Global FDI flows are expected to reach $1500bn in 2007, and are forecast to decline in 2008 as mergers and acquisitions (M&A) activity slows down and resumes a steady growth thereafter for the subsequent three years. According to the findings of an Economist Intelligence Unit (EIU) survey, this growth is largely demand driven, with much of that demand coming from emerging markets.

Also underlying this growth is the expected acceleration of the relocation of labour-intensive manufacturing to emerging markets and the ‘offshoring’ of services. Emerging markets fare well in this scenario, with FDI inflows expected to reach $535bn in 2007, declining in 2008, and growing in the subsequent three years at an annual rate of 3% to 4%.

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Emerging market sources

Emerging markets are also becoming important sources of FDI for the rest of the world – outflows increased from $12bn in 1991 to $99bn in 2000. The EIU estimates these investments to be about $210bn in 2007, driven by growth and market potential in developing countries, high commodity prices and outward FDI liberalisation. It estimates that there are more than 20,000 multinationals headquartered in emerging markets, many with potential to expand their overseas presence further.

Nearly one third of the EIU’s survey respondents based in developed countries said that FDI from emerging markets would have the greatest influence on global FDI trends in the next five years. A significant portion of south-based FDI also finds its way into other emerging markets (south-south investment). By investing in other developing countries, south-based multinationals, like their north-based counterparts, are looking primarily for new growth markets. But there are more factors driving south-south investment, including:

  • a rising demand for energy, with many national oil companies pursuing joint ventures and other forms of collaboration overseas;

 

  • an increase in south-south trade and regional integration schemes;

 

  • the size and experience of many multinational enterprises based in developing countries, which allows them to be competitive only in countries with similar environments, cultural links and levels of development;

 

  • outward FDI promotion by developing countries’ governments, which are actively promoting this through loans on preferential terms, tax rebates and investment insurance. China’s Going Global strategy is one such example. This trend is supported by a sharp increase in the number of bilateral investment treaties and double taxation agreements concluded among developing countries in the past decade.

 

Perceptions of political risk

According to a global survey of 602 executives worldwide carried out by EIU, there is a growing perception that political risk is rising. This finding is reinforced by an Ernst & Young report that identifies political risk as the single most important type of risk that companies based in developed countries face. For south-based multinationals, political risk does not rank as high as as commerical risk.

As for industrialised firms, perceptions of political risk for emerging market multinationals depend on a variety of factors:

  • the investment sector. Natural resource extraction, involving mining and oil/gas contract renegotiations, nationalisations and rising domestic ownership ceilings, is viewed as riskier than other sectors.

 

  • the mode of investing. Greenfield investments and the types of investment found in infrastructure/utilities are viewed as riskier than joint ventures or cross-border M&As.

 

  • the location of the investment. Countries with close cultural affinity or geographical proximity are perceived to be less risky than others. For example, companies based in the Middle East do not view countries in the same region as exhibiting high political risk, as manifested by the low demand for investment insurance sought from the Islamic Corporation for Insurance of Investments and Export Credits (ICIEC).

 

  • the home country environment. A higher threshold for political risk is associated with operating in a politically difficult or unstable environment at home. Indian multinationals interviewed, for example, said that their higher risk tolerance arises from having to operate in a politically and economically uncertain domestic environment.

 

  • history and experience in overseas investing. Investors discount the importance of political risk for projects run successfully over a relatively long period of time.

 

The experience of Indian multinationals illustrates that south-based firms have a lower perception of political risk when investing abroad. Some considered that investing in the developing world was politically safe for foreign investors. They did not view expropriation and payment restrictions as a significant risk. They argued that host country governments were unlikely to act arbitrarily against foreign investors because FDI was globally accepted as an important development driver.

Although there seems to be a perception among south-based firms that political risk in general is not a bigger threat now than in the past, the threat of terrorism and civil disturbance is expected to intensify in the next few years.

Investment insurance

Awareness of the presence of political risk appears to be increasing and hence demand for investment insurance is rising. This is illustrated by Sinosure’s portfolio, in which the share of outward investment insurance has increased from 0.7% in 2004 to 8.7% in 2006.

A survey administered by the Multilateral Investment Guarantee Agency to Berne Union and Prague Club members and to the Lloyd’s syndicate during October and November 2007 also provides overwhelming support to the notion that emerging market investors’ demand for political risk insurance will grow in the next five years. For the respondents, most of the projects insured against political risk have tended to be small ($20m or less). Insurance against expropriation is in greatest demand, followed by war and civil disturbance, breach of contract and transfer restrictions.

Although most industrialised countries offer investment insurance to their companies that invest overseas, the availability of political risk insurance to south-based multinationals cannot be taken for granted. Brazil, for example, which invested $28bn abroad in 2006, does not have a national agency that insures investments from the country. Investment insurance can be obtained from private or multilateral organisations, but not having a national agency means that domestic companies do not have easy access to such insurance and sends the signal that political risk is not important in investment decisions.

Different cover

Even countries whose export credit agencies or other entities do offer investment insurance may not offer the same product/service range as their counterparts in the industrialised world. The Export Credit Guarantee Corporation of India, for example, does not explicitly offer coverage for breach of contract, although it allows for such coverage if specifically approved by the government.

Related to that are issues of capacity, pricing and access to reinsurance and products tailored to the needs of small and medium-sized firms, which are often the core of outward investment from emerging markets. In general, the products and services on offer in emerging market countries are less sophisticated and not as extensive as those in the developed world.

However, some products offered by south-based investment insurers are better tailored to the needs of investors. One such example is sharia-compliant investment insurance that ICIEC offers to investors from its member countries. Another example is Sinosure’s services to facilitate access to financing for Chinese companies; Sinosure strives to mobilise financial resources and work out effective solutions for domestic investors.

Lack of advice

Export credit agencies and investment insurance providers in industrialised countries often offer advisory services to potential investors, including country-specific information, to help companies assess risks before deciding on a particular location. With few exceptions (such as Sinosure) these services are not typically found in south-based investment insurers, which tend to provide only insurance.

As the world becomes a riskier place for investors, it is in governments’ interest to ensure that their companies are protected against political risk when investing abroad. For countries that actively promote outward FDI, political risk mitigation could become an integral part of their programmes. Initiatives may include setting up national political risk insurance providers, or expanding the services offered by existing export credit insurance agencies to include investment insurance, raising awareness about the presence of political risk, and appropriate mitigation tools.

Persephone Economou works in MIGA’s external outreach department in Washington, DC.