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War and peace and FDI

The link between foreign direct investment and peace is clear, but the direction in which it runs is less obvious.

fdi-peace-iraq
Does peace bring FDI or does FDI bring peace? In countries such as Iraq, the cessation of hostilities has been followed by an easing of restrictions on foreign investment in potentially lucrative sectors, such as oil in Iraq’s case. (Photo by Haidar Hamdani/AFP via Getty Images)

In his 1795 essay ‘Perpetual Peace’, philosopher Immanuel Kant argued that the “spirit of commerce” was incompatible with war. Trade, Kant thought, would create such a dense interdependence among nations that war would become economically unthinkable.

Kant’s predictions about the forward march of economic interdependence were prescient, more so than his belief that this would usher in an age of global harmony. By the time of Kant’s essay, international trade had already driven Europe’s violent conquest of the Americas and India, and the search for investment opportunities abroad would soon usher in the even bloodier era of high imperialism.

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Nonetheless, Kant’s argument – derived from Montesquieu – received renewed attention as capitalism spread across the former Soviet bloc, seemingly cementing a new Pax Americana. In 1996, Thomas Friedman famously wrote: “No two countries that both have a McDonald’s have ever fought a war against each other.”

Is it FDI or profits that bring the peace?

The US bombing of Belgrade put an end to Friedman’s theory, but its general thrust has proven largely correct. Study after academic study has shown that greater foreign direct investment (FDI) flows between two countries are associated with a much lower incidence of conflict between them. For instance, researcher Quan Li found that countries at peace have, on average, 40% greater bilateral FDI flows than countries at war.

Arguments positing a simple relationship between FDI and peace, however, are complicated by the inadequacies of FDI data. FDI statistics lump together a wide range of capital flows with varying implications. Greenfield investments can be expected to contribute to job creation, for instance, while the impact of mergers and acquisitions is more ambiguous.

When it comes to the effects of FDI on conflict, the key distinction may be sectoral. Analysing data on FDI and civil conflict from 1980 to 2013, one study found that primary sector FDI – including agriculture and extractive industries – was associated with a greater level of civil strife, while the opposite was true for FDI in the service sector. FDI in manufacturing, meanwhile, was found to have ambiguous effects.

More importantly, these studies don’t necessarily show that FDI is a force for peace. Instead, the causal relationship may run in the exact opposite direction. In Friedman’s terms, it may be that McDonald’s only invests in countries that the US is at peace with. 

Political instability and FDI

Whether FDI promotes peace or vice versa is of more than just academic interest. The gradual decoupling of the US and Chinese economies, for instance, could be seen as either a symptom of geopolitical tensions or a contributing factor.

Indeed, an expansive literature has demonstrated that investors avoid political instability – and particularly violence – to the best of their ability. A 2019 World Bank survey of investors found that political stability was the single most important factor affecting their decision making, with 49% describing it as ‘critically important’, compared with just 33% who said the same about local wages.

It is not hard to understand why investors might prefer to avoid war zones. Not only does conflict endanger the physical security of the investment and those operating it, but political instability more generally may increase the risk of expropriation and capital controls.

In contrast to the survey evidence, statistical efforts to demonstrate an effect of conflict on FDI inflows have produced more ambiguous findings.

One explanation for this is that conflict has different effects on FDI at different points in a project’s life cycle. Researcher Colin Barry found that conflicts do reduce investors’ propensity to enter a market, but do not encourage existing investors to leave. Only the longest and most intense civil wars, he found, motivate investors to flee in significant numbers.

This is because investors that have already entered a market have, depending on the nature of their investment, sunk costs that cannot easily be retrieved in the event of a hasty exit. This is particularly true for investors in industries such as oil and gas extraction, mining and utilities, who therefore have strong financial incentives to stay put and wait for the conflict to blow over.

Disentangling the relationship between war and FDI

Disentangling the causal relationship between FDI and conflict has proven difficult for researchers. Li found that wars do tend to occur between countries that already have lower levels of bilateral investment, seemingly suggesting that FDI promotes peace, rather than the other way around. FDI flows, he found, only decreased by a relatively small amount after the war’s onset.

As Li notes, however, this could equally be a result of investors anticipating the risks of conflict ahead of time, and therefore evidence for peace shaping FDI flows.

FDI flows also tend to surge between countries that have just ended hostilities – reaching levels far exceeding the flows that existed immediately before the war. Li suggests that this indicates that investors not only anticipated conflict in the year before the war, but anticipate a period of peace following the conclusion of hostilities.

An alternative explanation gives causal primacy to neither FDI nor conflict, but a third factor: politics. War, in some cases, may remove obstacles to investment that kept bilateral FDI flows particularly low in the period before the conflict. The US-led invasion of Iraq in 2003, for instance, was followed by a substantial easing of restrictions on foreign investment in the country’s extensive oil sector.

Historically, imperial powers frequently launched wars in order to open up other countries to inward investment. As the liberal Italian economist Achille Loria wrote in 1899: “While the manufacturer and trader are well content to trade with foreign nations, the tendency for investors [is] to work towards the political annexation of countries.”

However, investment protection today rarely requires war or annexation. Instead, it has been judicialised through the spread of investment treaties and domestic investment protection laws. With notable exceptions, such as Iraq, this system tends to be expanded through non-military means – whether that be the election of pro-business governments or the imposition of structural adjustment programmes by the IMF and World Bank.

While surveys can demonstrate that peace promotes investment, no such simple evidence exists to test whether investment promotes peace. The link between FDI and peace is clear, but the direction in which it runs is less obvious.

Ben van der Merwe

Ben van der Merwe is a data journalist at GlobalData Media, specialising in FDI.