Risky Business

February 23, 2009

There’s an audacious and unfounded claim circulating in the world of development finance, perpetuated by the World Bank.  And while you might not be kept up at night by it (and frankly neither am I), I’m here to debunk the myth.

The myth is that when developing countries invest in other developing countries, they are immune to political risks because they understand political risk in other developing countries better.  The entire argument relies on cultural affinity and shared business practices, despite the fact that the evidence does not support this argument at all.  If you’ll allow me to draw on some of my research and consultancy work on political risk and rant for a moment…

The amount of so-called “south-south investment”, foreign direct investment from one developing country to another, has increased over the past decade.  While in 1995 south-south FDI was 15% of total FDI flows, in 2003 it was almost 37%.   This was more than northern countries invested in southern countries (nonetheless, the bulk of FDI is still between developed countries).   The World Bank claims that the majority of these south-south flows are within region.  But there are some important exceptions.

According to their own data, China’s investment in South-East Asia (its “southern region”) only accounts for 20% of total south-south FDI.  India’s investment in South-Asia is only 25% of its total.  Even Russia, whose investment is often argued to be extremely regional, still invests more than 60% of its south-south FDI out of its region. Data for Brazil wasn’t as easily available, but as we’ve now shown that 3 out of 4 so-called “BRIC” countries do not have FDI flows predominantly within their region, the idea that political risk for south-south investment is mitigated by the fact that southern multi-national corporations invest in  “countries that share the same cultural and ethnic  links and heritage, frequently neighboring ones where they are already familiar with the local business environment through trade” seems a bit far fetched.

The World Bank stretches this invalid argument to its very limits, arguing that developing countries are more likely to disregard weak institutions when investing:  “Banks from developing countries are more likely to enter developing countries with weak institutions. This result seems to indicate that banks from developing countries, being more familiar with working in domestic environments where institutional development is low, are more suited to investing in such markets.”  I find it incredible that this was even published, seeing as it is complete conjecture, and makes limited sense.

Nonetheless, the branch of the World Bank that provides political risk insurance reports that, when asked, CEOs of southern MNCs investing in other developing countries report less concern about political risk than CEOs of Northern firms investing in developing countries.  I think that there are only two plausible, non-cultural (and therefore non-bogus) explanations of why developing country MNCs might perceive political risk to be lower when they invest in other developing countries.

The first is that particularly in the case of China, many of the firms doing the investing are state-owned.  Having the explicit backing of the central government makes firms more risk-acceptant, and increases the chances that the Chinese government will go to bat for the firm in question if its operations in another developing country suffered expropriation or interference via other types political action.  A US firm operating in Angola may not enjoy the automatic support of the American government in the same way.

The second reason seems to be that southern MNCs have not yet been burned, and therefore have little to fear.   Why perceive political risk as being important if everything has been smooth sailing to date?  This is, after all, a new investment trend.   As south-south investment becomes more established, the number of cases of political interference in these investments will increase, and so will perception of risk.

Two examples seem to be a case in point: when a leftist government was elected in Bolivia and began to renegotiate foreign contracts for natural resource extraction, the neighbouring left-leaning Brazilian government believed that its petroleum investments would remain untouched out of “cultural and ethnic  links and heritage.”  But oops!  The first company the Bolivian government expropriated was Petrobras.  Additionally, an article I read recently about Chinese energy security argued that “Chinese energy companies… have only a short history of managing the political risks of venturing into an overseas market,” citing mismanagement of deals in the Caspian as evidence.

So all of this to say that political risks are not magically erased through some sort of third-world solidarity or secret poor country handshake.  South-south FDI is as prone to politically-induced losses as north-south FDI.  It’s just not as big of a problem… yet.


2 Responses to “Risky Business”

  1. […] Bank have been known as occasionally being far from the gospel truth. An insightful article by the Interdependence Complex blog notes one particular World-Bank perpetuated misconception, this time on FDI between developing […]

  2. Hey, cool tips. I’ll buy a bottle of beer to that man from that forum who told me to go to your blog :)

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