Political Risk and Government Policy Changes. Presented By: Alysa Shcherbakova

Political Risk  Potential for the value of an investment to change due to changes in government policy. Definition

Host Country Policy  Severe  Expropriation  Nationalization  Mild  Tax Increases  Additional Government Regulation Continuum

Home Country Policy Continuum  Severe  Required Divestment  Sanctions  Mild  Licensing Requirements  Tax changes affecting treatment of foreign income

Types of Policy Changes  Not directed at foreign owners  Examples:  Tax increase  Change in government regulation General Selective  Directed primarily at foreign owners  Usually single out specific industries  Examples:  Scrutiny of transfer prices  Equity dilution

Benefit-Cost Analysis

Benefit-Cost Analysis Continued  Considers the benefits and costs of government action  Government policy changes occur when the present value of the benefits from intervention exceeds the present value of the costs of intervention Definition

Benefit-Cost Analysis Continued  Expropriation – country receives firm’s assets and future cash flows  Increased Price/Currency Controls – macroeconomic controls  Equity Dilution – higher employment, improved job training and access to technology  Stricter Regulation – microeconomic control over affected industries  Increased Taxes – additional revenues Benefits of Policy Change for the Host Country

Benefit-Cost Analysis Continued Long Term Consequences of Policy Change  Expropriation – less investment in the future and some disinvestment resulting in a decline of economic base, higher unemployment, reduced transfer of technology  Increased Price/Currency Controls – unemployment and general stagnation of the economy  Equity Dilution – less investment and less technology transfer  Increased Taxes – firms will locate profits abroad

Benefit-Cost Analysis Continued  Estimating benefits and costs of government intervention is difficult  Government has no motivation do to a general analysis but rather prefers specific analysis approach In Summary

Bargaining Power Analysis

Bargaining Power Analysis Continued  Occurrence and severity of incidents depends on one party’s bargaining power vis-à-vis the other party involved. Definition

Host Country The Firm Bargaining Power Analysis Continued  Size of the market it offers  Wealth of the market  Abundance of skilled labour or raw materials  Uniqueness of the product and sophistication of technology required to product it  Size of the Multinational  Ongoing investments in the host country

Example: Intel’s Site Selection in Latin America  Brazil vs. Costa Rica  Brazil has high bargaining power relative to Intel because of FDI in the country – Intel needs Brazil’s opportunities more than Brazil needs Intel  Cost Rica has low bargaining power relative to Intel and was willing to negotiate and make concessions as it needs Intel’s Investment Intel Chose Costa Rica as its manufacturing location because it had a relatively high BP compared to the BP of Costa Rica.

Bargaining Power Analysis Continued Bargaining Power Leverage over Time  Initial Investment – firm BP > country BP otherwise investment will not occur.  Country is interested in obtaining something from the firm - technology, product, etc.  As time progresses, BP shifts to host country.  Size and wealth of the market increase and nationals eventually acquire skills necessary to operate the project  Similarly, the longer a firm operates in a country the more highly specific assets it acquires, decreasing its BP  However, if the firm’s operations grow or exports increase the firm may sustain its BP  With time, Firm BP = Country BP

Bargaining Power Analysis Continued Factors Influencing Bargaining Power  Two Main Factors:  Best alternative to no agreement  Status Quo  The farther one is between its current state and the status quo, the less BP it is likely to have  Other Factors:  Drastic changes in economic environment can shift the bargaining power  Different countries have different levels of bargaining power and acquire additional bargaining power at different rates.

Bargaining Power Analysis Continued In Summary  BP Analysis is useful in predicting incidents within a particular country  Is not very good at predicting incidents across countries  Example:  Brazil vs. Bolivia – while risk analysis suggests that Bolivia is riskier than Brazil because of high uncertainty, BP analysis would suggest that Brazil is a riskier investment because it’s BP is high and growing rapidly

Questions?