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Political Risk AnalysisPolitical Risk Analysis

Dr. Sima MotamenDr. Sima Motamen Westminster Business SchoolWestminster Business School

March 6, 2008March 6, 2008

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Political Risk & Political Risk & Foreign investment Foreign investment

Investors might become exposed to a Investors might become exposed to a range of political risks when investing in a range of political risks when investing in a foreign country.foreign country.

Political risk refers to the potential losses Political risk refers to the potential losses to foreign investors from adverse political to foreign investors from adverse political developments in the host country.developments in the host country.

Political risks cover a wide range of risks Political risks cover a wide range of risks from outright expropriation of investor’s from outright expropriation of investor’s assets, to concern about changes in the assets, to concern about changes in the tax laws that may hurt the profitability of tax laws that may hurt the profitability of foreign projects.foreign projects.

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Classification of political riskClassification of political riskDepending on how firms or investors might be affected Depending on how firms or investors might be affected by an incidence, political risk can be classified into 3 by an incidence, political risk can be classified into 3 categories:categories:1.1. Country specific risks (Macro risks) Country specific risks (Macro risks)

• Political & Economic stability of the country, attitude of government and Political & Economic stability of the country, attitude of government and public in the host country towards government of foreign investors public in the host country towards government of foreign investors

• Host country’s political & government administrative infrastructure. For Host country’s political & government administrative infrastructure. For example, number of political parties, frequency of change in example, number of political parties, frequency of change in governments, (this can cause frequent policy changes, and inconsistent governments, (this can cause frequent policy changes, and inconsistent & discontinuous economic and political environment.& discontinuous economic and political environment.

• Track records of political parties and their relative strength, e.g. what 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?type of ideology they support, what is the ideology of the main party?

2.2. Firm specific risk (Micro risks)Firm specific risk (Micro risks)• Conflict between the activities/goals of firm and those of the host Conflict between the activities/goals of firm and those of the host

country as evidenced by existing regulations.country as evidenced by existing regulations.

3.3. Global specific risksGlobal specific risks

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Country specific risks (Macro risks)Country specific risks (Macro risks) These affect MNCs at the project and corporate level These affect MNCs at the project and corporate level

and and originate at the country level.originate at the country level. They include:They include:1)1) Transfer riskTransfer risk, , which arise from uncertainty about cross-which arise from uncertainty about cross-

border flows of capital payments and know-how, unexpected border flows of capital payments and know-how, unexpected imposition of capital controls inbound or outbound, blocked imposition of capital controls inbound or outbound, blocked funds, withholding taxes on dividend and interest payments, funds, withholding taxes on dividend and interest payments, etc. etc.

2)2) Operational risksOperational risks, , these are associated with uncertainty these are associated with uncertainty about the host country’s policies affecting the local operations about the host country’s policies affecting the local operations of MNCs, some overlap with firm specific risk, e.g. unexpected of MNCs, some overlap with firm specific risk, e.g. unexpected changes in environmental polices, sourcing local content changes in environmental polices, sourcing local content requirements, etc. requirements, etc.

3)3) Cultural & institutional risks, Cultural & institutional risks, related to ownership related to ownership structure, human resource norms, minimum wage laws, structure, human resource norms, minimum wage laws, religious heritage, nepotism and corruption, intellectual religious heritage, nepotism and corruption, intellectual property rights, and protectionism.property rights, and protectionism.

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Firm specific risk (Micro risks)Firm specific risk (Micro risks) These affect the MNC at the project/corporation These affect the MNC at the project/corporation

level. level. Three types:Three types: Interest rate and Foreign exchangeInterest rate and Foreign exchange risksrisks, ,

These arise from fluctuation in host country’s interest rate or These arise from fluctuation in host country’s interest rate or currency vis-à-vis home currency.currency vis-à-vis home currency.

Business risksBusiness risks, , arise from factors affecting cash flows and arise from factors affecting cash flows and hence profitability of the firm, such as change in taxation for hence profitability of the firm, such as change in taxation for foreign firms, or local disputes with trade unions or suppliers, etc.foreign firms, or local disputes with trade unions or suppliers, etc.

Governance & Control risksGovernance & Control risks,, arise from uncertainty about arise from uncertainty about the host country’s policy regarding ownership, and control of local the host country’s policy regarding ownership, and control of local operation, restriction on access to local credit facilities, goal operation, restriction on access to local credit facilities, goal conflict between a MNC and the host government.conflict between a MNC and the host government.

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Global specific risksGlobal specific risks These too affect the MNCs at the project These too affect the MNCs at the project

or corporate level but or corporate level but originate at the originate at the global level.global level.

Examples:Examples:• Terrorism Terrorism • Anti-globalization movementsAnti-globalization movements• Environmental concernsEnvironmental concerns• PovertyPoverty• Cyber attacksCyber attacks

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Problems in assessing political riskProblems in assessing political risk

Difficulties in anticipating:Difficulties in anticipating:

1.1. If any change is likely to occur over the life of the If any change is likely to occur over the life of the

project.project.

2.2. How those changes might affect the host How those changes might affect the host

country’s goal priorities?country’s goal priorities?

3.3. How new regulations might be implemented to How new regulations might be implemented to

reflect new priorities?reflect new priorities?

4.4. What might be the likely impact of such changes What might be the likely impact of such changes

on the firm’s operation?on the firm’s operation?

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Predicting Country-Specific Risk Predicting Country-Specific Risk In order to assess country specific risks, one needs to assess In order to assess country specific risks, one needs to assess

political & economic stability of a country in terms of;political & economic stability of a country in terms of;1)1) Evidence of turmoil or dissatisfactionEvidence of turmoil or dissatisfaction2)2) Indicators of economic stabilityIndicators of economic stability3)3) Trends in cultural and religious activitiesTrends in cultural and religious activities

Data can be assembled by;Data can be assembled by;a)a) monitoring the local media (local newspapers, monitoring the local media (local newspapers, radio radio & & TV broadcasts.TV broadcasts.b)b) publications of diplomatic sourcespublications of diplomatic sourcesc)c) Tapping knowledge of outstanding expert Tapping knowledge of outstanding expert consultantsconsultantsd)d) Contact other businesses who have had recent Contact other businesses who have had recent experience experience in the host countryin the host countrye)e) Conduct on site visitsConduct on site visitsf)f) Examine reports of the ratings agenciesExamine reports of the ratings agencies

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Watch for Watch for Significant changes are rarely identified in advance. Significant changes are rarely identified in advance. Economic indicators may not continue moving in the Economic indicators may not continue moving in the

same direction in the future.same direction in the future. Assessment of only one rating company is not Assessment of only one rating company is not

sufficient.sufficient. Consider ratings of a number of agencies that assess Consider ratings of a number of agencies that assess

county risks, such as:county risks, such as:• S&PS&P• Moody’sMoody’s• EIUEIU• EuromoneyEuromoney• Institutional InvestorInstitutional Investor• International Country risk guideInternational Country risk guide• Milken Institute Capital Access IndexMilken Institute Capital Access Index• Overseas Private Invest Corp.Overseas Private Invest Corp.

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Managing Country-Specific Risks: Managing Country-Specific Risks: Transfer Risk Transfer Risk

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

During the operations a firm can move funds During the operations a firm can move funds through variety of repositioning.through variety of repositioning.

Funds that can not be moved must be Funds that can not be moved must be reinvested in local country such that, avoid reinvested in local country such that, avoid deterioration in the real value due to inflation deterioration in the real value due to inflation or exchange rate depreciation.or exchange rate depreciation.

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Pre-investment strategy to Pre-investment strategy to Anticipate Blocked FundsAnticipate Blocked Funds

Assess both Assess both temporary and long termtemporary and long term impact of funds’ blockage on expected impact of funds’ blockage on expected return of investment.return of investment.

Minimize the effect of blocked funds by; Minimize the effect of blocked funds by; • Borrow locally to avoid problems of repayment Borrow locally to avoid problems of repayment

of external loans.of external loans.• Arrange swap agreementsArrange swap agreements

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

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Strategies for Moving Blocked fundsStrategies for Moving Blocked funds1.1. Provide alternative conduitsProvide alternative conduits for repatriating funds. for repatriating funds.2.2. Use transfer pricingUse transfer pricing between related units of the between related units of the

MNCs.MNCs.3.3. Lead and lag paymentsLead and lag payments4.4. Use fronting loansUse fronting loans (parent company deposits fund (parent company deposits fund

with an international bank and that bank lends to the with an international bank and that bank lends to the firm. In case of hostility between the parent country firm. In case of hostility between the parent country and the local country, the local govt. may still allow and the local country, the local govt. may still allow funds to be repaid to the international bank). funds to be repaid to the international bank).

5.5. Create unrelated exportsCreate unrelated exports (some new exports can (some new exports can be created to move the profits out).be created to move the profits out).

6.6. Special dispensationSpecial dispensation ( Bargain to get at least some ( Bargain to get at least some part of the blocked funds out).part of the blocked funds out).

7.7. Beware of self-fulfilling propheciesBeware of self-fulfilling prophecies ( some ( some actions may backfire and cause full blockage of actions may backfire and cause full blockage of funds).funds).

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Forced ReinvestmentForced Reinvestment Temporary blockage Temporary blockage

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

Long term blockage Long term blockage • invest in bonds or bank time deposits or lend to invest in bonds or bank time deposits or lend to

other businessesother businesses No possibility of short or long term investment, No possibility of short or long term investment,

• invest in another related line of activity, e.g. in Peru invest in another related line of activity, e.g. in Peru an airline co. invested in hotelsan airline co. invested in hotels

• purchase other assets that might better cope with purchase other assets that might better cope with inflation, e.g. buy land, office buildings, or inflation, e.g. buy land, office buildings, or commodities that can be exported to global marketscommodities that can be exported to global markets

• Stockpile inventories that can be sold at a later Stockpile inventories that can be sold at a later stage.stage.

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Country-Specific; Country-Specific; Cultural and Institutional RisksCultural and Institutional Risks

There might be a number of Cultural &/or There might be a number of Cultural &/or Institutional differences between MNCs & the local Institutional differences between MNCs & the local country:country:

• Differences in allowable ownership structuresDifferences in allowable ownership structuresCountries may require majority local share ownership. In particular in certain Countries may require majority local share ownership. In particular in certain

industries such as banks, national defence, etc.industries such as banks, national defence, etc.• Differences in human resource normsDifferences in human resource norms

Requirement to recruit locally might cause difficulties in firing some workersRequirement to recruit locally might cause difficulties in firing some workersEmployment of women managers may face resistanceEmployment of women managers may face resistance

• Differences in religious heritageDifferences in religious heritageReligious differences might restrict the activity of the firmReligious differences might restrict the activity of the firmFirm’s link with HQ/subsidiary in some countries may cause problemFirm’s link with HQ/subsidiary in some countries may cause problem

• Nepotism and corruption in the host countryNepotism and corruption in the host countryThese may restrict the ability of the firm to operate efficiently. They might also add 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 more costs in terms of corruption or adversely affect firms reputation at home in terms

of Corporate Social Responsibility. of Corporate Social Responsibility. • Protection of Intellectual Property Rights (IPR)Protection of Intellectual Property Rights (IPR)

Need to draw some legal agreement with the host country to protect IPR. Need to draw some legal agreement with the host country to protect IPR. • ProtectionismProtectionism

Need for awareness about the sectors that are highly protected, e.g. defence, Need for awareness about the sectors that are highly protected, e.g. defence, agriculture, etc.agriculture, etc.

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Predicting Firm specific risksPredicting Firm specific risks Main objective: anticipate the effect of political change on Main objective: anticipate the effect of political change on

activities of a specific firm.activities of a specific firm. Different firms have different degrees of vulnerability to Different firms have different degrees of vulnerability to

change in policy or regulations. change in policy or regulations. For example, a food chain franchise may not experience For example, a food chain franchise may not experience

similar risks as a car manufacturer, or a firm involved in similar risks as a car manufacturer, or a firm involved in hotel and catering. hotel and catering.

Need for tailor-made studies by in-house analysts for a firm Need for tailor-made studies by in-house analysts for a firm specific activity.specific activity.

Outside analysts may not have full view of position of firms Outside analysts may not have full view of position of firms and changes that are taking place.and changes that are taking place.

Need to plan protective steps to minimize risks of damage Need to plan protective steps to minimize risks of damage from unanticipated changes.from unanticipated changes.

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Firm-Specific Governance RisksFirm-Specific Governance Risks This is related to ability to exercise effective control over This is related to ability to exercise effective control over

firm’s operation within a country’s legal & political firm’s operation within a country’s legal & political environment.environment.

Government goals might be different from firm’s goals. Government goals might be different from firm’s goals. Governments try to protect their constituencies, firms try to Governments try to protect their constituencies, firms try to protect their shareholders.protect their shareholders.

Possible areas of conflict;Possible areas of conflict;• Impact of firm’s activity on the economyImpact of firm’s activity on the economy• Perceived infringement on national sovereigntyPerceived infringement on national sovereignty• Foreign control of key industriesForeign control of key industries• Sharing or non-sharing of ownership and control with local Sharing or non-sharing of ownership and control with local

interestsinterests• Impact on a host country’s balance of paymentsImpact on a host country’s balance of payments• Influence on the foreign exchange value of the country’s Influence on the foreign exchange value of the country’s

currencycurrency• Control over export marketsControl over export markets• Use of domestic versus foreign executives and workersUse of domestic versus foreign executives and workers• Exploitation of national resources.Exploitation of national resources.

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Reduce Governance Risks by Reduce Governance Risks by Negotiating investment AgreementNegotiating investment Agreement

To avoid future conflicts it is better to anticipate To avoid future conflicts it is better to anticipate future problems and negotiate in advance.future problems and negotiate in advance.

Investment agreement should spell out managerial Investment agreement should spell out managerial and financial policies on the following issues;and financial policies on the following issues;

i.i. The basis on which funds may be remitted, e.g. The basis on which funds may be remitted, e.g. dividends, management fees, royalties, patent fees, dividends, management fees, royalties, patent fees, and loan repayments.and loan repayments.

ii.ii. The basis for setting transfer prices.The basis for setting transfer prices.iii.iii. The right to export to 3The right to export to 3rdrd country markets. country markets.iv.iv. Obligations to build or fund social & economic Obligations to build or fund social & economic

overhead projects, such as schools, hospitals, and overhead projects, such as schools, hospitals, and retirement system.retirement system.

v.v. Methods of taxation, including the rate & type of Methods of taxation, including the rate & type of taxation, and means by which the base rate is taxation, and means by which the base rate is determined.determined.

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More NegotiationMore Negotiationvi.vi. Access to host country capital markets, particularly for Access to host country capital markets, particularly for

long term borrowing.long term borrowing.vii.vii. Permission for 100% foreign ownership versus required Permission for 100% foreign ownership versus required

local ownership (joint venture) participation.local ownership (joint venture) participation.viii.viii. Price controls, if any, applicable to sales in the host-Price controls, if any, applicable to sales in the host-

country markets.country markets.ix.ix. Requirements for local sourcing versus import of raw Requirements for local sourcing versus import of raw

materials and components.materials and components.x.x. Permission to use expatriate managerial and technical Permission to use expatriate managerial and technical

personnel, and to bring them and their personal personnel, and to bring them and their personal possessions into the country free of exorbitant charges possessions into the country free of exorbitant charges or import duties.or import duties.

xi.xi. Provision for arbitration of disputes.Provision for arbitration of disputes.xii.xii. Provision for planned divestment, should such be Provision for planned divestment, should such be

required, indicating how the going concern will be required, indicating how the going concern will be valued and to whom it will be sold.valued and to whom it will be sold.

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Investment Insurance and GuaranteesInvestment Insurance and Guarantees Insure political risk with a home country public agency. Insure political risk with a home country public agency.

For example, Overseas Private Investment Corporation For example, Overseas Private Investment Corporation (OPIC) in the USA.(OPIC) in the USA.

Some of the risks insured in developed countries: Some of the risks insured in developed countries: • InconvertibilityInconvertibility (risk of not being able to convert profits, royalties, (risk of not being able to convert profits, royalties,

fees, or other income, as well as the original capital invested).fees, or other income, as well as the original capital invested).

• ExpropriationExpropriation (risk of host government preventing the investing (risk of host government preventing the investing firm to take control over the use of property for one year)firm to take control over the use of property for one year)

• War, revolution, insurrection, civil strifeWar, revolution, insurrection, civil strife (risk of damages to (risk of damages to the property and activity of investor and firm’s inability to repay a the property and activity of investor and firm’s inability to repay a loan)loan)

• Business incomeBusiness income (risk of loss of business income resulting from (risk of loss of business income resulting from damages incurred due to political violence)damages incurred due to political violence)

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Operating Strategies after the FDI Operating Strategies after the FDI Political change can result in introduction of Political change can result in introduction of

new rules, or cancellation of earlier new rules, or cancellation of earlier agreements.agreements.

Better to renegotiate & revise the existing Better to renegotiate & revise the existing agreement in light of changes made by the agreement in light of changes made by the host governmenthost government

Future bargaining position can be enhanced by Future bargaining position can be enhanced by careful consideration of policies in; careful consideration of policies in; • production, production, • logistics, logistics, • marketing, marketing, • finance, finance, • organization, organization, • personnel.personnel.

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Reducing political risksReducing political risks

MNCs should secure some bargaining points.MNCs should secure some bargaining points. Local sourcing Local sourcing (purchase of raw material & components (purchase of raw material & components

locally can reduce political risk but increase commercial and locally can reduce political risk but increase commercial and financial risk)financial risk)

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

Control of transportation Control of transportation (can substantially influence (can substantially influence the bargaining power of both local governments and MNCs, and the bargaining power of both local governments and MNCs, and hence political risk. E.g. oil pipelines cross national frontiers.)hence political risk. E.g. oil pipelines cross national frontiers.)

Control of technology Control of technology ( control over key patents can ( control over key patents can reduce political risks for firms.)reduce political risks for firms.)

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More Bargaining pointsMore Bargaining points

Control of Markets Control of Markets (firms can increase their (firms can increase their

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

Brand name and trademark control Brand name and trademark control Keep control of brand name ad trademark. Keep control of brand name ad trademark.

Thin equity base Thin equity base borrow locally rather than financing all the capital externallyborrow locally rather than financing all the capital externally

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

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Predicting Global Specific RisksPredicting Global Specific Risks More difficult to predict than the other More difficult to predict than the other

two typestwo types Sometimes impossible, e.g. Sept. 11Sometimes impossible, e.g. Sept. 11thth

Once something happens various Once something happens various protective measures may be taken in protective measures may be taken in anticipation of further attacks.anticipation of further attacks.

Assess the following:Assess the following:• Type of terrorist threatsType of terrorist threats• Their locationTheir location• Potential targetsPotential targets

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Global-Specific Risks; Global-Specific Risks; Terrorism and WarTerrorism and War

Support government efforts to fight Support government efforts to fight terrorism & Warterrorism & War

Manage Cross-Border Supply Chain by:Manage Cross-Border Supply Chain by:• Keeping larger InventoryKeeping larger Inventory• Work more closely with local suppliers Work more closely with local suppliers • Evaluate air Transportation vis-à-vis landEvaluate air Transportation vis-à-vis land

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Other Global-Specific RisksOther Global-Specific Risks MNCs have been criticised for their role in MNCs have been criticised for their role in

globalization, global warming & povertyglobalization, global warming & poverty

Hence are exposed to extreme reactions by Hence are exposed to extreme reactions by activists.activists.

Attacks might happen both at home and in Attacks might happen both at home and in

foreign countries. foreign countries.

Need for government support to manage the Need for government support to manage the riskrisk