Political Risk

Portfolio Investment
Sovereign debt
Default risk premium (likelihood of default) Financial crisis (banking, liquidity, currency)
Cannot borrow at all

Market decides that the country is insolvent

PV(FS) > NA + PV (FR)

Spillover to other financial investments

Foreign Direct Investment

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 business (or a subsidiary) that is caused by uncertainty about political or policy changes

Nature of political risk

Host country policy
Taxation Foreign exchange control Expropriation and nationalization

Price control
Forces JV Equity dilution

Nature of political risk

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

Effect of home-country and thirdcountry 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)

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

Political Risk Assessment (home country)

Trade climates Investment attitudes Potential for embargos Forced divestments

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

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

Host country continuum

Friendliness to FDI
Complete prohibition North Korea India U.S Many incentives Ireland and Singapore

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

Political Risk Assessment (host country)

Aggregate Summary Average Overall Risk 2.76 2.82 3.4 1.93 2.55 2.93 Avg Pol Avg Eco Avg Leg Avg Tax Avg Ope Avg Sec

All Countries Asia-Pacific CIS Europe Latin America and Caribbean Middle East and North Africa

2.76 2.76 3.44 1.91 2.55 2.9

2.87 3.06 3.44 1.97 2.8 2.77

2.62 2.48 3.46 1.76 2.38 3.04

2.5 2.62 3.06 1.83 2.05 2.69

2.88 3.08 3.52 2.04 2.59 3.1

2.63 2.53 3.4 1.91 2.4 3.07

North America
Sub-Saharan Africa

1.46
3.37

1.5
3.43

1.5
3.45

1
3.3

1
3.19

1.5
3.44

2
3.14

Political Risk Assessment (micro approach)

Micro approach: industry-specific and business 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 business 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 business

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

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, golpes de estado, 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

Private vs. Government Insurance

Private No 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

Managing Political Incidents (ex post)

Follow the law and alter operations accordingly
business 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
business can use threat to discontinue operations to negotiate favorable treatment, but only if the country stands to lose if the business leaves

Benefits and costs of hostility toward FDI

Benefits
Expropriation: businesss 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