Risk and Foreign Direct Investment - Index of

A Review of Theory Concerning Risk and the Foreign Investment Decision 17
of stakeholders is usually ignored, the next generation. It is impossible
to commit future unborn generations to current risk-sharing arrangements
through private contracts. There is a danger future generations
may reject such contracts, sometimes through the political process,
sometimes not. Complete intergenerational risk sharing is ruled out.
Nor can any private entity ever credibly commit not to default on its
future obligations; there is always some default risk. An individual may
default deliberately as a matter of strategy or be forced to default by circumstances
beyond his/her control. Sometimes the default has a
significant negative impact on the conduct of business.
Another difficulty is that some benefits and costs, including particular
types of risk, are not fully reflected in the price of a product, but are
externalised. Externalities exist at every level of an economy. They may
simply be external to a project but still internal to an enterprise or
external to the enterprise but internal to an industry.
There may also be dangerous feedback loops such as financial panics
resulting from contagion effects. Depositors will withdraw money from
an otherwise sound institution simply because there is danger that
others will do so. In a race to get access to liquid assets many depositors
may lose out and the institution may go bankrupt regardless of its
initial state. The same might apply at the country level with a run on a
country, resulting in a rapid and large outflow of financial assets. All
market economies operate on the basis of perceptions and therefore of
confidence.
Network effects are a positive manifestation of an externality, where
the value received by a consumer in his/her consumption reflects the
number already consuming. For example, the greater the number of
consumers operating a third generation mobile phone, the greater the
potential benefit to be derived by a new consumer. It does matter how
many other consumers you can link up with. This is similar to the old
bootstraps argument which was once advanced on the basis of pecuniary
external economies, that is, that the simultaneous implementation
of a number of linked projects favours them all, if only in the
increased demand generated.
A second assumption is that all players have similar knowledge, that is,
they are exposed to the same new information, perceive it and are
capable of processing it in the same way. In the literature on both risk
and FDI there has been an increasing focus on imperfections in access to
information. Much uncertainty or risk arises because of ignorance, a lack
of adequate information on possible risk-generating events. The frequency
of occurrence of some risk-generating shocks cannot be predicted