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
company’s value is threatened by political events
– America’s 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
Price control
Forces JV
Equity dilution
Expropriation and
nationalization
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 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
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
Many
incentives
India
U.S
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
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
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
CIS
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 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, 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 country’s
breach or repudiation of the investor’s 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: business’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