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Are Rates of Return in Places that are Fragile and Affected by Conflict Really Higher?

Paul Barbour's picture

Supporting populations in fragile and conflict-affected situations (FCS) is a key priority for the World Bank Group.  The Group’s President, Jim Yong Kim, has repeatedly stressed the importance of finding ways to bring sustainable peace and development to these difficult contexts. According to the World Development Report 2011: Conflict, Security, and Development, more than 1.5 billion people in today’s world live in FCS, or in countries with high levels of criminal violence.

Apart from the very human cost of fragility, it colors foreign investors’ perceptions of risk, especially political risk, affecting private sector activity. This begets a vicious cycle, where economies worsen, increasing fragility. The importance of political risk, including political violence, in the perceptions of investors is well documented, including in the annual MIGA-EIU surveys presented in MIGA’s World Investment and Political Risk report. In particular, MIGA’s 2011 report focused specifically on investing into FCS, and the survey results demonstrate that political violence remains a very serious factor inhibiting investment.

Aside from capital, foreign direct investment (FDI) can bring essential knowledge and technology across borders. These benefits are often what make FDI so sought-after by policy makers. But investors have to consider the return on their investment relative to the risks they are taking, especially political risks such as expropriation, currency convertibility and transfer restrictions, breach of contract by the sovereign, and war and civil disturbance.
 

Conventional investment wisdom states that with higher risk should come higher returns. Given the heightened political risk associated with FCS, at MIGA we sought to estimate the return on investment (RoI) on FDI into FCS.

In its annual World Investment Report , the UN’s Conference on Trade and Development (UNCTAD) publishes rates of return of inward FDI by country, with the metric defined as: “annual rates of return are measured as annual FDI income for year divided by the average of the end-of-year FDI positions for years t and t-1.”
 
Our first step was to assemble a list of countries (53 in total) that have ever been on the World Bank’s FCS list since its creation in 2004. Next, using the data on rates of return on inward FDI for these countries, which UNCTAD generously shared with MIGA, we calculated the median average rate of return for each country for the years 2006-2011. We repeated the exercise using the list of countries classified as low-income countries (for the same period of time) as a control group. Finally, we compare the findings with the global average rate of return. It is important to note that there are limitations in the dataset since not all countries consistently report their FDI data.
 
We found that for the years 2006-2011, the average rate of return on inward FDI into FCS, after removing outliers, was 14.5%. In all low-income countries the average was 9.7% for the same period, and the global average was 6.2%.
 
This very preliminary exercise suggests that the data bear out an important premise for investors: FCS countries, while more risky, may provide a higher RoI (when compared to all low-income countries or globally) to compensate for this risk.  Amid the current quest for yield, FCS may offer an opportunity for FDI especially when effective schemes to mitigate the political risks exist.
 
While rates of return are a measure of return to foreign investors, the broader economy-wide benefits of FDI, when undertaken with appropriate safeguards, are perhaps most important to host country governments and their people. In recognition of this, MIGA is committed to guaranteeing investments in FCS that have strong, long-term development impacts.
 
MIGA’s multi-country, donor-funded Fragile and Conflicted Affected Economies Facility (CAFEF) was launched in July 2013 to encourage further investment into FCS. MIGA’s goal is that Facility-insured projects will promote stability and sustainable economic activity, contribute to rebuilding efforts following conflict, and bring much-needed capital, employment, technology, and skills. This is particularly important for infrastructure projects, which underpin private sector investment and create jobs.
 
FDI into FCS brings high returns and is one way to enhance sustainable economic development. If one of the key obstacles to such FDI (political risk) can be mitigated by MIGA, other parts of the World Bank Group, or other donors or partners, then investors—and all of us—have an opportunity that should not be missed. 
 
 

Comments

Submitted by Adam Flick on

Does this calculation include United States FDI into Iraq and Afghanistan? Imagine that would massively influence the result.

Dear Adam, thank you for your interest and question. As noted, we need to consider the dataset limitation. Afghanistan is a good example where data on total FDI is very limited. As for Iraq, the rate of return on global FDI into Iraq, when available, starts very strong at around 25% in 2007 but deteriorates rapidly reaching around 1.8% in just two years. It stays at this level for the remainder of the time horizon considered in the blog. This weak performance makes Iraq’s FDI influence on the overall results relatively small (around 0.4% only).

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