Political Risk Analysis

1. Political Risk Analysis • Dr. Sima Motamen • Westminster Business School • March 6, 2008

2. 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 investor’s assets, to concern about changes in the tax laws that may hurt the profitability of foreign projects.

3. Classification of political risk Depending on how firms or investors might be affected by an incidence, political risk can be classified into 3 categories: • 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 country’s 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? • Firm specific risk (Micro risks) • Conflict between the activities/goals of firm and those of the host country as evidenced by existing regulations. • Global specific risks

4. Country specific risks (Macro risks) • These affect MNCs at the project and corporate level and originate at the country level. • They include: • Transfer risk, which arise from uncertainty about cross-border 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 country’s 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.

5. Firm specific risk (Micro risks) • These affect the MNC at the project/corporation level. • Three types: • Interest rate and Foreign exchangerisks, These arise from fluctuation in host country’s interest rate or currency vis-à-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 country’s policy regarding ownership, and control of local operation, restriction on access to local credit facilities, goal conflict between a MNC and the host government.

6. 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

7. Problems in assessing political risk • Difficulties in anticipating: • If any change is likely to occur over the life of the project. • How those changes might affect the host country’s goal priorities? • How new regulations might be implemented to reflect new priorities? • What might be the likely impact of such changes on the firm’s operation?

8. 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

9. Watch for • 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 • Moody’s • EIU • Euromoney • Institutional Investor • International Country risk guide • Milken Institute Capital Access Index • Overseas Private Invest Corp.

10. 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.

11. 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.

12. Strategies for Moving Blocked funds • 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).

13. 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.

14. Country-Specific; Cultural and Institutional Risks There might be a number of Cultural &/or Institutional differences between MNCs & the local country: • Differences in allowable ownership structures Countries may require majority local share ownership. In particular in certain industries such as banks, national defence, etc. • Differences in human resource norms Requirement to recruit locally might cause difficulties in firing some workers Employment of women managers may face resistance • Differences in religious heritage Religious differences might restrict the activity of the firm Firm’s link with HQ/subsidiary in some countries may cause problem • Nepotism and corruption in the host country 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. • Protection of Intellectual Property Rights (IPR) Need to draw some legal agreement with the host country to protect IPR. • Protectionism Need for awareness about the sectors that are highly protected, e.g. defence, agriculture, etc.

15. 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.

16. Firm-Specific Governance Risks • This is related to ability to exercise effective control over firm’s operation within a country’s legal & political environment. • Government goals might be different from firm’s goals. Governments try to protect their constituencies, firms try to protect their shareholders. • Possible areas of conflict; • Impact of firm’s 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 country’s balance of payments • Influence on the foreign exchange value of the country’s currency • Control over export markets • Use of domestic versus foreign executives and workers • Exploitation of national resources.

17. 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; • The basis on which funds may be remitted, e.g. dividends, management fees, royalties, patent fees, and loan repayments. • The basis for setting transfer prices. • The right to export to 3rd country markets. • Obligations to build or fund social & economic overhead projects, such as schools, hospitals, and retirement system. • Methods of taxation, including the rate & type of taxation, and means by which the base rate is determined.

18. More Negotiation • Access to host country capital markets, particularly for long term borrowing. • Permission for 100% foreign ownership versus required local ownership (joint venture) participation. • Price controls, if any, applicable to sales in the host-country markets. • Requirements for local sourcing versus import of raw materials and components. • 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. • Provision for arbitration of disputes. • Provision for planned divestment, should such be required, indicating how the going concern will be valued and to whom it will be sold.

19. 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 firm’s inability to repay a loan) • Business income(risk of loss of business income resulting from damages incurred due to political violence)

20. 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.

21. 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 the bargaining power of both local governments and MNCs, and hence political risk. E.g. oil pipelines cross national frontiers.) • Control of technology ( control over key patents can reduce political risks for firms.)

22. 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 just from home banks

23. 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

24. 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-à-vis land

25. 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