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