
important factors influencing the decision making process, while later studies
minimize their importance.
It can probably be said with some certainty that all of the studies are correct
and all of them are incorrect because it does not make much sense to generalize
about what motivates foreign investment decisions. Existing theories and arguments
fail to explain the rationale behind what motivates many foreign investment
decisions. One is left to speculate about such motivations, although the A.T.
Kearney surveys lead one to conclude that economic motivations are stronger
than political deterrents in influencing foreign investment decisions. Perhaps
in the future a brave academic will tackle this question.
Also yet to be addressed in the literature is the question of whether certain
sectors of an economy are more sensitive to the negative effects of terrorist
attacks than others. Or why do some countries experience protracted terrorism
over time, and what is its impact on FDI decision making? A lengthy history
of terrorism has not prevented foreign oil companies from making, and continuing
to make, long-term investments in Colombia or Algeria. Angola continued to receive
huge foreign investments in its energy industry at the height of its civil conflict.
Of course, investment in all these countries would presumably have been much
higher in the absence of recurring terrorism or civil conflict. The United States
continues to be one of the world's top foreign investment destinations, even
though it is Al Qaeda's number one target. Although the level of FDI is down
significantly in the United States post 9/11, it is hard to say for certain
whether this was due primarily to a changed perception of the United States
as a "safe haven" destination, or whether the prevalence of low interest rates
prompted capital investors to seek more lucrative alternatives.
Some companies are concerned primarily with profit maximization while other
companies are more concerned with risk management and loss minimization. The
impact of government-to-government relations on the FDI equation can be an important
factor motivating FDI flows, as can the desire to establish and maintain international
trade links. Experienced foreign investors may discount terrorism risk automatically
because they will have had good experience or strong corporate and government
relationships locally. Other foreign investors may never pursue cross-border
investment opportunities because of the absence of prior experience or meaningful
corporate and governmental relationships.
The question of what would happen in the event of a truly catastrophic terrorist
event must also be considered. Would new construction-related investment flow
in, as is the case when natural disasters occur? Would the explosion of a dirty
bomb make a city so dangerous that the replacement of damaged buildings would
not be possible? It is questions like these that serve to reemphasize the limited
value of generalizing about terrorism's impact on FDI. Theorists can speculate
all they want about what "may" happen if such an event were to occur, but theories
and complicated forecasting models have been proven wrong many times in the
past.
Depending on the investment destination, terrorism either already is, or
has the potential to become, a primary consideration in formulating investment
decisions. Much will depend on the motivations, experience, and resources of
a given foreign investor. As the Pakistan example noted above demonstrates,
it is vitally important not to rely solely on widely held perceptions about
the nature of terrorism risk in a particular country. A wise foreign investor
will separate fact from fiction to arrive at an investment decision based on
reality on the ground that is consistent with its investment objectives.
This article will appear in the April/May issue of FDI Magazine and is published here in
advance with permission from the Magazine.