Lecture 91 Risks in Foreign Investments I.Sources of Political Risk Macro Risks Micro Risks II. Management of Political Risk Assessing Political Risk Managing Political Risk

Lecture 92 I.Sources of Political Risk Political Risk: the possibility that the firm may be adversely affected by political events in the host country. 1.Macro (country-specific) Risks - that affect all foreign firms in a country Expropriation Risks : possibility of host government seizure of property without fair compensation Risk of Ethnic, Racial, Religious, Tribal or Civil Strife –not necessarily directed to foreign firms but affects their operations –Expropriation Risks less likely in recent times. More important is the overall quality of the legal system, and the degree of legal protection investors are provided and law enforcement

Lecture 93 Sources of Political Risk cont’d Two aspects of the legal system: - The general quality of the legal system - the prevalence of the rule of law - the efficiency of the judicial system - extent of corruption (which undermines fair enforcement of laws) - Laws specific to the financial system - laws that protect outside equity holders - laws that protect creditors - regulations that govern banking and security exchanges

Lecture 94 Sources of Political Risk cont’d The Rule of Law: What does the rule of law mean? - fair application of the laws on the book - all people are governed by the same rules; - fair and strong enforcement of laws - restraint of arbitrary exercise of power by governments Consequence: high Confidence and Trust - confidence that rules, contracts, business practices etc are fair and can be trusted. ** for foreign investors, high rule of law => low country risk Corruption: - Corruption undermines the rule of law - a bribed judge or public official is not an impartial agent

Lecture 95 Sources of Political Risk cont’d Causes and Consequences of Corruption (Mauro (1995)) - Corruption as a rent-seeking behavior Causes: Trade restrictions; Government Subsidy; Price Controls; Foreign Exchange controls; Natural Resource endowments etc Consequences: - Lower investment and retardation of economic growth * corruption as a form of ‘taxes’ * improvement in corruption measure by 2 points => increases investment/GDP by 4%, and per capita GDP by 1/2% (Mauro(1995)) * 1% increase in corruption equivalent marginal tax rate reduces FDI by 5% (Wei(1997)) * 1% increase in bribery rate (bribe/sales) reduces firm sales growth by 3% in Uganda (Fisman and Svennson (1999)

Lecture 96 Sources of Political Risk Investor Protection and Legal Enforcement Degree of legal protection afforded to investors vary by the legal tradition of countries. Countries can be classified into legal families –Common Law vs Civil Law –English (common law) origin –French (civil law) origin –German (civil law) origin –Scandinavian (civil law) origin Measuring degree of investor protection Laws and their enforcement differ around the world Common law tradition countries more protective of investors than civil law tradition countries (particularly French civil law countries) Law enforcement differ across countries. German and Scandinavian civil law countries best law enforcement Countries develop substitute mechanisms for poor investor protection. Example high ownership concentration (associated with poor investor protection)

Lecture 97 Sources of Political Risk cont’d 2.Micro (firm specific) Risks - specific to an industry, a firm or a project Risks arising from Goal conflicts –conflicts between firm’s activities and host country’s rules and regulations Types of regulatory constraints: –Non discriminatory regulations regulations not particularly directed against foreign firms –e.g. Requirement that local nationals hold top mgt positions –construction of social facilities (e.g. schools) –imposition of a requirement on local content in manufactured goods –Discriminatory Regulations regulations that provide specific advantages to local firms –e.g. nationalizing an industry dominated by foreign firms –allowing only joint ventures with foreign firms as minority holders –Wealth Deprivation by Host Governments regulations that cause economic loss to foreign firms –e.g. enforcing price controls –Restricting distribution of products –restrictions on dividends and mandatory reinvestment

Lecture 98 Sources of Political Risk cont’d Measuring Country Risk: Risk Rating Services Institutional Investor –Country credit rating index Political Risk Services –International Country Risk Guide –Political, Financial, Economic and Composite Risk Measures Euromoney –Political, Financial, Economic and Composite Risk Indices Economist Intelligence Unit –Political, policy, medium-term lending, short-term trade, composite risk indices Moody’s Investor Services –Sovereign debt ratings Standard and Poor’s Ratings Group –Sovereign debt ratings

Lecture 99 Sources of Political Risk cont’d

Lecture 910 II.Management of Political Risk –Assessing Political Risk –Managing Political Risk Negotiating the Environment Prior to Investment –Investment Agreement –Investment Insurance and Guarantee Strategies after Investment Decisions –maintain policies that enhance firm’s continual value to host country –include policies in production and logistics, marketing, financial and organizational areas –Financial Strategies »Thin Equity Base »Multiple Source of Borrowing »Shared ownership with locals Crises Planning