Terror, Political Risk, and Effect on Foreign Direct Investment

Abstract

Terrorist attacks have important social, political, and economic effects. One of the effects of terrorism involves the impact on foreign direct investment (FDI). While existing research suggests that terrorism negatively impacts FDI by increasing political risks, it is unclear how the effects of terrorism are conditioned by host country institutions. Political institutions may affect investors’ perceptions of political risk following a terrorist attack by shaping expectations of future political risk. We argue that the conditional effect of institutions and terrorism is non-linear: Terrorism has a negative effect on FDI inflows to countries with a medium level of institutional effectiveness only. Using quantitative analyses of FDI flows and political risk ratings, we show that terrorism has no effect on FDI in host countries with very high or very low levels of political institutional effectiveness. In a qualitative analysis of FDI and terrorism during the civil wars in Algeria and El Salvador, we demonstrate that concerns about institutional effectiveness played an important role in producing disinvestment by foreign investors. This research contributes to the literature on the determinants of FDI, effects of terrorism and political risk, and suggests that institutions play an important role in affecting how investors perceive political risk.