Bachelor Thesis in Economics and Business Economics
The impact of terrorism on FDI in affected emerging and frontier markets
Author: Supervisor:
Maximilian Ast Caroline Witte
381650
July 17th, 2016
Academic Year 2015/2016
Abstract:
This study investigates the impact of terrorism on foreign direct investment in emerging and frontier markets. Data on foreign direct investment, terrorism and a number of measures potentially influencing foreign direct investment were retrieved in order to conduct an empirical analysis ought to test the causal effect of terrorist acts of violence and the mere threat of terrorism on foreign direct investment as a whole or sector specific. Additionally, a real options model is laid out, which illustrates investors’ behavior in light of a threat of terrorism. Using a fixed effects model approach, the study found no evidence of an impact of terrorism on foreign direct investment in any way, irrespective of the sector.
Table of Contents
1 Introduction 4
2 Theoretical Framework 5
2.1 Terrorism....................................................................................................... 5
2.2 Foreign Direct Investment.......................................................................... 6
2.3 Literature Review.......................................................................................... 6
2.4 Real Options Theory.................................................................................... 10
3 Methods and Material 14
3.1 Data..................................................................................................................... 14
3.1.1 Data Sources........................................................................................ 14
3.1.2 Definition Emerging Markets and Frontier Markets.......................... 14
3.1.3 Selection of cross-section units............................................................ 15
3.1.4 Panel Data ........................................................................................... 15
3.1.5 Summary of Variables.......................................................................... 16
3.2 Methodology........................................................................................................ 19
3.2.1 Approaches to Empirical Analysis of Panel Data................................ 19
3.2.2 Hausman Test...................................................................................... 20
3.2.3 The Fixed Effects Model....................................................................... 21
4 Results 21
4.1 Terrorist acts of violence and their impact on FDI in emerging markets........... 21
4.2 The impact of terrorism on FDI in emerging markets varies by sector.............. 22
4.3 The mere threat of terrorism and its impact....................................................... 24
5 Conclusion 24
6 Appendix 28
1. Introduction
An underlying and vital condition for a country’s sustainable economic progress is its securing of political stability and safety (Busey, 1965). Sporadic, unexpected terrorist attacks have become a prominent threat to this very condition in the recent past.
Parallel to this trend, Foreign Direct Investment (FDI) is becoming an increasingly important component of a successful investment strategy for companies that are seeking high returns in today’s rapidly evolving global economic integration. FDI is especially lucrative for investors when applying it in market economies that are considered to be emerging, i.e. the world expects to see these countries’ GDP to experience high growth in the near future (Angel, Eunni & Fouto, 2010). Next to emerging markets, it is also frontier markets that have attracted attention. Both classifications receive this attention due to their diversification opportunities. This is a result of their low correlation with markets in developed countries (FTSE Russell, 2014).
Developing countries are considered emerging markets or frontier markets when these experience significant growth and reach a number of other economic benchmarks (MSCI 2015). A definition for when a market economy can be classified as emerging or frontier market is retrieved from the US company MSCI that created and annually updates the MSCI Emerging Markets Index. According to the Financial Times, MSCI checks for the number of quoted companies of a certain size and for the proportion of shares available for ordinary investors to buy (2016). Furthermore, the market’s openness to foreign ownership and capital is crucial in order to be classified as an emerging market (FTSE Russell, 2014).
Apart from being characterized by fast economic growth, emerging and frontier markets are often characterized by an immature political and institutional system making them vulnerable to war crime or, specifically, terrorism. Ideally, an emerging market’s institutional and political environment improves as its economy progresses, so that it has the power to defend itself against transnational terrorism or to put an end to domestic radical movements before they evolve to being a potential violent threat. Unfortunately, this is not always the case and the reality is that we see deeply embedded socioeconomic discrepancies and political instability in countries that are actually proving to have economic potential. Hence, it becomes a crucial task for an investor to assess a market’s socioeconomic and political issues before deciding on FDI in that country.
This thesis aims to research exactly this problem. By investigating 32 countries that are currently classified as emerging and frontier markets by the MSCI and FTSA, a possible relationship between the exposure to terrorist acts of violence and the volume of FDI in a given country will be studied. This leads to the following research question, which shall be answered in the course of this paper:
What are the consequences of exposure to terrorism for FDI in emerging and frontier markets?
In order to come to an answer to this question, panel data on terrorist acts of violence in all relevant emerging and frontier markets between 2002 and 2012 as well as panel data on FDI for the same time period and entities will be statistically analyzed in order to reveal possible evidence for a negative impact of terrorism on FDI in emerging and frontier markets.
First, a possible negative impact of terrorist acts of violence on FDI will be examined by means of a fixed effects estimation model, regressing on the total amount of FDI in a given market. Following, we examine whether this negative impact may vary by sectors to which FDI is flowing in. Lastly, a real options model is tested, which investigates whether or not the mere threat of terrorism causes FDI to decrease.
Before the statistical analysis begins, though, all relevant concepts and underlying economic theories will be defined and thoroughly explained in a theoretical framework, which makes the next part of this thesis.
2. Theoretical Framework
2.1 Terrorism
So far, there has not been a universally accepted definition for terrorism. Nonetheless, for this thesis, I formulate a definition that is based on widely accepted rationales in understanding and talking about terrorism. For this, I refer to the U.S. Code’s official definition: “[…] terrorism involves violent acts or acts dangerous to human life that is against federal or state law”. Furthermore, these acts are motivated by one or more of the following three objectives: “(i) to intimidate or coerce a civilian population; (ii) to influence the policy of a government by intimidation or coercion; or (iii) to affect the conduct of a government by mass destruction, assassination, or kidnapping”. [1] Additionally, it is important to note that terrorism does not necessarily include an executed act of violence; the mere threat of use of violence is enough in order to be classified as terrorism (Oetzel & Oh, 2013). To illustrate, the creation of widespread intimidation or fear among civilians who are not directly involved in a conflict already puts pressure on political decision makers who are then often forced to concede to terrorists’ demands (Bueno de Mesquita 2005; Kydd & Walter 2002). Moreover, terrorism can stem from a range of different types of motivations such as religious, political, or ideological. For the purpose of this thesis, we consider any type of terrorism that has the potential to affect the decision of a multinational enterprise (MNE) to directly invest in a foreign emerging country. Lastly, one distinguishes between domestic and transnational terrorism. When a terrorist attack in a country involves targets, victims, institutions, or citizens of another country, we speak of transnational terrorism (Enders & Sandler, 1996).
Since we deal with foreign direct investment, it is only foreign capital that can be affected by terrorism in the scope of this thesis. For terminology reasons, we can therefore conclude that only transnational terrorism will be taken into account in this study. (Enders & Sandler, 1996).
2.2 Foreign Direct Investment
Foreign Direct Investment (FDI) plays a crucial role in global economic integration by creating long-lasting international relationships between economic agents (Harrison, 1994). It represents an agreement in which both parties benefit: the investing company is able to introduce its products to new markets and the host may benefit from knowledge spill-overs and consequential economic growth. According to OECD, FDI is defined as “cross-border investment by a resident entity in one economy with the objective of obtaining a lasting interest in an enterprise resident in another country” (2016). An important criterion is that the direct investor holds an ownership of at least 10% of the voting power with which he exhibits significant influence on the management’s decision making, motivated by his long-term interest in the invested enterprise. Additionally, Net Foreign Direct Investment (NFDI) stands for the residual of all foreign capital in- and outflows.
2.3 Literature Review
There has been a variety of research conducted on FDI in emerging markets and whether the presence of terrorism can have an influence on it. In order to provide the reader with an overview of what previous studies have found on this topic and to provide a basis for the formulation of hypotheses, a number of relevant papers will be discussed. First, previous research on the effect of terrorism on FDI in specific regions will be examined. Secondly, the focus will be on papers that investigated the effects of terrorism on FDI in specific industries. Following, studies discussing the effects of a mere risk or threat of terrorism on FDI are outlined. To conclude, a real options model is laid out which illustrates investors’ behavior when confronted with the risk of terrorism.
Abadie and Gardeazabal (2003) investigated to what extent the Spanish terrorist ensemble ETA affected the Basque Country’s economy, the Spanish state which incurred the most severe terrorist attacks in the 20th century. The two authors aimed at distilling the magnitude of the terrorist attacks on the Basque economy by comparing the Basque economy’s development to that of other Spanish states where a similar economic development could be expected, while being spared from terrorism. In order to make a feasible comparison possible, it was necessary to construct a “synthetic” Basque Country, that is, a Spanish state that is very similar to the Basque state in terms of economic characteristics. This allowed the authors to assume that fluctuations in the Basque economy can be narrowed down to the effects related to terrorist attacks by ETA. Concluding, Abadie and Gardeazabal state that after the outbreak of terrorism in the late 1960’s, per capita GDP in the Basque Country declined by about 10 percentage points relative to a synthetic Spanish control region (2003).
Enders and Sandler (1996) also initiated an attempt to investigate whether or not terrorism influences foreign direct investment in specific regions. For their analysis, they focused on Greece and Spain – two countries that could have been considered as emerging markets at that time, making the article a very relevant reference for this thesis. Enders’ and Sandler’s primary purpose was to ascertain whether terrorist acts had a measurable and significant effect since the 1970’s on NFDI in Spain and Greece. To find this out, the authors aimed to quantify the influence of terrorism on NFDI by employing modern tools of time-series analysis. They concluded that in both countries, terrorism led to a persistent and significant negative influence on NFDI and on the stock of foreign-owned capital.
A. Zussmann, N. Zussmann, and Nielson (2006) affirm the results of Enders and Sandler (1996) and Abadie and Gardeazabal (2003). According to the three Cornell based professors, Israel-Palestine conflicts caused a significant decline in asset prices during their occurrences (Zussmann et al, 2006). Moreover, they found that if peace treaties were initiated, the trend goes into the opposite direction: Asset prices increased in Israel if active diplomatic steps were taken to resolve the violent conflicts. Eckstein and Tsiddon (2004) make clear, however, that during times Israel became victim of terror, the long run equilibrium is of lower output and welfare, despite the government’s efforts to offset terror by spending tax revenue on defense.
Given these findings of previous research on the effect of terrorism on FDI, the first hypothesis to be empirically tested is the following:
H1: Terrorist acts of violence have a negative impact on FDI in emerging markets
Five years after their first publication, Abadie and Gardeazabal (2008) conducted another study in which they approached the topic of terrorism from a broader perspective. They examined how the exposure to terrorist acts of violence affected the world economy on the whole, instead of focusing on one specific location (Abadie & Gardeazabal, 2008). Abadie and Gardeazabal outline which four main effects terrorism has from an economic standpoint. These effects include the reduction of a country’s capital stock (human and physical) and the induction of higher levels of uncertainty. Furthermore, an increase in counter-terrorism expenditures is to be expected, which draws resources from productive sectors (Abadie & Gardeazabal, 2008). Lastly, terrorism is known to negatively affect specific industries such as tourism (Abadie & Gardeazabal, 2008).
Given this finding, it is worth questioning whether some industries are more inclined to be negatively affected by terrorism than others. Presumably, industries which are more capital-intensive are more vulnerable to terrorism. At least, this was the case during the terror in the Basque country, where several corporate buildings were destroyed by the terror group ETA (Abadie and Gardeazabal, 2003). Thus, FDI in the manufacturing sector, a capital-intensive industry that usually includes the construction and maintenance of large plants and machinery, is assumed to be more severely affected by a terrorist attack than FDI in the service sector, for instance, where, for example, office space does not even need to be purchased or built, but can simply be rented.
In order to investigate whether the magnitude of the negative impact of terrorism on FDI in emerging markets varies among industries, the following hypothesis is going to be tested:
H2: The impact of terrorism on FDI in emerging markets varies by sector
While in the studies mentioned in the beginning terrorism caused numerous casualties, Abadie and Dermisi (2008) analyze the case where merely the threat of terrorism was present. Specifically, they focus on Chicago, a city whose downtown central business district (CBD) represents a favorable target for terrorists given its high population density, economic significance, and the existence of government facilities and landmark buildings, such as the Sears Tower or the Hancock Center. In fact, it was exactly these characteristics that arguably made New York City the target of the 9/11 terrorist attacks. Given that Chicago may be regarded as a potential target of terrorists, Abadie and Dermisi investigated the economic impact of the increase in the perception of risk in Chicago’s CBD as a result of 9/11 by comparing the evolution of vacancy rates. More precisely, the authors observed the evolution of vacancy rates at office buildings around landmark buildings, such as the Sears Tower (highest building in the US), as well as vacancies within Chicago’s landmark buildings themselves. Their results indeed suggest that 9/11 influenced the location decision of many high-end office tenants, limiting the economic growth opportunities that come along with agglomeration effects which one normally expects in CBD’s like downtown Chicago.