How does political risk matter for foreign direct investment into Arab economies?

ABSTRACTThe present paper extends previous work by Burger et al. ([2016]. Risky business: Political instability and sectoral greenfield foreign direct investment in the Arab world. World Bank Economic Review, 30(2), 306–331. https://doi.org/10.1093/wber/lhv030) that has attempted to investigate empirically the impact of political instability on FDI flows into the Arab host region. Specifically, based on gravity model approach and annual panel dataset on bilateral FDI projects in Arab countries from 2003 to 2018 (12,240 projects), it explores the following research questions: how does a host country’s political instability and institutional fragility affect the bilateral inward FDI project? Is there any sectoral specificity to this impact if it exists? Which component of political risk poses the most threat for the foreign investor in a specific sector? The empirical investigation highlights the negative, significant and robust impact of perceived political risk in the Arab host-country. It also establishes that there is substantial heterogeneity in foreign investment reactions to political risk reflecting both differences in the component of political risk and sectoral characteristics.KEYWORDS: Gravity modelforeign direct investmentpolitical riskArab countriesJEL classification: C23F21F23P48 AcknowledgementsI would like to thank the anonymous reviewer, who generously shared his ideas and made this publication possible. I am particularly grateful for the valuable suggestion on how to improve the overall structure and consistency of the first version of the present paper.Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1 This concern is supported by the global investment competitiveness survey results, commissioned by the World Bank Group to apprehend the perceptions of international investors on the role of investment climate factors in guiding their FDI decisions. These results reveal that more than three-quarters of investors surveyed encountered some type of PR in their investment projects in developing world, including Arab countries (World Bank, Citation2017). Growing global instability and increased investments in developing countries are thereby driving more demand for PR insurance, as evidenced by the considerable increase of the market capacity for PR insurance coverage over recent years. It has in fact reached USD 3.2 billion in 2021, almost 2.7 times the capacity of USD 1.2 billion available a decade ago (BPL Global Market Insight, Citation2021).2 This refers to the fact that colonial ties, religious affinity and common language are especially influential on FDI.3 Such as Noorbakhsh et al. (Citation2001), Campos and Nugent (Citation2003), Li and Vashchilko (Citation2010) and Blonigen and Piger (Citation2014).4 See, for example, Biglaiser and DeRouen (Citation2006) and Asiedu and Lien (Citation2011) as regards the positive relationship between conflict and FDI, and Witte et al. (Citation2017) as regards the insensitivity of resource-related FDI to political conflict.5 When expected benefits of investing in a specific sector are high, foreign firms are often most eager to take more risk to capture these rents and are much less sensitive to weak institutional structures. Furthermore, sectors differ in terms of natural resource requirements that may be met only in certain specific geographical locations where the presence of limited investment opportunities may cause a relative insensitivity of foreign investors to political risks involved.6 The source-country characteristics are considered only for robustness check and the results are significantly different from those obtained with the baseline model.7 The four broad sectors are resources and energy, non-tradable manufacturing and services, tradable manufacturing and tradable services.8 In this regard, it is worth noting that during the period 2003–2018 the greenfield mode of foreign capital entry was the mode preferred by multinational investors in the Arab countries, accounting for more than 85% of total FDI projects in average. Moreover, many policymakers, be they from Arab region or elsewhere, are particularly interested in attracting this component of FDI inflows, which would more likely affect growth and job creation via increased physical investment.9 Theoretical foundations for the gravity model have been established by a series of papers, in particular Anderson and van Wincoop (Citation2003). As regards the FDI flows, intuition and theory suggests that MNE and FDI behavior is likely much more complicated to model than trade flows (Blonigen, Citation2005).10 For details, see: https://unctad.org/en/PublicationChapters/wir2018chMethodNote_en.pdf.11 Detailed Results are available upon request.12 The PR proxy, whether considered as a composite indicator or representative for each specific category of PR, must be forward looking and should reflect political risk in a narrow sense, as opposed to a broad country risk. This is why PR indices developed by the International Country Risk Guide (ICRG) and compiled by the PRS Group are used. Independently acclaimed and sourced by researchers examining in what manner political risk/instability affects FDI (see, for example, Alfaro et al., Citation2008; Al-Khouri & Abdul Khalik, Citation2013; Asiedu & Lien, Citation2011; Baek & Qian, Citation2011; Busse & Hefeker, Citation2007; Howell & Chaddick, Citation1994; Méon & Sekkat, Citation2012), the ICRG has become one of the most prominent time-series databases of country risk analysis. Some authors find that PRS indices are more reliable and have power to differentiate/predict political risk effects better than other major political risk information providers (see, for example, Bekaert et al., Citation2014; Click & Weiner, Citation2010; Hoti, Citation2005; Howell & Chaddick, Citation1994). One drawback of using the ICRG is that it may suffer from potential perception bias, since it only draws information from one source. For a discussion on the shortcomings with these types of data, see, for example, Svensson (Citation2003).13 Detailed Results are available upon request.14 These control variables have been taken from several sources including CEPII (Centre d'Etudes Prospectives et d'Informations Internationales) database (for distance, colonial link, common language and Regional Trade Agreement), ICSID (International Centre for the Settlement of Investment Disputes) database (for Bilateral Investment Treaty) and official UNCTAD online database (for relative size, trade intensity and industry).15 For details, see Chetty et al. (Citation2011), Chetty et al. (Citation2013), Stepner (Citation2014).16 Greenfield FDI series are deflated using the GDP deflator in the host country (2010 = 100).17 The estimation results support a negative and statistically significant Regional Trade Agreement (RTA) effect. This would seem a reasonable result given that RTAs liberalize trade in the first place, if no measures specific to foreign investors in terms of FDI liberalization were in place. It is consequently more likely that source-country exports replace FDI flows from the source country to host country parties of the RTA. In this regard, previous literature provides a highly ambiguous picture on the impact of trade and investment agreements on FDI (for overviews of the relevant literature, see UNCTAD, Citation2009; Sauvant & Sachs, Citation2009).