Lecture 9 1
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 9 2
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 9 3
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 9 4
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 9 5
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 9 6
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 9 7
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 9 8
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 9 9
Sources of Political Risk cont’d
Lecture 9 10
II. Management of Political Risk
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