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Political Risk

The Impact of Terrorism on Foreign Direct Investment

Daniel Wagner | February 1, 2006

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The behavior of foreign investors is difficult to predict and depends on a number of factors, including conventional wisdom, prior experience, perception and tolerance of economic and political risk, and long-term objectives. A survey of the literature on the effect of terrorism on FDI is mixed as to whether or not it has an impact on FDI flows.

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 2001-2003 3 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 1970s 4 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 study 8 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 study 9 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 University 10 (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 PSU 11 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 terrorism 12 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 Greece 14 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 conflict 15 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-2003 16 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 Trade 17 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.

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1 Compiled from the UNCTAD website and UNCTAD's World Investment Report, 2005.
2 In 2003 for example, 28 percent of terrorist attacks took place in developed countries (U.S. State Department, Patterns of Global Terrorism, 2004).
3 World Investment Report 2004 (United Nations Conference on Trade and Development, 2004) p. 14.
4 Such as Aharoni (1966), Basi (1963), Bass et al (1977), and Schollhammer (1974).
5 FDI Confidence Index, A.T. Kearney, September 2003, Vol. 6, p. 7.
6 FDI Confidence Index, A.T. Kearney, September 2004, Vol. 7, p. 7.
7 Political Risk and Foreign Direct Investment, Guy Leopold Kamga Wafo, Faculty of Economics and Statistics, University of Konstanz, 1998.
8 Terrorism and the World Economy, Alberto Abadie and Javier Gardeazabal, Harvard University/NBER and the University of the Basque Country, October 2005.
9 The Effects of Terrorism on Global Capital Markets, Andrew Chen and Thomas Siems, Cox School of Business and the Federal Reserve Bank of Dallas, August 2003.
10 Quan Li and Drew Schaub, "Economic Globalization and Transnational Terrorism," The Journal of Conflict Resolution 48, no. 2 (April 2004): pp. 230-258.
11 Quan Li, "Does Democracy Promote or Reduce Transnational Terrorist Incidents?," The Journal of Conflict Resolution 49, no. 2 (April 2005): pp. 278-297.
12 The "Academic Consensus" definition of "terrorism" as noted by the UN is: "Terrorism is an anxiety-inspiring method of repeated violent action, employed by a (semi-) clandestine individual, group or state actors, for idiosyncratic, criminal or political reasons, whereby the direct targets of violence are not the main targets. The immediate human victims of violence are generally chosen randomly (targets of opportunity) or selectively (representative or symbolic targets) from a target population, and serve as message generators. Threat- and violence-based communication processes between terrorist (organization), (imperiled) victims, and main targets are used to manipulate the main target (audience(s)), turning it into a target of terror, a target of demands, or a target of attention, depending on whether intimidation, coercion, or propaganda is primarily sought" (Schmid, 1988). (Source:
13 Quan Li, "Political Violence and Foreign Direct Investment," Regional Economic Integration, eds. Michele Fratianni and Alan M. Rugman (Elsevier Publishing, forthcoming).
14 Walter Enders and Todd Sandler, "Terrorism and Foreign Direct Investment in Spain and Greece," Kyklos 49, no. 3 (1996): pp. 331-352
15 Alberto Abadie and Javier Gardeazabal, The Economic Costs of Conflict: A Case Study of the Basque Country, Harvard University/NBER and the University of the Basque Country, July 2002.
16 Anti-Americanism in World Politics, Katzenstein, Keohane, and Siegel (Ithaca, N.Y.: Cornell University Press, forthcoming 2006).
17 Combating Terrorism in the Transport Sector—Economic Costs and Benefits, Australia Department of Foreign Affairs and Trade, 2004.
18 The Business Times, June 22, 2004.
19, November 16, 2005.
20 The views expressed herein are the author's and do not reflect the policies of the Asian Development Bank (ADB) or any other entity.