An Elementary Overview on the Relationship Between FDI and Country Risk

Foreign direct investment (FDI) has received a vast research attention that focuses on both its determinants and consequences. In recent years, the debate among academics and policymakers has shifted from whether or not countries should attract FDI to how countries can attract and reap the full benefits that come with FDI. Since most developing countries have limited access to international capital markets and loans received by multilateral institutions are usually insufficient to cope with the capital requirements, FDI can become a significant source of financing. In this respect, FDI is considered to be less prone to financial crisis since –typically- direct investors have a long-term perspective when engaging in a host country. In addition to the risk-sharing properties of FDI, it is widely believed that FDI provides a stronger stimulus to economic growth in host countries than other types of capital inflows. Furthermore, FDI has significant spillover effects in the economy in the form of employment, managerial skills and technology that are particularly beneficial for developing countries. Nonetheless and despite the dramatic increase in FDI flows worldwide during the last decades, many developing countries have failed in their efforts to attract FDI.

Investment profitability is of prime importance in the decision making process of foreign investors. Investment decisions are based on the relationship between risks and expected returns, within a particular environment and in a determined period of time. In high-risk environments, the risk-adjusted rate of return on capital must be reasonably high in order to attract FDI. However, investors are more concerned about the volatility of returns on their international business transactions and take into consideration several factor associated directly with the country they are investing in. For the long-term investor that assumes larger investment duration in a foreign country, the underlying financial position cannot be liquidated rapidly, generating a greater exposure to the different risks that can potentially affect the expected future cash flows. In this sense, foreign investors are more interested in a holistic assessment of risk that encompasses all the different variables that can impact the stream of expected revenues.

Country risk is a wide concept that encompasses many risk-related aspects of an investment decision. There are different methodologies that include many different variables depending on the depth of the analysis. However, most assessments assign a particular weight to the country’s political and macroeconomic characteristics. Also, other aspects like, financial stability, operational risk, infrastructure development, legal framework, taxation burden, openness to trade and security issues play a significant role.

When investors assess political risks, usually they try to measure the establishment of a specific political system (like democracy and political stability for example). They look at the government’s leadership influence on society and at the division and performance of the different branches of the government (think about the separation of power between the executive, legislative and judicial branches). Also, the investor should be aware of how well the different opinions of the population are fairly represented trough opposition parties. This is particularly important in developing countries where political ideology usually divides the population into socio-political classes.

Economic risk is directly associated with the choice of economic model that is prevailing in the country. A free-market model that is highly compatible with the global markets is preferred by foreign investors, while a regulated and centralized model where the government intervenes in the economy is considered more risky (In fact, government intervention is taken as a barrier to entry to FDI). Fiscal policy is regarded as an indicator of the role of the government in the economy and as a thermometer of government efficiency. For example, budget deficit to GDP is an indicator that measures the capacity of the government to sustain its policies and manage the administration. Monetary policy on the other hand, it's the main instrument for price stability and policymakers are usually concerned about maintaining low levels of inflationary volatility. Investors prefer low volatility since it’s easier for them to forecast their future returns. The industry-structure of the economy in terms of diversification is also very important to evaluate the country’s capacity for absorbing effectively external shocks. For example, a country with a low industrial diversification is highly vulnerable to foreign shocks (like oil price increase) that could affect the cost structure of the sector and consequently reduce GDP. Also, the responsiveness of the internal market demand, household consumption and saving patterns, the velocity of the business cycles, the current account balance, the internal labor market structure and the levels external debt are also closely observed to assess the economic riskiness of the country.

On the other hand, the appropriate -and internationally compatible- legal framework that includes the necessary business legislation and protection of private property is necessary to attract FDI. Furthermore, the level of transparency and influence by third parties in the execution of the law is a major aspect of the legal risks measured by investors. Legislation should also be fair in terms of the established tax burden to foreign business activities and the tax collection system should be accountable to perform its duty effectively.

Operational risks include the existence of the appropriate physical infrastructure to foster business operations as well as the level of corruption and red tape that is present in order to operate in a particular sector. Lastly, investors are adverse to crime, insurgencies, terrorism, civil war or any other form of violence or security treat that may harm their business activities in the country.

As it can be seen in this brief overview of country risk, investors have an incrementally complex task when they try to make a long-run investment decision in a foreign country. The analysis should use different sources of reliable data and expert knowledge of the different aspects of the risk measurement. In fact, specialized risk agencies are taking the lead in providing the necessary reports and risk rankings for the different countries and sectors of business interest for investors. However, the unpredictability of many events shifts the risk burden back to the investor who will ultimately make an informed decision considering his expected returns under the presence of the various country risks. 


Sources:


R. Ribeiro (2002) "Country Risk Analysis" Minerva Program (Unpublished)


Goldman Sachs (2001) "Global Emerging Markets - Portfolio Strategies"