Political Risk

1
Political Risk

• By Ying Lu

2
Introduction

• Political exposure the degree to which a
  companys value is threatened by political events
  
• Americas 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

3
Effect Host country of Policies

• Host countrys 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

4
Host country continuum

• Friendliness to FDI

Complete prohibition
Enormous incentives
India
U.S
North Korea
Ireland and Singapore
5
Effect of home-country and third-country policies

• Home country policies MNC home countrys
  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 shouldnt be able to
  sell nuclear technology to Iran (they arent)

6
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
• Aarons 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

7
Nature of political risk

• Host country policy

Taxation
Expropriation and nationalization
Foreign exchange control Price control Forces
JV Equity dilution
8
Nature of political risk

• Home country policy

Required divestment
Sanctions
Licensing requirements Change in tax treatment of
foreign income (the tax holiday) Transfer prices

9
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

10
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

11
Benefits and costs of hostility toward FDI

• 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

• Benefits
• Expropriation firms assets
• Currency controls more macroeconomic control
• More regulation microeconomic control over
  affected industry
• Tax increase in tax revenue

12
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

13
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

14
Change of Power
15
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

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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
17
Political Risk Assessment (home country)

• Trade climates
• Investment attitudes
• Potential for embargos
• Forced divestments

18
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?

19
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.

20
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

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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 investors 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

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Types of Coverage cont

• 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 detats,
  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
  countrys breach or repudiation of the investors
  contract
• Covers losses on project investments not loss of
  profits

23
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

24
Private vs. Govt 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

25
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