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Political Risk Insurance and International Development

September 30, 2016

While official development assistance[1] will continue to have a place in international development, recent years have seen greater recognition of the importance of private capital flows into developing countries. Several multilateral development banks have assumed an important role in encouraging these flows through the provision of political risk insurance.

By Pei Neo, MBA’16

Private capital flows take different forms, such as foreign direct investment flows, debt flows and portfolio equity flows. Infrastructure development is in particular need of private capital flows as there is often an inadequate level of public-sector resources for this purpose, which requires significant capital outlay.

International investors, however, may be wary of investing in developing countries. There is a perception of heightened risk of doing business in these countries for the following reasons: there may be inadequate respect of property rights and the government may expropriate the investor’s asset, the government may impose restrictions on currency conversion, or there may be war and civil disturbances that disrupt business operations, among other risks.

Figure 1[2]

Political risk that concerns investors in developing economies 

As such, several multilateral development banks have political risk insurance agencies that offer such insurance to investors to mitigate the impact of non-commercial risks in these markets. Subject to each agency’s conditions, if any of the above risks manifests itself, the agency will pay out a claim to the investor. In practice, if the agency learns of an imminent risk, it will attempt to manage the risk and facilitate the resolution of the issue through mediation, even before any damage occurs and a claim has to be paid out. 

Without the guarantee, the investors may not invest in the countries, or they may demand very high equity stakes and interest for loans, in exchange for taking on the risk. The investment guarantee therefore creates access to investment or lowers the amount a developing-country company needs to give up to access an equity or debt investment.

Developing countries also benefit from longer-term investment if foreign investors have confidence that they will not suffer significant losses even if negative political conditions surface in the country over time.

Moreover, the investment guarantee and endorsement given to a project by a multilateral agency could help the project attract more sources of financing. Multilateral development banks and their political risk insurance agencies are often perceived to have deep local knowledge and relationships that private financial actors may not always possess and, therefore, a greater ability to accurately evaluate the viability of a project.

Private sector insurers offer political risk insurance as well, but the insurance they provide tends to be of a shorter tenor than what multilateral insurance providers offer. In addition, given their development mandate, these multilateral insurance providers are likely to undertake more stringent due diligence on Environmental, Social and Governance issues and the development impact of a project before agreeing to provide insurance. The activity of private and multilateral insurance providers need not be mutually exclusive. In certain cases, private insurers may be encouraged to also underwrite an investment if a multilateral insurance provider is doing so. 

Official development assistance still retains its value in assisting economies at the earliest stages of development or recovery from a crisis. It also facilitates the development of sectors where private capital does not enter for lack of prospects of earning profit. However, private-sector investment should be encouraged where viable, and instruments such as political risk insurance are a vital means to do so. As the World Economic Forum recommended in 2006, multilateral development banks’ activities “should shift over time from direct lending to facilitating the mobilization of resources from the world’s largest private saving pools – international or domestic – for development-oriented investments through … wider use of risk mitigation instruments to alleviate part of the risk faced by investors”.[3]

In a world where the infrastructure-financing gap appears formidable for many countries, if private capital can help to fill that gap while earning a profit with the assurance that investments will be protected, one would be hard-pressed to reject that proposition.

 

References

  [1] Official development assistance (ODA) is “government aid designed to promote the economic development and welfare of developing countries. Loans and credits for military purposes are excluded. Aid may be provided bilaterally, from donor to recipient, or channelled through a multilateral development agency such as the United Nations or the World Bank. Aid includes grants, ‘soft’ loans (where the grant element is at least 25% of the total) and the provision of technical assistance. The OECD maintains a list of developing countries and territories; only aid to these countries counts as ODA”. Cited in https://data.oecd.org/oda/net-oda.htm.

  [2] Percentage figures reflect the percent of investors surveyed who are of the view that the respective risks are of greatest concern over a three-year horizon. From MIGA-EIU Political Risk Survey 2013 in World Investment and Political Risk 2013. Washington, DC: MIGA, World Bank Group. DOI: 10.1596/978-1-4648-0039-9 License: Creative Commons Attribution CC BY 3.0

  [3] World Economic Forum (2006), cited in https://www.iisd.org/sites/default/files/publications/credit-enhancement-green-projects.pdf.

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