FDI and Trade in an Instable Environment: Algeria by Samy Lounis

16 Pages·2012·0.16 MB·English

by  Jana Rosinski

FDI AND TRADE IN AN INSTABLE ENVIRONMENT: ALGERIA

FDI and Trade in an instable environment: Algeria
Samy Lounis
Eastern Michigan University
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FDI AND TRADE IN AN INSTABLE ENVIRONMENT: ALGERIA

Abstract
This paper provides an analysis on foreign direct investment and international trade,
and how these two relate to each other. In addition, it attempts to analyze the possible effect
of political instability on FDI, and thereby trade, for the country specific case of Algeria. It
discusses numerous relevant preceding research papers, and it provides a country analysis and
a research proposal which form the basis for a conclusion on these topics.
Keywords: foreign direct investment, trade, political instability, bi-directional linkages,
gross domestic investment, sociopolitical instability, net exporter, linear regression model and
political risk.
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FDI AND TRADE IN AN INSTABLE ENVIRONMENT: ALGERIA

Introduction
Algeria’s history of political instability and its economic focus on the fossil fuel
industry makes it a unique country and an interesting case for an economic study. Like many
of its Middle Eastern and North African (MENA) counterparts, the industry of fossil fuels,
such as gas and petroleum, accounts for a significant share of Algeria’s Gross Domestic
Product (GDP) (U.S. Department of State, Near Eastern Affairs, 2011). These vast amounts
of natural resources are likely to attract foreign economic interests, in the form of inward
foreign direct investments (FDI) flows, and increase trade flows between Algeria and
investing countries. Yet, on the other hand, for any country, political instability may prevent
any foreign investments. Therefore, in the following of this paper, I will attempt to establish
the effect of Algeria’s political instability caused by its civil war during the 1990s on inward
FDI flows and, additionally, I will venture to analyze how FDI contributes to trade. In order to
do so, I will narrow my scope of research to the country specific case of Algeria vis-à-vis the
United States.
In 1954 the Front de liberation Nationale (FLN) declared the Algerian War of
Independence, during which Algerian rebels fought their way to freedom and the
establishment of the independent People’s Democratic Republic of Algeria, as we know it
today (U.S. Department of State, Near Eastern Affairs, 2011). With this declaration of
independence came the end of an era of French oppression. Yet, it did not mean the end of
violence and political instability. As a result of a political conflict between the military and
the Front Islamique du Salut (FIS), Algeria fell into an ongoing civil war during the 1990s
(U.S. Department of State, Near Eastern Affairs, 2011). Despite its turbulent history, Algeria
has managed to become one of the largest gas and petroleum exporting nations. Statistics
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FDI AND TRADE IN AN INSTABLE ENVIRONMENT: ALGERIA
provided by the U.S. Energy Information Administration show that Algeria was the sixth
largest natural gas producer in the world in 2007, after countries such as Russia, the United
States and Norway, with a production of 3.03 trillion cubic feet of natural gas. Additionally, it
shows that Algeria contains Africa’s third largest proven oil reserves (12.2 billion barrels),
after Libya and Nigeria (United States Energy Information Administration, Independent
Statistics & Analysis: Country Analysis Brief). Other natural resources include iron ore,
phosphates, uranium and lead (Algeria: facts and figures, OPEC.org). But since the
hydrocarbon industry accounts for roughly 60 percent of Algeria’s budget revenue, 30 percent
of its GDP, and for more than 95 percent of its export revenue (Algeria: facts and figures,
OPEC.org), it is clearly the backbone of the economy. These facts also show how
undiversified the economy is and, therefore, how Algeria’s national income depends for a
significant share on this particular sector. Taking these facts into consideration, in the
following of this research paper, I will use national FDI and trade statistics, rather than
focusing on one industry. The purpose of this research setting is to provide a broader
overview of Algeria’s performance in the area of international trade and investment.
Furthermore, the dataset will consist of data ranging over a multiyear time period, from 1995-
2010 on both trade between the United States and Algeria and United States FDI in Algeria.
This time period enables me to assess the effect of political instability on FDI and how trade
between two nations within the same time frame relates to inward FDI.
In short, the general question of this research paper is whether we detect a positive
relationship between Foreign Direct Investment and Trade. In other words, do increased
levels of FDI (say from Home organizations into the Foreign economy) lead to higher trade
flows between those two economies? Applying this research setting to the country specific
case of Algeria vis-à-vis the United States, what patterns can be identified? And finally,
considering Algeria’s recent history, what effects do political instability have on attracting
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FDI, thereby affecting its trade flows with other nations? The continuing of this paper will
consist of a suitable research setting, allowing me to properly assess these problems. Based on
existing literature, dealing with both FDI and trade in general, as well as with the country
specific case of Algeria and the United States, I will then draw a conclusion on my findings,
in which I will hopefully provide some useful insights on this particular topic.
Literature
According to Aizenman and Noy (2005) FDI and trade are likely to be influenced by
similar factors, such as better institutions, growing markets and higher factor productivity.
Additionally, increased levels of trade may demand higher degrees of FDI, and an increase in
FDI may trigger trade volumes. When analyzing the relationship between FDI and trade in
general, it is therefore safe to assume that either of the two variables can influence the other.
As a result, none of the two variables is necessarily the sole explanatory variable, or
exogenously given. Consequently, a suitable research setting for this analysis is to allow for
two-way feedback i.e. endogeneity.
In their paper on two-way linkages between FDI and trade flows, Aizenman and Noy
(2005) have attempted to develop a model that would allow for such bi-directional linkages.
Within their model they assume a linear relationship between the two variables and they take
each variable once as the preceding (or explanatory) variable and once as the dependent
variable. Aizenman and Noy (2005) conclude that their analysis indicates that there is a two-
way relationship between FDI and trade. In their paper, Fontagné and Pajot (1997) argue
against the microeconomic theory that trade and FDI are substitute strategies. According to
them, empirical findings clearly show a positive relation between the two, indicating that FDI
and trade are complements rather than substitutes. Additionally, they state that when
accounting for any spillover effects of FDI on trade in other industries, the positive effect of
FDI on trade is even larger.
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Considering Algeria, no extensive literature has yet been provided on the topic of how
inward foreign direct investments have altered Algeria’s trade flows or patterns. Also, as
according to Martin (2001), levels of FDI in Algeria have always been relatively small. Since
the country relieved its restrictions on FDI in 1991, foreign direct investment flows have
never exceeded 0.1% of GNP or Gross Domestic Investment (GDI). Furthermore has this
share of FDI always been primarily in Algeria’s oil and gas sector. Possibly because of these
facts, the economic topic of how inward foreign direct investment has affected Algeria’s trade
patterns over time is still relatively unexplored.
Multiple extensive studies have been performed in the past that have allowed us to
assess the effect of sociopolitical instability on inward foreign investment flows. According to
Fitzpatrick (1983):
‘Political instability (or risk) as a concept should encompass every possible risk to
international business contained in its political environment.’’
Most existing definitions of political risk or instability focus on the concept from two
different perspectives, either in terms of government or sovereign actions or as the
occurrences of political events or constrains imposed upon a firm (Kobrin, 1979). Since
sociopolitical instability is not assumed to be the only factor affecting foreign investment
flows, most studies have a wider scope than just this particular variable. Numerous studies
approach this subject on a nationwide basis, allowing for additional variables such as, for
example, Gross Domestic Product, natural resources and labor condition. The article ‘‘The
Association between Political Instability and Flow of Foreign Direct Investment’’ by Fatehi-
Sedeh and Safizadeh (1989) presents an overview of multiple research projects on foreign
investment flows. Among others, it discusses a number of mail surveys held to collect
information from numerous multinational corporations on their foreign strategies and how
they deal with issues such as political instability. In this category of research methods,
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Aharoni (1966), Basi (1963) and Bass, McGregor and Walters (1977) all concluded that
political risk is a major consideration in foreign investment decisions. Based upon the
information collected, executives in charge of international operations, for example, perform a
so-called risk and profitability analysis. This allows them to weight the risk associated with
political instability against profit opportunities. Yet these conclusions do not justify any
assumption that political instability (or other types of risk) has a negative influence on the
willingness of corporations to invest in a particular economy. It simply shows that risk is
taken into consideration when forecasting costs and profit opportunities. When a corporation
believes it’s able to cope with certain risks and manage the associated cost, it might still
decide to seek profits in an instable economy (Fatehi-Sedeh and Safizadeh, 1989).
Although aforementioned findings seem applicable to Algeria, a number of
implications come into play. First of all, Algeria heavily restricted any form of FDI up until
1991. As a result, the difference in the legal environment in Algeria (pre- and post-1991) may
create a strong bias when assessing how Algeria’s political state during the 1990s has affected
inward FDI flows. Secondly, due to the lack of research being done on this subject
specifically for Algeria, I am unable to provide straight forward results based on the literature.
Nevertheless do the findings, which have been put forward, seem fitting to Algeria. Moreover,
in his research paper, Martin (2001) does recognizes how the surge of radical Islamism may
have contributed to performance of FDI in (mostly, but not only) Algeria. Going into this
subject he states:
‘’It’s a phenomenon which might have offset all the gains in environment
conditions for foreign investments derived from macroeconomic
streamlining and apt to scare many foreign investors altogether.’’
This in part, helps explain the relatively low degrees of foreign investment flows (as a
percentage of both GNP and GDI) over the years. On the other hand, he notes that despite the
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country’s instable situation during the 1990s, most investments were able to continue without
any serious disruptions. Specifically he states:
‘’At a country level, the pursuit of natural resources plays the key role in
inward FDI in Algeria, where the bulk of FDI has gone into the oil and
gas sectors. The relative isolation of the oil-producing areas have
permitted this investments to go on in spite of the adverse security
conditions in the country since 1992.’’
In short, most economic theory seems to agree on a positive relation between FDI and
trade. In case of Algeria, however, a number of other influential factors come in play. First of
all, its unstable political conditions and secondly its economic focus on the fossil fuel
industry. In the following sections I will develop a fitting research methodology, taking these
factors into account, analyze existing data and, finally, I will discuss my findings.
Country Analysis
The previous section has provided a good insight on some economic studies on the
topics of trade and foreign direct investment, and political instability. Applying different
methodologies, these studies have provided evidence in favor of a positive relation between
trade and FDI, where other studies have shown the effects of political instability on FDI.
With these studies in mind, in this section, I will go more in depth on these topics for the
Algerian economy. More specifically, in this section I will analyze the effect FDI in Algeria
on national trade volumes using current data and statistics. Additionally, I will address the
issue of Algeria’s political instability and in turn, how this has influenced the willingness
among corporations to invest in the Algerian economy. Based on my findings I will then draw
a conclusion.
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FDI AND TRADE IN AN INSTABLE ENVIRONMENT: ALGERIA
Trade statistics provided by the United States Census Bureau on Foreign Trade show
monthly trade flows between the United States and Algeria over the period from 1985 till
2011 (September). Figure 1 shows Algeria’s trade balance with the United States.

Figure 1
20,000.00
18,000.00
16,000.00
14,000.00
12,000.00
10,000.00
8,000.00
6,000.00
4,000.00
2,000.00
0.00
19851987198919911993199519971999200120032005200720092011

* Figure 1 shows Algeria’s trade balance with the United States during the period 1985 – 2011.

Without any yearly exceptions, during this period Algeria has always been a net exporter in
this trade relationship. These statistics also show some interesting developments. From 2002
and onwards, United States’ imports from Algeria start to increase significantly. Where total
imports in 2002 were valued at $2.36 billion, they almost doubled in 2003 ($4.7 billion), and
this import expansion has continued until now, reaching its highest levels in 2008 ($19.35
billion). Despite these increases in imports, United States’ exports to Algeria show no
significant changes during this period. With volumes valued between $1 billion and $2 billion
(or close to) during this same period, yearly export amounts have remained relatively
unchanged compared to earlier years. As a result, United States’ trade balance versus Algeria
has deteriorated significantly. Does this show that inward foreign direct investment mainly
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has an effect on a country’s exports? In order to answer this question I must first analyze
United States’ FDI in Algeria over the same time period. As mentioned before, levels of FDI
inflows in Algeria have always been relatively low Martín (2001). Both IMF and World Bank
statistics estimated last years (2010) total inflow of FDI to be approximately $2.3 billion,
which is 1.44% of Algeria’s GDP. These databases show even lower degrees of inward FDI
for preceding years.
A suitable model which would allow me to analyze the relationship between these
variables would be a linear regression model in two parts. First of all, a simple linear
regression model that explains Algerian trade volume as a dependent of inward FDI in
Algeria. Secondly I need to develop a model that allows me to explain FDI as a function of
macroeconomic conditions in the Algerian economy. In their research on the determinants of
United States FDI in Africa, Nnadozie and Osili (2004) summarize these macroeconomic
conditions in 6 economic, social and political factors. I agree with their choice of variables, so
I will base my model on these same conditions. Additionally, I will add a variable ‘size of
labor force’, because I believe this will strengthen the model. Translating all this into an
equation, I obtain:
• Trade (X+M) = f(FDI inflow) (1)
• FDI inflow = f(GDP, economic growth, quality of infrastructure, inflation rate,
political risk, quality of labor force, size of labor force) (2)
This would than translate into the following two linear regression models:
• Y(trade) = α + β(FDI inflow) (3)
• Y(FDI inflow) = [α + β1(GDP) + β2(economic growth) + β3(quality of
infrastructure) + β4(inflation rate) + β5(political risk) + β6(quality of labor
force) + β7(size of labor force)] (4)