Political Risk Analysis

Dr. Sima Motamen Westminster Business School

March 6, 2008

Political Risk & Foreign investment

Investors might become exposed to a range of political risks when investing in a foreign country. Political risk refers to the potential losses to foreign investors from adverse political developments in the host country. Political risks cover a wide range of risks from outright expropriation of investors assets, to concern about changes in the tax laws that may hurt the profitability of foreign projects.

Classification of political risk

Depending on how firms or investors might be affected by an incidence, political risk can be classified into 3 categories: 1. Country specific risks (Macro risks)
Political & Economic stability of the country, attitude of government and public in the host country towards government of foreign investors Host countrys political & government administrative infrastructure. For example, number of political parties, frequency of change in governments, (this can cause frequent policy changes, and inconsistent & discontinuous economic and political environment. Track records of political parties and their relative strength, e.g. what type of ideology they support, what is the ideology of the main party? Conflict between the activities/goals of firm and those of the host country as evidenced by existing regulations.

2.

Firm specific risk (Micro risks)

2.

Global specific risks

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Country specific risks (Macro risks)

1)

These affect MNCs at the project and corporate level and originate at the country level. They include: Transfer risk, which arise from uncertainty about crossborder flows of capital payments and know-how, unexpected imposition of capital controls inbound or outbound, blocked funds, withholding taxes on dividend and interest payments, etc. Operational risks, these are associated with uncertainty about the host countrys policies affecting the local operations of MNCs, some overlap with firm specific risk, e.g. unexpected changes in environmental polices, sourcing local content requirements, etc. Cultural & institutional risks, related to ownership structure, human resource norms, minimum wage laws, religious heritage, nepotism and corruption, intellectual property rights, and protectionism.
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2)

3)

Firm specific risk (Micro risks)

These affect the MNC at the project/corporation level. Three types: Interest rate and Foreign exchange risks,
These arise from fluctuation in host countrys interest rate or currency vis--vis home currency.

Business risks, arise from factors affecting cash flows and

hence profitability of the firm, such as change in taxation for foreign firms, or local disputes with trade unions or suppliers, etc.

Governance & Control risks, arise from uncertainty about

the host countrys policy regarding ownership, and control of local operation, restriction on access to local credit facilities, goal conflict between a MNC and the host government.

Global specific risks

These too affect the MNCs at the project or corporate level but originate at the global level. Examples:
Terrorism Anti-globalization movements Environmental concerns Poverty Cyber attacks
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Problems in assessing political risk

Difficulties in anticipating:
1. If any change is likely to occur over the life of the project. 2. How those changes might affect the host countrys goal priorities? 3. How new regulations might be implemented to reflect new priorities? 4. What might be the likely impact of such changes on the firms operation?
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Predicting Country-Specific Risk

In order to assess country specific risks, one needs to assess political & economic stability of a country in terms of; 1) Evidence of turmoil or dissatisfaction 2) Indicators of economic stability 3) Trends in cultural and religious activities Data can be assembled by; a) monitoring the local media (local newspapers, radio & TV broadcasts. b) publications of diplomatic sources c) Tapping knowledge of outstanding expert consultants d) Contact other businesses who have had recent experience in the host country e) Conduct on site visits f) Examine reports of the ratings agencies
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Significant changes are rarely identified in advance. Economic indicators may not continue moving in the same direction in the future. Assessment of only one rating company is not sufficient. Consider ratings of a number of agencies that assess county risks, such as:
S&P Moodys EIU Euromoney Institutional Investor International Country risk guide Milken Institute Capital Access Index Overseas Private Invest Corp.

Watch for

Managing Country-Specific Risks: Transfer Risk

Prior to making an investment, a firm should assess the impact of blocked funds on:
Expected return on investment Desired location of financial structure Optimal links with subsidiaries

During the operations a firm can move funds through variety of repositioning. Funds that can not be moved must be reinvested in local country such that, avoid deterioration in the real value due to inflation or exchange rate depreciation.
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Pre-investment strategy to Anticipate Blocked Funds

Assess both temporary and long term impact of funds blockage on expected return of investment. Minimize the effect of blocked funds by;
Borrow locally to avoid problems of repayment of external loans. Arrange swap agreements

Link sourcing & sales with subsidiaries to maximize potential for moving blocked funds.
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Strategies for Moving Blocked funds

1. 2.

3. 4.

5.

6.

7.

Provide alternative conduits for repatriating funds. Use transfer pricing between related units of the MNCs. Lead and lag payments Use fronting loans (parent company deposits fund with an international bank and that bank lends to the firm. In case of hostility between the parent country and the local country, the local govt. may still allow funds to be repaid to the international bank). Create unrelated exports (some new exports can be created to move the profits out). Special dispensation ( Bargain to get at least some part of the blocked funds out). Beware of self-fulfilling prophecies ( some actions may backfire and cause full blockage of funds). 12

Forced Reinvestment

Temporary blockage
invest in money market (if available), or deposit in banks (even though the rate of return might be low)

Long term blockage

invest in bonds or bank time deposits or lend to other businesses

No possibility of short or long term investment,

invest in another related line of activity, e.g. in Peru an airline co. invested in hotels purchase other assets that might better cope with inflation, e.g. buy land, office buildings, or commodities that can be exported to global markets Stockpile inventories that can be sold at a later stage. 13

Country-Specific; Cultural and Institutional Risks

There might be a number of Cultural &/or Institutional differences between MNCs & the local country:
Countries may require majority local share ownership. In particular in certain industries such as banks, national defence, etc.

Differences in allowable ownership structures Differences in human resource norms Differences in religious heritage

Requirement to recruit locally might cause difficulties in firing some workers Employment of women managers may face resistance Religious differences might restrict the activity of the firm Firms link with HQ/subsidiary in some countries may cause problem

These may restrict the ability of the firm to operate efficiently. They might also add more costs in terms of corruption or adversely affect firms reputation at home in terms of Corporate Social Responsibility.

Nepotism and corruption in the host country

Protection of Intellectual Property Rights (IPR) Protectionism

Need to draw some legal agreement with the host country to protect IPR.
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Need for awareness about the sectors that are highly protected, e.g. defence, agriculture, etc.

Predicting Firm specific risks

Main objective: anticipate the effect of political change on activities of a specific firm. Different firms have different degrees of vulnerability to change in policy or regulations. For example, a food chain franchise may not experience similar risks as a car manufacturer, or a firm involved in hotel and catering. Need for tailor-made studies by in-house analysts for a firm specific activity. Outside analysts may not have full view of position of firms and changes that are taking place. Need to plan protective steps to minimize risks of damage from unanticipated changes.
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Firm-Specific Governance Risks

This is related to ability to exercise effective control over firms operation within a countrys legal & political environment. Government goals might be different from firms goals. Governments try to protect their constituencies, firms try to protect their shareholders. Possible areas of conflict; Impact of firms activity on the economy Perceived infringement on national sovereignty Foreign control of key industries Sharing or non-sharing of ownership and control with local interests Impact on a host countrys balance of payments Influence on the foreign exchange value of the countrys currency Control over export markets Use of domestic versus foreign executives and workers 16 Exploitation of national resources.

Reduce Governance Risks by Negotiating investment Agreement

To avoid future conflicts it is better to anticipate future problems and negotiate in advance. Investment agreement should spell out managerial and financial policies on the following issues;
i. The basis on which funds may be remitted, e.g. dividends, management fees, royalties, patent fees, and loan repayments. ii. The basis for setting transfer prices. iii. The right to export to 3rd country markets. iv. Obligations to build or fund social & economic overhead projects, such as schools, hospitals, and retirement system. v. Methods of taxation, including the rate & type of taxation, and means by which the base rate is 17 determined.

More Negotiation
vi. Access to host country capital markets, particularly for long term borrowing. vii. Permission for 100% foreign ownership versus required local ownership (joint venture) participation. viii. Price controls, if any, applicable to sales in the hostcountry markets. ix. Requirements for local sourcing versus import of raw materials and components. x. Permission to use expatriate managerial and technical personnel, and to bring them and their personal possessions into the country free of exorbitant charges or import duties. xi. Provision for arbitration of disputes. xii. Provision for planned divestment, should such be required, indicating how the going concern will be 18 valued and to whom it will be sold.

Investment Insurance and Guarantees

Insure political risk with a home country public agency. For example, Overseas Private Investment Corporation (OPIC) in the USA. Some of the risks insured in developed countries:
Inconvertibility (risk of not being able to convert profits, royalties, fees, or other income, as well as the original capital invested).

Expropriation (risk of host government preventing the investing

firm to take control over the use of property for one year)

War, revolution, insurrection, civil strife (risk of damages to

the property and activity of investor and firms inability to repay a loan) damages incurred due to political violence)

Business income (risk of loss of business income resulting from

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Operating Strategies after the FDI

Political change can result in introduction of new rules, or cancellation of earlier agreements. Better to renegotiate & revise the existing agreement in light of changes made by the host government Future bargaining position can be enhanced by careful consideration of policies in;
production, logistics, marketing, finance, organization, personnel.

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Reducing political risks

MNCs should secure some bargaining points.

Local sourcing

(purchase of raw material & components locally can reduce political risk but increase commercial and financial risk)

Facility location

(production facilities can be located such that to minimize risk. Resource oriented activities have to be near resources, but footloose and market oriented activities can move to other locations to reduce risk, e.g. oil wells and refineries)

Control of transportation (can substantially influence Control of technology

( control over key patents can reduce political risks for firms.) 21

the bargaining power of both local governments and MNCs, and hence political risk. E.g. oil pipelines cross national frontiers.)

More Bargaining points

Control of Markets

(firms can increase their bargaining power by controlling the markets where their products are sold, e.g. petrol stations back at home. Some governments try to bypass this, e.g. Q8)

Brand name and trademark control

Keep control of brand name ad trademark.

Thin equity base

borrow locally rather than financing all the capital externally

Multiple-source borrowing
If funds need to be raised externally, then it is better to borrow from a number of different banks in different countries rather than 22 just from home banks

Predicting Global Specific Risks

More difficult to predict than the other two types Sometimes impossible, e.g. Sept. 11th Once something happens various protective measures may be taken in anticipation of further attacks. Assess the following:
Type of terrorist threats Their location Potential targets

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Global-Specific Risks; Terrorism and War

Support government efforts to fight terrorism & War Manage Cross-Border Supply Chain by:
Keeping larger Inventory Work more closely with local suppliers Evaluate air Transportation vis--vis land

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Other Global-Specific Risks

MNCs have been criticised for their role in globalization, global warming & poverty Hence are exposed to extreme reactions by activists. Attacks might happen both at home and in foreign countries. Need for government support to manage the risk
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