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 TaxationExpropriation and nationalization Foreign exchange control Price control Forces JV Equity dilution

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

Effect of home-country and third- country 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 Many incentives North KoreaIreland and Singapore IndiaU.S

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 SummaryAverage Overall Risk 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 North America Sub-Saharan Africa

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