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Political Risk Analysis
Political Risk Analysis
March 6, 2008
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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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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.
hence profitability of the firm, such as change in taxation for foreign firms, or local disputes with trade unions or suppliers, etc.
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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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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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
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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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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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)
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.
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.
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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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.
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.
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).
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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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)
the bargaining power of both local governments and MNCs, and hence political risk. E.g. oil pipelines cross national frontiers.)
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)
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
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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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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