Political Risk Assessment and Management Chapter 16 Political Risk Assessment and Management

Defining Political Risk In order for an MNE to identify, measure, and manage its political risks, it must define and classify these risks. This text classifies these risks as: Firm-specific Country-specific Global-specific This method of risk classification differs from the traditional method that classifies risks according to the disciplines of economics, finance, political science, sociology and law. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Exhibit 16.1 Classification of Political Risks Firm-Specific Risks Country-Specific Risks Global-Specific Risks • Business risks • Terrorism & War • Foreign-exchange risks • Anti-globalization movement Transfer Risk Cultural and Institutional Risk • Governance risks • Environmental concerns • Poverty • Blocked funds • Ownership structure • Cyberattacks • Human resource norms • Religious heritage • Nepotism & corruption • Intellectual property rights Copyright © 2004 Pearson Addison-Wesley. All rights reserved. • Protectionism

Assessing Political Risk At the macro level, firms attempt to assess a host country’s political stability and attitude toward foreign investors. At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Assessing Political Risk Predicting firm-specific risk (micro risk): Assessing the political stability of a country is only a first step The real objective is to anticipate the effect of political changes on activities of a specific firm Clearly, different foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regulations Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Assessing Political Risk Predicting country-specific risk (macro risk): Political risk studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activities Analysis of trends in these metrics leads many to speculate that the future will resemble the past, which is often not the case Despite this difficulty, the MNE must conduct adequate analysis in preparation for the unknown Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Assessing Political Risk Predicting global-specific risk: Global-specific risk is clearly quite difficult to predict (i.e. September 11th) There are many groups interested in disrupting MNEs operations for the cause of religion, anti-globalization, environmental protection, and even anarchy We can expect to see a number of new indices, similar to country-specific indices, but devoted to ranking different types of terrorist threats, their locations, and potential targets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks The firm-specific risks that confront MNEs include: Business risk Foreign exchange risk Governance risks Governance risk is the ability to exercise effective control over an MNE’s operations within a country’s legal and political environment For an MNE, it must be addressed for the individual business unit as well as for the MNE as a whole Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks Corporate governance principles include: Accountability (transparent ownership, appropriate board size, defined board accountability, and ownership neutrality) Disclosure and transparency (broad, timely and accurate disclosure, use of proper accounting standards) Independence (dispersed ownership, independent audits and oversight, independent directors) Shareholder equity (one share, one vote) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks Negotiating investment agreements: An investment agreement spells out specific rights and responsibilities of both the foreign firm and host government The presence of MNEs is as often sought by development-seeking host governments as a particular foreign location is sought by an MNE An investment agreement should spell out policies on many areas including (among others): The basis of fund flows (fees, royalties, dividends) The basis for setting transfer prices The right to export to third-country markets Methods of taxation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks Investment insurance and guarantees: OPIC MNEs can sometimes transfer political risk to a home-country public agency through an investment insurance and guarantee program The US investment insurance and guarantee program is managed by the government-owned Overseas Private Investment Corporation (OPIC) OPIC offers insurance for four separate types of political risk: Inconvertibility Expropriation War, revolution, insurrection, and civil strife Business income (resulting from political violence) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks Operating strategies after the FDI decision: Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changes Most MNEs, in their own self-interest, follow a policy of adapting to changing host-country priorities whenever possible The essence of such adaptation is anticipating host-country priorities and making the activities of the firm of continued value to the host country Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Firm-Specific Risks Host countries may look for control of: Local sourcing of raw materials and components Facility location Transportation Technology Markets Brand names and trademarks Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Transfer Risk Transfer risk is defined as limitations on the MNE’s ability to transfer funds into and out of a host country without restrictions. When a government runs short of foreign exchange and cannot obtain additional funds through borrowing or attracting new foreign investment, it usually limits transfers of foreign exchange out of the country, a restriction known as blocked funds. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Exhibit 16.4 Management Strategies for Country-Specific Risks Transfer Risk Cultural and Institutional Risk Blocked Funds Ownership Structure Human Resource Norms • Preinvestment strategy to anticipate blocked funds • Joint venture • Local management & staffing • Fronting loans Religious Heritage Intellectual Property • Creating unrelated exports • Understand and respect host country religious heritage • Legal action in host country courts • Obtaining special dispensation • Forced reinvestment • Support worldwide treaty to protect intellectual property rights Nepotism and Corruption • Disclose bribery policy to both employees and clients Protectionism • Retain a local legal advisor • Support government actions to create regional markets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Transfer Risk MNEs can react to the potential for blocked funds at three stages: Prior to making an investment, a firm can analyze the effect of blocked funds on return on investment, the desired local financial structure etc. During operations a firm can attempt to move funds through a variety of repositioning techniques Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Cultural and Institutional Risks When investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences: Differences in allowable ownership structures Differences in human resource norms Differences in religious heritage Nepotism and corruption in the host country Protection of intellectual property rights Protectionism Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Cultural and Institutional Risks Ownership structure: Many countries have required that MNEs share ownership of their foreign subsidiaries with local firms or citizens This requirement has been eased in most countries in recent years Human resource norms: MNEs are often required by host countries to employ a certain proportion of host country citizens rather than staffing mainly with foreign expatriates It is often very difficult to fire local employees due to host country labor laws and union contracts Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Cultural and Institutional Risks Religious heritage: Despite religious differences, MNEs have operated successfully in emerging markets, especially in extractive and natural resource industries such as oil, natural gas, minerals and forest products Nepotism and corruption: There is clearly endemic nepotism and corruption in many important foreign investment locations Bribery is not limited to emerging markets, as it is also a problem in industrialized nations such as the US and Japan Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Cultural and Institutional Risks Intellectual property rights: Intellectual property rights grant the exclusive use of patented technology and copyrighted creative materials Courts in some countries have historically not done a fair job of protecting these rights Protectionism: Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competition Industries that are usually protected are defense, agriculture, and infant (emerging) industries Protectionism occurs through the use of tariff and non-tariff barriers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Global-Specific Risks Global-specific risks faced by MNEs have come to the forefront in recent years: Terrorism and war Poverty Anti-globalization Cyber attacks Environmental concerns Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

MNE movement towards multiple primary objectives: Exhibit 16.7 Management Strategies for Global-Specific Risks Terrorism & War Anti-Globalization Environmental Concerns • Support government efforts to flight terrorism and war • Support government efforts to reduce trade barriers • Show sensitivity to environmental concerns • Crisis planning • Recognize that MNEs are the targets • Support government efforts to maintain a level playing field for pollution controls Poverty Cyber Attacks • Provide stable, relatively well-paying jobs • No effective strategy except internet security efforts • Establish the strictest of occupational safety standards • Support government anti-cyber attack efforts MNE movement towards multiple primary objectives: Profitability, Sustainable Development, Corporate Social Responsibility Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Illustration of Global-Specific Risks: The Case of Starbucks Starbucks found itself an early target of the anti-globalist movement. The company appeared to be yet another American cultural imperialist. As global prices for coffee plummeted in the late 1990’s, companies like Starbucks were criticized as being unwilling to help improve the economic conditions of the coffee growers themselves Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Exhibit 16.8 Arabica Bean Coffee Prices, 1981-2001 US cents/pound Source: International Coffee Organization (ICO), www.ico.org. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Illustration of Global-Specific Risks: The Case of Starbucks Much of the growing pressure on all multinational companies for sustainable development and social responsibility arose directly from consumer segments. In response, the company introduced in 1998 coffee that was cultivated under the canopy of shade trees in host countries (a practice considered ecologically sound). In addition, in 2000, the company introduced “Fair Trade” coffee in an effort to improve the living standards of coffee growers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

Starbucks’ coffee buyers work with coffee wholesalers and directly with small farmers and farm cooperatives in procurement Infrastructure, including schools, clinics, and coffee processing facilities Supplemental funding for farm credit programs to support farm capital needs Contributions to CARE, the non-profit international relief organization Shade Grown Mexico Brand Partnership formed in 1998, encourages production of shade-grown coffee using ecologically sound growing practices to promote bio-diversity and to financially support farms employing these practices (with Conservation International, CI) Fair Trade Certified Brand Partnership in which Starbucks promises consumers that the farmers who produced the coffee beans were paid a guaranteed minimum price that helps support a better life for farm families (with TransFair USA) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.