Political Risk

By: Ying Lu

Introduction Political exposure: the degree to which a

company’s value is threatened by political events America’s presidential or congressional elections

Political risk: the variability in the value of the firm (or subsidiary) that is caused by uncertainty about political or policy changes

Effect Host country of Policies

Host country’s DFI policies Countries prohibit investments threatening national security

Dubai port issue, maritime and airport cabotage In cases of JV, some countries require majority ownership by “host”

partner Thailand and India

Host countries often try to protect domestic firms and industries from foreign competition This may induce more FDI

Toyota and Hyundai have built plants in the US to circumvent trade barriers

Host country continuumFriendliness to FDI

Complete prohibition

Enormous incentives

North Korea Ireland and Singapore

India U.S

Effect of home-country and third-country policies

Home country policies: MNC home country’s policies that restrict trade and investment activities

Often overlooked but very important in formulating a corporate strategy to deal with political risk

US embargo against Cuba Tend to have technology restrictions to protect

national security US defense firms probably shouldn’t be able to sell nuclear

technology to Iran (they aren’t)

Reasons for FDI policies

Often driven by foreign policy Some Arab nations prohibit trade between themselves and Israel

Want to protect domestic industry Protectionist policies to protect constituents

Taxation has a large role as part FDI policies Aaron’s presentation Companies seek out countries with the lowest tax rate Countries with a lot of foreign trade/direct investment may find it

necessary to lower tax rates to increase tax revenues

Nature of political risk

Host country policy

Taxation Expropriation and nationalization Foreign exchange control

Price control

Forces JV

Equity dilution

Nature of political risk

Home country policy

Required divestment

SanctionsLicensing requirements

Change in tax treatment of foreign income (the tax holiday)

Transfer prices

Multilateral Policies

UNCTC: United Nations Center on Transnational Corporation

OECD: Organization for Economic cooperation and Development

WTO: World Trade Organization EU: European Union

Serve as checklists for mutual privileges and responsibilities

General vs. Selective

General policy changes: not directed at FDI Any change in tax code or government policies can

effect everyone Selective policy changes: directed mainly at FDI

Usually industry specific Most costly kind of government policy

Drives away FDI Less tax revenue for government May reduce total investment

Benefits and costs of hostility toward FDI

Benefits Expropriation: firm’s assets Currency controls: more

macroeconomic control More regulation:

microeconomic control over affected industry

Tax: increase in tax revenue

Cost Expropriation: less FDI

decline in economic base, higher unemployment, and less technology transfer

Macroeconomic controls: general stagnation

Tax: reduction in tax revenues because firms will begin to shop for more favorable tax rates

Bargaining Power (host country)

Size of market Wealth of market Abundance of raw materials Host country has more bargaining power if they

are strong in these areas Can play companies against one another Intervention is likely to takes place when bargaining

power of the country exceeds that of company

Bargaining power (firm)

Uniqueness of product or technology required to produce it

Rate of technological advancement Size of company Growth in operations

Usually not at the same rate as the host country Brazil vs. Bolivia

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Bargaining power of country

Bargaining power of country

Bargaining power of company

Bargaining power of company

Intervention more likely to occur.Countries want to be here

Intervention more likely to occur.Countries want to be here

Companies want to be here

Companies want to be here

Political Risk Assessment (host country)

The “macro approach” Aggregation of subjective assessments by a panel of

experts on various economic, social, and political factors Global Research Center Political Risk Yearbook (Political Risk Services of East

Syracuse, New York) International Country Guide The Economist Intelligence Unit

Provides quarterly ratings and individual report on each country

Political Risk Assessment (host country)

Aggregate Summary Average Overall Risk

Avg Pol

Avg Eco

Avg Leg

Avg Tax

Avg Ope

Avg Sec

All Countries 2.76 2.76 2.87 2.62 2.5 2.88 2.63

Asia-Pacific 2.82 2.76 3.06 2.48 2.62 3.08 2.53

CIS 3.4 3.44 3.44 3.46 3.06 3.52 3.4

Europe 1.93 1.91 1.97 1.76 1.83 2.04 1.91

Latin America and Caribbean 2.55 2.55 2.8 2.38 2.05 2.59 2.4

Middle East and North Africa 2.93 2.9 2.77 3.04 2.69 3.1 3.07

North America 1.46 1.5 1.5 1 1 1.5 2

Sub-Saharan Africa 3.37 3.43 3.45 3.3 3.19 3.44 3.14

Political Risk Assessment (home country)

Trade climates Investment attitudes Potential for embargos Forced divestments

Political Risk Assessment (micro approach)

Micro approach: industry-specific and firm specific factors Political risk depends directly on the characteristic of

foreign investment Who owns it? What technology does it use? What is its economic sector?

Political Risk Assessment (take away)

It can be diversified away High risk (variance) is usually associated with high (mean)

returns. Most of the variance in returns to investment is driven by

local and global economic conditions. Global economic conditions account for the portion of risk

you cannot diversify away (the covariant portion of your cash flows from investments in various parts of the world). Political risk is local and residual (not correlated with global economic conditions). Therefore, you ought to be able to diversify it away.

Managing Political Risk (ex ante) OPIC: Overseas Private Investment Corporation

50% of firm must be own by US citizens Foreign corporation: 95% must be owned by US entity

Subsidiary MIGA: World Bank Multilateral Investment Guarantee

Agency Incorporation in member nation Majority own by citizens of member nation

97 countries have signed MIGA convention, 71 have ratified Ratification is required to participate Host country need to also be a member of MIGA

Lloyds of London private insurance firm

Types of Coverage

Expropriation: protects against partial or total loss of investment as result of governmental actions Losses are assessed based on book value

Currency inconvertibility: protection against losses arising from an investor’s inability to convert local currency into the foreign currency specified in the policy Devaluation is not covered Date of loss is considered to be the date when the request for

funds transfer is denied, not on the expiration date of the stated waiting period

Types of Coverage con’t

War and civil disturbance: protects against losses resulting from damage, destruction or disappearance of assets as the result of acts of war or civil disturbance Covers: revolution, insurrection, coup d`etats, sabotage, and

terrorism In case of war firms do not have to loss property to file a claim,

they do have to show interruption to business Losses are assessed at book value

Breach of contract: protects against a host country’s breach or repudiation of the investor’s contract Covers losses on project investments not loss of profits

Managing Political Incidents (ex post)

Follow the law and alter operations accordingly Firm with low bargaining power usually have no

choice but to do so Discontinue operations

The law may hurt your operations to such an extent that following the law is not acceptable (IBM)

Negotiate a settlement Firm can use threat to discontinue operations to

negotiate favorable treatment, but only if the country stands to lose if the firm leaves

Private vs. Gov’t Insurance

Private Not host country nationality

requirements Will insure new and existing

projects Shorter terms (3 year basis--

renewable) More flexibility and opportunity

to negotiate policy provisions Non-disclosure provision Harder to collect on your claim

Government Usually requires “home”

country citizenship Only insure new projects and

expansion to existing ones Longer terms (15-20 years) Usually cheaper than private

insurance Less flexibility in policy

provisions Full disclosure to host

government Easier to collect on claim

De Facto Political Risk Insurance

Joint venture Borrow from a local bank Get a multilateral institutions to be an investor

World bank or Inter-American Development Bank