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Political Risk


Political risk: the variability in the value of the firm ... Brazil vs. Bolivia. Change of Power. Political Risk Assessment (host country) The 'macro approach' ... – PowerPoint PPT presentation

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Title: Political Risk

Political Risk
  • By Ying Lu

  • 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

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

Host country continuum
  • Friendliness to FDI

Complete prohibition
Enormous incentives
North Korea
Ireland and Singapore
Effect of home-country and third-country policies
  • Home country policies MNC home countrys
    policies that restrict trade and investment
  • 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
  • Countries with a lot of foreign trade/direct
    investment may find it necessary to lower tax
    rates to increase tax revenues

Nature of political risk
  • Host country policy

Expropriation and nationalization
Foreign exchange control Price control Forces
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

Multilateral Policies
  • UNCTC United Nations Center on Transnational
  • OECD Organization for Economic cooperation and
  • WTO World Trade Organization
  • EU European Union
  • Serve as checklists for mutual privileges and

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

Benefits and costs of hostility toward FDI
  • Cost
  • Expropriation less FDI ? decline in economic
    base, higher unemployment, and less technology
  • 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

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

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

Change of Power
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

Political Risk Assessment (host country)
Political Risk Assessment (home country)
  • Trade climates
  • Investment attitudes
  • Potential for embargos
  • Forced divestments

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?

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

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
  • 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
  • Ratification is required to participate
  • Host country need to also be a member of MIGA
  • Lloyds of London? private insurance firm

Types of Coverage
  • Expropriation protects against partial or total
    loss of investment as result of governmental
  • 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, 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
  • Covers losses on project investments not loss of

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
  • 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

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

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
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