marCh 2012 68295 Investment Climate In PractIce No. 20 INvestmeNt PolICy Political Risk: The Missing Link in Understanding Investment Climate Reform? Political risk has once again become a key concern of investors after the perceived openness and liberalization of foreign direct Stephan Dreyhaupt Ivan Nimac investment (FDI) regimes in the 1990s. Governments that do Kusi Hornberger not recognize this trend pay a high price in lost investments. Confronting political and regulatory risks as part of the investment Stephan Dreyhaupt (sdreyhaupt@ worldbank.org) is program climate is thus crucial for countries to make their business manager in the Economics and Policy Group of the Multilateral environments more competitive. This note suggests reforms that Investment Guarantee Agency (MIGA). He led the team that can have immediate impacts: addressing ex ante and ex post issues in launched the agency’s World Investment and Political Risk the legal and regulatory framework to protect investors, mitigating report in 2009. risks at the sector level, managing reputational and integrity risks at Ivan Nimac (inimac@ifc.org) is head of the World Bank Group’s the project level, and using financial instruments to ease short-term Investment Climate Department office in Vienna. He manages impediments in the investment climate. investment climate advisory in Europe and Central Asia and the Middle East and North Africa. Kusi Hornberger (khornberger@ worldbank.org) is an economist in the Investment Climate When considering investments, companies threats, economic crises, and developing Department. assess countries’ investment climates as well as countries’ desire to control their natural The authors are grateful to Ana- the stability and likely direction of their laws, resources and civil societies. Turbulent economic Mita Betancourt, Persephone regulations, and political institutions. Political and political developments in Europe, the Economou, Xavier Forneris, Pierre Guislain, Peter Kusek, Jana risk—the probability of disruptions in company Middle East, and the United States have Malinska, Shaun Mann, Keith Martin, operations by political forces and events— exacerbated concerns about such risks. Judith Pearce, Christine Qiang, is one of the main concerns for corporate Cecilia Sager, Damien Shiels, Mikael G. Sundberg, Lakshmi Shyam- investments.1 Surveys of multinational The global shift in FDI toward emerging Sunder, Ravi Vish, and Robert enterprises by the Multilateral Investment markets—which received nearly 40 percent of FDI Whyte for useful comments. Guarantee Agency (MIGA) have consistently in 2011 but are considered riskier recipients— This note was developed by the found that political risk is investors’ top might have amplified investor concerns about World Bank Group’s Investment concern over the medium term.2 political risk. Accordingly, the demand for political Climate Department in conjunction with MIGA. risk insurance, one of the main tools available to Part of this concern is due to recent global investors for mitigating political risk, jumped from developments, with investor perceptions of $10 billion in 1998 to more than $43 billion in political risk heightened by issues like terrorist the first half of 2011 (Berne Union 2011).3 But even a more supportive global environment commitments are thus crucial in promoting FDI. would not assuage investor concerns that By understanding and introducing policies, laws, governments will renege on promises made and institutions that reduce investor perceptions at the outset of investments. For example, of risk, governments can make their business host governments might promise investors tax environments more competitive—lowering advantages or investments in public infrastructure, investors’ transaction costs, which can significantly yet later find that they cannot afford those slow new investments if too high. In addition, promises or simply change the conditions of targeted interventions at the industry and project investments once they have been made. levels strengthen governance, providing investors with more transparent risk mitigation strategies Though the bargaining power of an investor at the and improving project outcomes. start of a negotiation is strong due to a “buyer’s marketâ€? for FDI, this power declines once an Governments cannot afford to ignore such investment is made. And the bargaining position opportunities. More than a quarter of corporate of a host government, which starts out weaker, investors surveyed in the past year stated that increases over time and so provides incentives to political risk had caused their companies to change the rules of the game. Figure 1 shows key withdraw from existing investments or cancel medium-term concerns of investors. planned ones (MIGA 2011). Less visible but just as important are costs that investors initially absorb but ultimately pass on to host countries, Why should governments such as through increased demand for incentives be concerned? or reduced project benefits or investments, resulting in lower growth and tax revenue. Institutional structures that enhance credibility and moderate pressure to alter government When facing certain political risks—real or perceived—investors can mitigate their concerns by buying political risk insurance. Coverage is Figure 1: Top invesTor ConCerns abouT Foreign DireCT available from a range of providers: public export invesTmenT, 2012–14 credit agencies, private risk insurers such as Lloyd’s (percentage of firms citing as top concern) of London, and multilateral investment insurers such as MIGA. These providers underwrite the risk of government intervention in projects Political risk in exchange for varying premiums. A better Access to quali ed sta investment climate, as measured by Investing Across Borders 2010 (World Bank Group 2010), Macroeconomic instability is associated with lower political risk premiums (Figure 2). In other words, a government better Corruption able to address shortcomings in its investment Access to nancing climate is more likely to have lower costs related to political risk—resulting in more investments, Infrastructure capacity better project outcomes, or both. Limited market opportunities Increased regulation Investment clImate and polItIcal rIsk are Interconnected Other Investors may see links between low political risk 0 5 10 15 20 and enabling investment climates. Countries that Source: MIGA 2011. offer business-friendly regulations and efficient Over the medium term, investors are most wary of political risk when making processes have lower sovereign and political risks decisions about foreign direct investment. (Figure 3). Political risks such as expropriation, nationalization, and currency transfer and Investment Climate In Practice 2 convertibility are more closely associated with Figure 2: Links beTween The invesTmenT CLimaTe anD The investment climates than less controllable risks CosTs oF poLiTiCaL risk, 2010 such as civil disobedience and violence. Most 300 This correlation could arise because healthier (BASIS POINTS) investment climates reduce political risk due to laws and institutions that make it harder for political forces to change the rules of the game. Similarly, more 250 predictable, rule-based, stable governments make it easier to create laws, regulations, and institutions PREMIUM that protect investor interests over the long term. 200 ImplIcatIons for Investment MIGA POLITICAL RISK 150 clImate polIcy Confronting political risk requires concerted institutional responses at multiple levels— 100 economy, industry, and firm—and a comprehensive approach combining proven diagnostic tools, advisory services, and financial Least 50 products with innovative new measures. 0 20 40 60 80 100 Lowest Highest 1. Economy-wide interventions: strengthening INVESTING ACROSS BORDERS INDEX investor confidence Source: MIGA data; World Bank Group 2010. Investors’ confidence in their defense against Better investment climates are associated with lower political risk premiums. unlawful and detrimental acts by host governments depends on the legal and institutional protections (continued on p. 4) Figure 3: sTrong invesTmenT CLimaTes have Lower risk perCepTions, 2010 Aaa 200 SOVEREIGN RISK RATING POLITICAL RISK PREMIUM A1 175 Baa1 (BASIS POINTS) 150 Ba1 125 B1 100 MOODY’S Caa1 MIGA Caa3 75 C 50 Lowest Highest Highest Lowest INVESTING ACROSS BORDERS RANK EASE OF DOING BUSINESS RANK Sources: IFC and World Bank 2010; World Bank Group 2010; Moody’s 2010 country risk ratings; MIGA data. Governments that make it easier to do business are also less prone to political risk. Investment Climate In Practice 3 available to them—including their enforcement. investor disputes and how rules were applied. To At the economy-wide level, policymakers test the effectiveness of their investor protection should consider two issues. First, ex ante FDI framework, policymakers should also consider protection describes the theoretical or de jure aspects of what has happened after breaches have protection that an investor would receive occurred and gather the views of investors, lenders, as embodied in national laws, regulations, and intermediaries on issues and constraints. The and treaties. Second, ex post FDI protection World Bank Group’s Investing Across Borders considers what happens after a breach has database can provide governments with useful occurred and provides investors with a practical information on these issues. The following measure of the stability and strength of existing measures should be considered: laws, policies, and institutions. â??â??Enforcement of laws, including practices for Ex ante FDI protection. Several measures can accessing legal recourse and enforcing awards. be used to strengthen the confidence of foreign â??â??Strength of institutions, including the investors. Governments should review their laws, efficiency of the agency involved, strength regulations, and policies to assess these frameworks and quality of institutions (such as in and determine whether they provide: arbitration procedures), assistance provided by the judiciary, and existence of and support â??â??Investor protection. Governments will not for alternative dispute resolution mechanisms. expropriate investors’ property except for â??â??Effectiveness of policies and procedures, public purposes, on a nondiscriminatory including their timeliness, such as the length basis, based on laws and procedures, and with of arbitration procedures relative to global prompt, sufficient compensation. best practice. â??â??Arbitration. Investors can resort to domestic or international mediation for 2. Industry-specific interventions: managing commercial disputes and are entitled political risks at the sector level to timely resolution of disputes and Political risk concerns vary by sector (Box 1). For enforcement of awards. Alternative dispute example, firms in mining and agriculture are more resolution guarantees help mitigate risks concerned about breach of contract, while those associated with indirect expropriation. in manufacturing and utilities are more likely to â??â??Repatriation of funds. Governments allow be worried about restrictions on transferring and investors to freely and promptly transfer project converting currency. To confront these sector- funds in a convertible currency of their choice. specific concerns, government agencies need to be â??â??International investment regimes and risk able to identify them. mitigation instruments. Investors can draw on favorable conditions set out in bilateral The Investing Across Borders database provides investment treaties and other international indicators on investing across sectors that examine agreements, and access risk mitigation de jure and de facto constraints and can serve as an instruments provided by international financial entry point to analyze impediments and potential institutions. International trade agreements risks to doing business in a particular sector. reassuring investors about the quality of a For example, restrictions on foreign ownership country’s investment climate are more credible of industrial land are major impediments to than domestic policies because reneging on investment because they carry an inherent risk of them is more costly. Between 1970 and 2000 government interference. Governments impose developing countries that entered into binding a wide range of approaches to foreign land international agreements attracted more FDI ownership that carry considerable discretionary (Buthe and Milner 2008).4 power. These practices range from prohibition of foreign land ownership to requirements for Ex post FDI protection. Prudent investors will prior authorization, registration of foreign land not simply take a government’s legal promises acquisitions, prior notice of transactions, and post- at face value. They will also examine previous acquisition notice. Investment Climate In Practice 4 3. Firm-level interventions: learning from box 1: miTigaTing risk in Tourism invesTmenTs corporate risk mitigation strategies Firms address political risk at the investment project Developing countries have significant potential for tourism investments. Tourism level. Government agencies are most effective in is among the top five sectors with high potential in 95 percent of these countries confronting political risk as an investment climate- and so is central to many of their private sector development strategies. Though related phenomenon when paying attention to the that suggests opportunities for investors and countries alike, investing in tourism same issues tracked by corporate risk managers. is not without risk. Managing reputational and integrity risks. According to data from MIGA-insured tourism projects, the biggest concerns The corollary of protecting the interests of for foreign investors are expropriations and restrictions on currency transfers. foreign investors is taking steps to ensure that Transfer restrictions in particular complicate project financing, adding to those investments meet required standards. imbalances between foreign-denominated debt and locally denominated revenue Governments should understand that meeting and making it difficult for investors to get projects off the ground. social, environmental, and integrity standards can help manage reputational risks for project Strengthening foreign investors’ confidence in tourism requires a broader dialogue sponsors, protect the environment, and reduce between the public and private sectors on issues such as barriers to entry, revenue political risks—ensuring better project outcomes. repatriation, and project-specific risk concerns. For example, an investor unfamiliar with a country, culture, or domestic political institution will mainly be concerned Managing reputational and integrity risks is about “creepingâ€? government expropriation—making the investor likely to prefer important for attracting FDI and reducing an upfront grant to help with startup costs. At the same time, an experienced investor perceptions of political risks. A investor in close geographic or cultural proximity to a potential investment government that identifies and mitigates potential will have a different risk perception and fewer risk concerns. In that case a tax integrity risks in FDI—such as the adverse holiday—which requires little upfront payment but may have a high monetary reputation of a project or investor, project-related value over time—might be the best investment incentive. Choosing the most corruption or bribery, or money laundering or appropriate policy instrument can sometimes mitigate risk by itself. terrorist financing—can strengthen its country’s reputation as an attractive investment destination (Box 2). Similarly, investors and projects with clean reputations are less likely to suffer adverse box 2: whaT To Look For in a projeCT: conduct such as expropriation. Due DiLigenCe on inTegriTy Understanding and using financial instruments. Corruption stunts development, and research shows that countries with Multinational enterprises and banks face various reputations for corruption have difficulty attracting the wide range of high- risks when conducting business overseas. Some quality foreign investment needed to foster sustainable, long-term growth. of these risks can be removed or mitigated But by taking a risk-based approach, governments can use a variety of tools to by conducting due diligence on the parties identify and mitigate potential integrity issues in foreign investments, just as involved and on the economic viability of investors and lenders check on one another. the proposed business. Other risks are harder for investors and lenders to predict. These For example, integrity risks specific to certain sectors can be identified, checks on include commercial risks as well as political beneficial owners can be conducted, and reviews of the regulatory frameworks of risks. Companies use a variety of financial investors’ home countries, codes of conduct, and governance protocols—along instruments that help provide a more stable with their reputations in markets—can indicate how they are likely to perform in environment for investments in developing new investments. countries and to expand access to finance. Investment agencies and other entities charged with attracting foreign investors Understanding how and which financial and can publicize unethical and illegal activities that may include environmental, risk management instruments can be used to social, and financial crime issues such as corruption, fraud, money laundering, or bridge short-term obstacles in the investment other patterns of unwanted behavior that they would use to deselect investors. By environment, how such instruments work, and publicizing these standards, host countries send a strong signal about the quality of what implications they have for government the investors that they want to attract and provide additional comfort to potential intervention will help policymakers attract investors about the type of investment climate that they will provide. Investment Climate In Practice 5 investments that maximize benefits for their notes countries. Few investors can make major FDI decisions without considering the availability of 1. In host countries political risk is largely financing, regardless of the investment climate. determined by uncertainty about the actions not only of governments and political institutions, but also of minority groups conclusIon and separatist movements. The political risk insurance industry uses a narrower definition Political risk is a key concern to investors and of “insurableâ€? risks that include currency lenders that increases transaction costs and convertibility and transfer, expropriation, is often the determining factor in whether political violence, breach of contract by a host investments are made. As such, it impedes government, and failure to honor sovereign governments’ ability to attract and retain financial obligations. When addressing investment. As the analysis in this note shows, political risk as part of the investment reforming the investment climate has an climate, a broader concept should be applied immediate payoff because higher institutional that includes unfavorable regulatory changes quality is correlated with lower risk premiums. and weak government institutions. Over the long term, a better risk profile also 2. In recent years various business surveys strengthens a country’s reputation as an attractive have shown that political risk features in investment destination. investment decisions and is moving back toward the top of corporate agendas. An Confronting political and regulatory risk Economist Intelligence Unit survey of 602 as part of the investment climate is thus investors in 2007 found that companies crucial for countries to make their business expected political risk to become a much environments more competitive. The policy greater problem for investments, especially implications of political risk can be addressed in emerging markets (Economist Intelligence through concerted institutional responses at Unit and Columbia Program on International multiple levels—economy-wide, industry, and Investment 2007). Ernst & Young identified firm—using proven diagnostic tools, advisory political risk as the main investment services, financial products, and innovative new constraint for companies based in developed measures. The World Bank Group is working countries (Ernst & Young 2007). Lloyd’s of on all these fronts to provide countries with the London and the Economist Intelligence Unit knowledge and tools needed to address investor found that more than one-third of 154 global concerns about political risk. By doing so, businesses were avoiding overseas investments policymakers can deliver real benefits for their for fear of political violence (Lloyd’s of countries. London and Economist Intelligence Unit 2007). Grant Thornton (2008), based on survey evidence, found political and economic Investment Climate In Practice 6 stability to be as important as market size references and growth potential when determining Investment the location of FDI. A survey by Atradius Atradius and Economist Intelligence Unit. 2008. Climate and the Economist Intelligence Unit (2008) “Promise or Peril? The Lure of Emerging Markets.â€? In Practice found that political instability tops the list London. of government or bureaucratic obstacles in This note series is published emerging markets. Finally, the Economist Berne Union. 2011. “Berne Union Members by the Investment Climate Intelligence Unit’s Business Environment on Track to Support $1.4 Trillion of Global Department of the World Rankings (BER) model, which measures Trade and Investment in 2011.â€? Press release, Bank Group. It discusses the attractiveness of a country’s business 20 October. Bern. practical considerations and approaches for implementing environment based on the relative weight of Buthe, Tim, and Helen Milner. 2008. “The reforms that aim to improve multiple criteria used by companies in their Politics of Foreign Direct Investment into the business environment. investment decisions, found that only policy Developing Countries: Increasing FDI through The findings, interpretations, directed explicitly at FDI and the total BER International Trade Agreements?â€? American and conclusions in this note score (which captures the fact that many Journal of Political Science 52 (4): 741–62. are those of the authors and do not necessarily reflect BER components have a complementary the views of the Executive effect) appear to have a more powerful Economist Intelligence Unit and Columbia Directors of the World Bank influence on FDI than does political risk Program on International Investment. 2007. or the governments they (MIGA 2009). World Investment Prospects to 2011: Foreign represent. 3. The Berne Union is the world’s leading Direct Investment and the Challenge of Political industry association for export credit and Risk. London. investment insurance. About the Ernst & Young. 2007. “Risk Management in 4. Using statistical analysis for 122 developing Investment Climate Emerging Markets.â€? London. countries from 1970 to 2000, Buthe and Department of the Milner (2008) show that international Grant Thornton. 2008. Emerging Markets: World Bank Group agreements such as the General Agreement Reshaping the Global Economy. Chicago. on Tariffs and Trade (GATT) and The Investment Climate preferential trade agreements provide credible IFC (International Finance Corporation) Department of the mechanisms for making commitments to and World Bank. 2010. Doing Business 2011. World Bank Group helps foreign investors about the treatment of Washington, DC. http://www.doingbusiness.org. governments implement reforms to improve their their assets, reassuring the investors and Lloyd’s of London and Economist Intelligence business environments increasing FDI. International commitments Unit. 2007. Under Attack? Global Business and and encourage and retain are more reliable commitment devices than the Threat of Political Violence. London. investment, thus fostering competitive markets, growth, domestic policy choices because reneging on and job creation. Funding them is more costly; they typically include MIGA. 2009. World Investment and Political is provided by the World provisions that allow investors to sue host Risk 2009. Washington, DC. Bank Group (IFC, MIGA, and governments in an international tribunal if the World Bank) and over ———. 2010. World Investment and Political their rights are violated. 15 donor partners working Risk 2010. Washington, DC. through the multidonor FIAS platform. ———. 2011. World Investment and Political Risk 2011. Washington, DC. World Bank Group. 2010. Investing Across Borders 2010. Washington, DC. Investment Climate In Practice 7 the Investment ClImate In PraCtICe note serIes (hTTps://www.wbginvesTmenTCLimaTe.org/pubLiCaTions/in-praCTiCe.CFm) No. 20 “Political Risk: The Missing Link in Understanding Investment Climate Reform?â€? Stephan Dreyhaupt, Ivan Nimac, and Kusi Hornberger. March 2012. No. 19 “Providing Incentives for Renewable Energy: Advice for policymakers.â€? Nathalie McGregor and Sebastian James. November 2011. No. 18 “The Power of Renewable Energy: Fostering investment and competition to generate electricity.â€? Tania Begazo Gomez and Martha Martinez Licetti. October 2011. No. 17 “Leveraging Technology to Support Business Registration Reform: Insights from recent country experience.â€? John R. Wille, Karim O. Belayachi, Numa de Magalhaes, and Frederic Meunier. June 2011. No. 16 “Investment Regulation and Promotion: Can They Coexist in One Body?â€? Robert Whyte, Celia Ortega, and Carlos Griffin. March 2011. No. 15 “Using Strategic Communications to Engage Stakeholders in Tax Reform.â€? Shaela Rahman. December 2010. No. 14 “Taxing Tourism in Developing Countries: Principles for improving the investment climate through simple, fair, and transparent taxation.â€? Laurent Corthay and Jan Loeprick. June 2010. No. 13 “Using Taxation to Enable a Fair and Thriving Mining Industry.â€? Farid Tadros and Kristina Svensson. June 2010. No. 12 “Managing Risk in Customs: Lessons from the New Zealand Customs Service.â€? Rebecca Foley and Bruce Northway. April 2010. No. 11 “Developing a Single Window to Facilitate Trade in Senegal.â€? Ibrahima Diagne. April 2010. No. 10 “Ghana Leads West Africa in Transit Reform.â€? Luc De Wulf. April 2010. No. 9 “Reforming Customs Clearance in Pakistan.â€? Manzoor Ahmad. April 2010. No. 8 “Tax Compliance Cost Surveys: Using data to design targeted reforms.â€? Jacqueline Coolidge. February 2010. No. 7 “Providing Incentives for Investment: Advice for policymakers in developing countries.â€? Sebastian James. January 2010. No. 6 “Investment Promotion Essentials: What sets the world’s best investment facilitators apart from the rest.â€? Celia Ortega and Carlos Griffin. September 2009. No. 5 “Local Taxes, Regulations, and the Business Environment: Finding the right balance.â€? Laurent Corthay. April 2009. No. 4 “Introducing the Value-Added Tax: Considerations for implementation.â€? Farid Tadros. April 2009. No. 3 “Tackling Corruption through Tax Administration Reform.â€? Aminur Rahman. April 2009. No. 2 “Linking Business Tax Reform with Governance: How to measure success.â€? Max Everest-Phillips and Richard Sandall. February 2009. No. 1 “Small Business Taxation: Reform to encourage formality and firm growth.â€? Jan Loeprick. February 2009. WWW.WBGINVESTMENTCLIMATE.ORG