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Foreign direct investment, aid, and terrorism

By Subhayu Bandyopadhyay, Todd Sandler, and Javed Younas


In recent years, developing nations have been major venues of terrorism. One significant problem caused by terrorism in developing nations is the reduction of foreign direct investment (FDI) into these nations as potential investors seek safer locations. Terrorism raises political instability, destroys infrastructure, and puts the lives and property of workers (foreign and domestic) at greater risk. The ex ante effect of these risks is akin to a reduction of output produced from a given level of inputs, effectively lowering the rate of return of FDI. Thus, the greater the terrorism risk in a particular developing nation, the greater the diversion (and outflow) of FDI from that potential destination nation to a competing lower-risk destination.

The literature on the economics of terrorism has helped to quantify the adverse effects of terrorism on FDI. For example, Abadie and Gardeazabal (2008) find that a significant increase in terrorism risk can reduce net FDI position by approximately 5 percent of a nation’s GDP. However, this literature does not tell us whether the two components of terrorism, domestic and transnational, have similar effects on FDI. A terrorism incident is “domestic” when it is entirely homegrown and home-directed, where the perpetrators, victims, supporters, and targets are all from the venue nation. In contrast, terrorism is “transnational” where at least two nations’ citizens or properties are involved. While both forms of terrorism enhance investment risk, we anticipate a greater marginal impact of transnational terrorism on FDI in the venue nation for at least two reasons.

First, it is possible that foreign assets and personnel may be directly targeted by the terrorists to achieve greater international attention. Second, in the case of transnational terrorism, terrorists’ assets may be partly based abroad, making it harder for the venue nation to succeed in its counterterrorism efforts. Ultimately, comparisons of the effects of the two types of terrorism on FDI require careful empirical analysis. Using data from 78 developing nations between 1984-2008, we find that a one standard deviation increase in domestic terrorist incidents per 100,000 persons reduces net FDI between 323.6 to 512.94 million US dollars for an average developing country. Turning to transnational terrorism, a one standard deviation increase in incidents per 100,000 persons reduces net FDI between 296.49 to 735.65 million US dollars for an average developing country. It should be noted that the decline in FDI is larger for domestic terrorism because in terms of absolute numbers, domestic terrorism incidents far outweigh transnational terrorism incidents in developing nations. Indeed, along the lines of our expectation above, we find that, at the margin, an incident of transnational terrorism causes a greater adverse effect on FDI than an incident of domestic terrorism.

Foreign aid provided by developed nations can provide scarce resources that developing nations can use to fund their counterterrorism activities. To the extent that foreign aid is fungible, aid given for other purposes may still help in relaxing the counterterrorism resource demands of a developing nation, thereby mitigating FDI losses from terrorism. Our analysis reveals that this is precisely the case – the lower estimates of FDI losses due to domestic terrorism are reduced to US$113.44 million or by just under two-thirds. The reduction of losses due to transnational terrorism is also dramatic with the lower estimate being reduced to US$45.24 million or by about five-sixths. The mitigating influence of aid on terrorism-induced losses in FDI has not been recognized nor quantified in the literature.

Finally, we distinguish between multilateral and bilateral aid, and find that bilateral aid is more effective in reducing the adverse FDI effects of transnational terrorism, while multilateral aid is more effective in limiting FDI losses due to domestic terrorism. Due to data limitations, we cannot explicitly investigate what causes this difference. One possible explanation is that donors provide bilateral aid to nations where they have FDI interests, thus closely tying such aid to specific counterterrorism measures that safeguard donors’ interests. In contrast, multilateral aid may help the recipient nations improve their overall economic performance, thereby curbing grievances and the ensuing domestic terrorism. Improved economic performance and more harmonious citizens can then enhance FDI inflows.

Subhayu Bandyopadhyay, Todd Sandler, and Javed Younas are authors of ‘Foreign direct investment, aid, and terrorism’, published in Oxford Economic PapersSubhayu Bandyopadhyay is a Research Officer at the Federal Reserve Bank of St. Louis. His research interests include international trade and the economics of terrorism. Todd Sandler is the Vibhooti Shukla Professor of Economics and Political Economy at the University of Texas at Dallas. He has contributed articles on terrorism to top journals in economics and political science since 1983. Javed Younas is an Associate Professor of Economics in American University of Sharjah. His research is in the areas of international economics, development economics and economics of terrorism.

Oxford Economic Papers is a general economics journal, publishing refereed papers in economic theory, applied economics, econometrics, economic development, economic history, and the history of economic thought.

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