Diaspora Investment: Filling the Financing Gap in FCS Economies

Filling the financial gap in FCS economies

Private sector development and economic growth are critical to the peacebuilding process in fragile and conflict-impacted states (FCS). In order to realize the potential of the private sector in these contexts, small and medium-sized enterprises (SMEs) need access to capital. However, for a variety of reasons, access to capital in fragile contexts is extremely limited. Who has the motive and means to make the investments in high-risk situations necessary to help pull fragile states out of a cycle of conflict? Diaspora investors may be a key piece of the puzzle in bridging this investment gap.

Capital Scarcity in FCS Economies

FCS economies are often characterized by extremely limited access to capital for private sector development, particularly for SMEs, for two primary reasons. The first is the domestic financial sector. Domestic financial sectors in these economies are often underdeveloped, with very low levels of banking penetration compared to global averages. What’s more, these nascent financial institutions often avoid the kind of small-scale commercial lending necessary for SME development. Domestic financial institutions are, understandably, risk averse during and immediately after conflict. This, combined with the informal nature of many SMEs in these economies, means financial institutions focus lending primarily on only the largest of domestic firms.

In many cases, a shortfall in domestic lending would create an opportunity for increased foreign capital inflows. However, in the context of FCS economies, perceptions of security and political risk limit investor willingness to place capital. In many cases, conflict emergence or escalation leads to foreign capital flight, and investors that have left are often hesitant to return to a country while the potential for renewed conflict lingers.

This combination of underdeveloped domestic financial institutions and risk perceptions among foreign investors leads to significant investment capital scarcity. Many firms in FCS economies must rely entirely on internally generated capital for growth. This places a significant artificial cap on the growth potential of domestic SMEs. Hamstrung private sector growth in turn limits the potential peacebuilding benefits of economic development.

So, how might this gap in critical investment capital be filled?

Diaspora Investment: The Missing Piece to the Puzzle?

There are several reasons why increased diaspora investment in their countries of origin may help fill this gap in development finance in FCS contexts.

  • Already Remitting. Many diaspora members are already regularly contributing to development in their countries of origin through remittances sent to family and friends. An estimated $450 billion in remittances was sent globally in 2016. Many diaspora members remit significant amounts on a regular basis and are, therefore, already financially invested in the welfare of communities in their country of origin. However, while remittances are critical for insuring short-term welfare, very little of the money remitted is used for employment and income-generating activities, limiting its impacts on long-term development. Diaspora members who are already remitting may be interested in investment because of its more sustainable impact on development, in addition to financial returns.
  • Capable and Interested Investors. Many diaspora communities from FCS states are large and well established, and have accumulated significant savings that could be leveraged for investment. For example, the global Somali diaspora was estimated to include 1.9 million members with a collective savings of $10.6 billion in 2012. Diaspora communities from developing countries were estimated to collectively hold $500 billion in savings. What’s more, surveys demonstrate many diaspora members are active investors interested in opportunities in their countries of both residence and origin. This is not to say that every diaspora member is in a position to invest in their country of origin, but there is a significant pool of investors with the means and desire to invest when presented with the right opportunity.
  • Unique Motivations. But what makes diaspora investors unique? One of the distinguishing characteristics of diaspora is their unique combination of motivations for making investments. Like any investor, diaspora members strongly consider financial risk and returns in their investment decisions. However, diaspora investors also describe being motivated by a desire to impact social welfare, and in some cases prepare the way for a return to their countries of origin in their investment decisions. These additional, nonfinancial motivations are likely to change the decision-making calculus of diaspora members, making them more willing to accept investment in risky environments where opportunities meet their dual financial and social good motivations. In this way diaspora members are well suited to serve as frontier investors in FCS economies that other sources of capital still consider too volatile.
  • Investing Advantages. Finally, there is reason to believe that diaspora members are not only more willing but potentially better suited to succeed when investing in their FCS countries of origin. This investment advantage largely boils down to access to information. Familiarity with the language, culture, business climate, and regulatory/legal environment in their country of origin allows diaspora investors to find lucrative opportunities and minimize risk in ways traditional foreign investors cannot. Because of these advantages and relatively high returns on investment in FCS economies, diaspora members do not need to be driven primarily by social factors to invest in their countries of origin, as there is the potential for significant financial gain.

The Path Forward

Given the unique potential of diaspora to contribute to development finance in fragile contexts, how can such investment be increased? A new report by OEF Research explores some of the various investment mechanisms, engagement strategies, and public policies that could help facilitate this critical flow of investment into FCS economies. Fragile state governments, international financial institutions, development agencies, diaspora networks, NGOs, and academia can all contribute in various ways toward this goal.