IDAL  recently took part in the Annual Investment Summit which was held in Dubai where many issues related to fostering investments to emerging markets were discussed. One of the topics that stood out, was the impact of political and economic risk in attracting investments in emerging markets and on the strategies adopted by investors to mitigate those risks.

Key Findings

One of the key findings from the panel which included representatives from Indonesia and Nigeria is that foreign investment flows are not directly related to political risk in emerging markets. This statement might sound counterintuitive at first,  but what people tend to forget is that emerging markets are inherently risky, and that despite the risk, they have been growing at double digit rates, much higher than those of developed economies in some years, and generating high returns for investors. Risk is business as usual in these countries, including several destinations in the MENA region. This has not prevented them, however, from attracting big conglomerates looking for high return.  Countries such as Ukraine, North Africa and Thailand have high political risk but have been very appealing to investors due to the long-term opportunities. Indonesia for example has been one of the top 20 prospective  host economies as per UNCTAD World Investment Report, despite the high political risk in the country. A best case example is Lebanon which was able to achieve sustained flow of FDI over the last 3 years amidst the repercussions of the Syrian crisis and the Arab Spring.

More specifically foreign investment flows witnessed a slight increase in 2012 compared to 2011 at the prime of the Arab spring while FDI flows to the region registered their 4^th consecutive year of decline. This performance was achieved at a time when Lebanon's country and political risk fluctuated between negative and stable as rated  by rating agencies. In fact, despite the prevailing political risk, Lebanon remained one of highest recipients of FDI amongst non-oil economies, highlighting the continued confidence of investors in the economy and the potential of Lebanon as gateway to the MENA region.

What can we learn from this?

The main message here is that political risk is but one part of the equation for investors looking for returns. Over the years, investors have learned how to cope with risk and to factor it in their decision. At a time when growth in the EMEA is subsiding, (growth in EMEA or in Europe) companies are looking to have a footprint in new promising markets. The MENA region in particular is an important region for investors, not only given its growth potential but also due to the size of its markets and its proximity to the Asian market. 

Another important nuance is that it is often misleading to look at risk as a national phenomenon as risk is usually a regional one.  For instance,when media channels hammer a country's image with political risk messages, they are mostly focusing on events that are taking place at a local / regional level in a country, rather than a country in its entirety.

To add to these findings, an empirical study conducted by the Institute of Developing Economies (Discussion paper No.281) using a sample of 93 countries concludes that political risk doesn't have a significant impact on FDI. Political risk encompasses many variables including institutional quality, internal conflict, external conflict, corruption, law and order, and investment profile, among others. The most important factor that seems to influence FDI flows is institutional quality. Institutions are a robust predictor of FDI and property rights security is the most important aspect of institutions in determining FDI flows.

How do investors then manage political and economic risk?

The FDI process is divided into many stages mainly decision making, project implementation and management. At the decision making level, investment promotion agencies (IPA) have become the key entry points for investors in the local market. By providing accurate and transparent information on the local market (e.g. information on cost, regulatory framework, arbitration / conflict resolution entities, credit risk agencies, experience of other investors, etc..), IPAs already remove a good chunk of the uncertainty factor that investors face. Effective institutions such as IPAs reduce the uncertainty and provide a predictable framework for investments.  In the Lebanese context, IDAL has been actively playing that role and has put in place a transparent platform on the doing business parameters.

On the project implementation front, investors are resorting to localization to manage risk. Instead of serving a region from their headquarter, foreign companies become local, and by doing so, are better able to assess risk as they are closer to their customers. Localization is usually taking place through Joint Venture Agreements with local companies. Partnerships are usually formed not only to counter political risk but also to promote long term relations in a country. We are now seeing decoupling as companies are focusing on the bottom line and not the top line .

On the management front, investors can mitigate political risk through regulatory risk insurance or guarantees. Many institutions provide these insurance products in emerging markets including MIGA, a World Bank group arm. The US Overseas Private Investment Corporation (OPIC), also provides investors with financing, guarantees, political-risk insurance and support.

In summary, political risk remains  but one variable in companies' investment decisions. Empirical evidence has shown that whenever countries present real opportunities and display competitive advantages, they are still able to attract foreign capital.  Companies ultimately learn to swiftly adapt to the new environment and risk is underwritten in their decision when they invest.

We took part in the workshop organized by the OECD, and which was held at the League of Arab States Headquarters in Cairo on April 7 & 8 to discuss ''The amended Arab League Investment Agreement: key improvements and ratification process".