From an all-time high of more than $180bn in 1999, FDI flows into developing countries have fallen by more than a quarter, according to the World Bank’s Global Development Finance. Moreover, these flows are skewed to just a few countries. China, Brazil, Mexico, Russia and India received the major share last year; just 13% of investment flows went to the 70 countries that were considered high risk and low income.

There are signs that the tide might finally be turning: according to the latest report from the United Nations Conference on Trade and Development (Unctad), the outlook for 2004 and beyond is promising. This assessment is based on cross-border merger and acquisition volumes, global economic growth, corporate profitability and the continuing liberalisation of FDI regimes.

What is particularly encouraging is the greater emphasis that is being put on the investment climate in discussions about development. For the first time, governance, strengthening institutions, reducing transaction costs, and narrowing the business information gap are taking centre stage. The pressure has never been greater on developing countries to create an environment conducive to attracting and sustaining investment.

The World Bank Group’s Doing Business 2005, which benchmarks regulatory performance and reforms in 145 countries, further highlights the need for developing countries to address investment climate reforms. It also gives policy makers a powerful tool for measuring performance, learning from best practice and prioritising reforms.

While it is clear that the attractiveness of a host country’s investment climate is a key determinant of investor interest, ignorance about opportunities in developing countries and how properly to assess and mitigate political risks is also a factor.

Managing political risk

Increasingly, managing political – along with commercial – risks is becoming a normal part of the corporate decision-making process for companies that invest abroad. With a good understanding of the investment environment and appropriate risk management, there are clearly tremendous opportunities for investors to make both profitable and productive investments that also benefit people in the developing world. Indeed, through managing the risks relating to political uncertainties effectively, a good investment can go ahead in even the riskiest of environments.

The decision to pursue a business opportunity in a developing country depends, very simply, on two things: the rate of return on the investment and the risk associated with it. While the former is relatively easy to assess, the latter is more complicated. Investors are particularly concerned about the risks to their business that they cannot control.

These include inadequate business regulations, poorly defined ownership rights, failure to enforce the rule of law, exchange control restrictions and limitations on repatriation of funds, and the costs of war, civil disturbance and terrorism. Venturing into difficult markets therefore requires a good assessment and management of these non-commercial risks, especially when considering longer-term investments.

Political risk insurance is an important instrument for equity investors and financiers. This insurance, which is available from both public and private entities, protects investors against politically motivated acts or government actions that can affect the viability of a project. It includes coverage for inconvertibility and currency transfer restriction; expropriation; breach of contract; and war, terrorism and civil disturbance.

This insurance alleviates country risk, thereby making a project largely country-neutral. In turn, this increases a sponsor’s ability to attract scarce loan financing. In fact, political risk insurance can not only reduce the cost of financing, but in some instances, it can also be the key to securing financing for the project in the first place. It can also extend the tenor of financing.

Risk mitigation tools, especially from a provider such as the Multilateral Investment Guarantee Agency (MIGA), offer something rather unique in the market; they give investors the confidence to enter high-risk markets with a better understanding of country conditions and the knowledge that potential losses arising from political risks are less likely to occur.

A unique risk mitigator

As a member of the World Bank Group, with 164 countries as its shareholders, MIGA is a unique multilateral risk mitigator that focuses on promoting FDI into those countries that need it most. The agency can help investors to assess opportunities and risks in developing countries through a suite of online information services about business conditions and investment environments. Through its technical assistance work, it can provide policy makers with investor feedback about risks in order to improve the countries’ investment climates.

For investors, MIGA’s insurance products provide a unique safety net in the event of government actions that could disrupt investment. And when issues arise, MIGA can mediate disputes between investors and host countries, not only to avoid claims, but also to allow projects to continue for the benefit of all parties.

Historically, MIGA’s leverage on the ground has enabled it to resolve a number of disputes between host governments and investors. Helping clients and hosts to solve problems encountered in Venezuela, Russia, Argentina, Nicaragua, Bolivia, Kyrgyzstan, and Nigeria, among others, has allowed worthwhile, productive projects to continue.

Being a multilateral, MIGA can also focus on complementing – as opposed to competing in – the insurance market, as well as on opening up difficult or frontier markets to both clients and insurance partners. It follows that almost half of the agency’s portfolio is weighted toward high-risk/low-income countries. MIGA is in a better position to manage the risks involved and can encourage other insurers into markets that they may feel uncomfortable venturing into on their own. These partnerships between public and private insurers increase the capacity of the insurance industry and help to diversify risks for all parties.

Investing in conflict-affected countries

Years of conflict colour investors’ perceptions of risk. Although the potential rewards are many, and investment opportunities abound, particularly in areas such as infrastructure rebuilding and financial services, doing business in a country that is transitioning from war to peace can be a daunting prospect for most investors. But avoiding countries that are conflict-affected overlooks the potentially high returns that are available if risks are managed properly.

In a number of conflict-affected countries, MIGA has been able to help companies “go in first,” paving the way for others. In Bosnia and Herzegovina, for example, MIGA has issued $278m in guarantees for 12 projects, including a Coca-Cola plant and the first post-war foreign bank entry – several co-insured by an EU guarantee trust fund facility.

These investments helped to signal that the country is a viable place to do business and assisted its post-conflict development. From 1997 to 2001, foreign investment in Bosnia and Herzegovina leapt from $1m to $164m.

In Mozambique, where prolonged civil war ended in 1992, political risk insurance has been instrumental in supporting large, complex projects in infrastructure and industry. Both the investors and host governments have enjoyed the benefits of these investments.

Afghanistan will now hopefully benefit from investment as a result of a new guarantee facility that involves MIGA, the World Bank and the Asian Development Bank, with up to $60m in coverage capacity. This will commence operations shortly.

Conflict-affected countries, for their part, need to strengthen their institutional capacity to attract and retain foreign investment. MIGA is currently assisting Bosnia and Herzegovina, Serbia and Montenegro, Guatemala, El Salvador and Mozambique in doing just that.

In addition, MIGA is helping western Balkan countries to reach out more effectively to prospective investors in Western Europe through a programme based in Vienna.

Building infrastructure in developing countries

Often countries that are perceived to be politically risky also have the greatest need for foreign investment in infrastructure. But the drop in FDI has been steep: from a high of $128bn in 1997, the amount of private investment in infrastructure into developing countries fell by nearly two-thirds, only reaching $47bn in 2002. The financial benefits of political risk insurance take on added importance in infrastructure projects that, over the past decade, have become more expensive, more difficult to finance, and more complex. Among the reasons for these developments are the blurring of the distinction between political and commercial risks; longer investment implementation and return periods; and (especially in the case of water projects) the involvement of local governments. There has also been an increased need for protection against risks associated with these sub-sovereign entities.

Expropriation dangers

For example, the risk of expropriation has changed considerably in nature since the 1970s, when it was not unusual for governments to seize assets without compensation. Today, the risks remain real – albeit better hidden. Investors might instead be faced with some form of “creeping expropriation”, whereby a series of acts could deprive them of their fundamental rights in their investment. These factors have led to a rising demand for breach of contract coverage for infrastructure projects.

Legal framework

Breach of contract coverage can be tailored to address specific concerns, such as the revocation of licences or concessions, as well as changes in tariffs and regulatory risks. Sovereign – or, in select cases, sub-sovereign – payment risk can also be part of the coverage. With respect to foreign exchange risk, political risk insurance can protect against losses incurred as a result of a host government’s failure to honour contractually agreed tariff adjustments. Insurance can also protect against the wrongful calling of the performance bonds that operators are often asked to post.

In the area of war and civil disturbance, coverage is typically extended to cover physical damage to assets as well as business interruption resulting from these events. Terrorism and politically related sabotage are also covered by most public insurers.

MIGA has a long record of supporting private investment in infrastructure – almost 40% of the portfolio is in its sub-sectors. And its guarantees can support the emerging private-public partnership model for these projects. Efforts have been made to build a base of experience in the critical water sector; three new projects – two in China, one in Russia – were insured last year.

But guarantees are not limited to project finance. MIGA’s portfolio covers a broad range of sectors in all regions of the developing world. For MIGA, the decision to be involved in a given project is based on more than just financial viability. MIGA involvement means that the investment is making a contribution to the economic, environmental and social development of the host country. For investors, projects that support sustainable development and integrate social and environmental practices lead to better long-term returns.

Summary

Profitable, developmentally sound investment opportunities abound in countries that need real investments, real jobs and real incomes for people. A continuing effort by development organisations, the private sector and the host countries to mitigate the risks effectively and to create a sound environment in which to do business is critical if the overall amount and distribution of FDI is to be increased. The same effort will be required to encourage investors not just to invest, but to invest and to stay.

Yukiko Omura is executive vice-president of the Multilateral Investment Guarantee Agency

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