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Political Risk and Political Risk Assessment

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Political Risk Analysis

Definitions

Empirical relationships

Forecasting techniques

Using risk analysis

Managing political risks

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Definition of Political Risk

Possibility of an unexpected politically- motivated event affecting the outcome of an investment

Instability vs. risk

Classified based on- actor responsible- nature of effect- breadth (micro vs. macro)

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Types of Political Risks

CauseCause

ResultResult GovernmentGovernment OthersOthers

Property LossProperty Loss ConfiscationConfiscation DestructionDestruction

Income LossIncome Loss DiscriminationDiscrimination DisruptionDisruption

de la Torre & Neckar (1988), p. 223

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Main Types of Political RisksMain Types of Political Risksa)a) ExpropriationExpropriation ““Forced divestment of equity ownership of a foreign Forced divestment of equity ownership of a foreign

direct investor” (Minor 1994)direct investor” (Minor 1994) Peaked in the mid-70s; almost nil nowPeaked in the mid-70s; almost nil now Mostly Africa till 1980, then Latin AmericaMostly Africa till 1980, then Latin America Declined since:Declined since:

-Key sectors already nationalizedKey sectors already nationalized

-Economic need = > privatizationEconomic need = > privatization

-Regulate rather than expropriateRegulate rather than expropriate

Many hosts have joined MIGA (Multilateral Many hosts have joined MIGA (Multilateral Investment Guarantee Agency)Investment Guarantee Agency)

Some controversy over future:Some controversy over future:- is free enterprise here to stay, or will there be a backlash when is free enterprise here to stay, or will there be a backlash when

privatization, etc. fails to provide widespread benefits?privatization, etc. fails to provide widespread benefits?

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Main Types of Political Risks (Continued)Main Types of Political Risks (Continued)b)b) TerrorismTerrorism Terrorist acts infrequent, but spectacularTerrorist acts infrequent, but spectacular

- L. America #1 esp. kidnappings- L. America #1 esp. kidnappings

- U.S. – owned corps. Esp. targets, U.S. public institutions- U.S. – owned corps. Esp. targets, U.S. public institutions

- China, India, Turley, Israel etc.- China, India, Turley, Israel etc.

-sept 11, Iraq-sept 11, Iraq Little research-seems to be primarily groups denied a voice Little research-seems to be primarily groups denied a voice

in legitimate channelsin legitimate channels Symbolism particularly important (MacDonalds, etc.)Symbolism particularly important (MacDonalds, etc.)

c)c) Selective InterventionSelective Intervention Most risks are less dramatic changes in the rules of the Most risks are less dramatic changes in the rules of the

game.game. Some areas of government policy affect foreign-owned Some areas of government policy affect foreign-owned

companies more than most domestic onescompanies more than most domestic ones

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Main Types of Political Risks (Continued)Main Types of Political Risks (Continued)

Restrictions on Cross-Border Transfer of ResourcesRestrictions on Cross-Border Transfer of Resources Tariffs, NTBs inhibit sourcing, exportingTariffs, NTBs inhibit sourcing, exporting FX controls limit repatriationFX controls limit repatriation Capital controlsCapital controls Labour regsLabour regs

Taxation ConcernsTaxation Concerns Restrictions on transfer pricingRestrictions on transfer pricing Unitary taxation policiesUnitary taxation policies Withholding taxesWithholding taxes Availability of tax holidays and other incentivesAvailability of tax holidays and other incentives

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Main Types of Political Risks (Continued)Main Types of Political Risks (Continued)

Investment RestrictionsInvestment Restrictions Sectoral restrictionsSectoral restrictions Requirements for JVs, local ownershipRequirements for JVs, local ownership Transparency of licensing proceduresTransparency of licensing procedures Requirements for disclosure of technologyRequirements for disclosure of technology Requirements for forced divestitureRequirements for forced divestiture

Operating RestrictionsOperating Restrictions limits on expansion, ownership of land, etc.limits on expansion, ownership of land, etc. Discriminatory access to labour, inputsDiscriminatory access to labour, inputs Restrictions on local market accessRestrictions on local market access Performance requirements (e.g. employment & export Performance requirements (e.g. employment & export

levels, etc.)levels, etc.) Unequal access to government procurementUnequal access to government procurement

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Main Types of Political Risks (Continued)Main Types of Political Risks (Continued)

Non-Neutrality of the Legal EnvironmentNon-Neutrality of the Legal Environment Judges or other arbiters insulated from political Judges or other arbiters insulated from political

pressurepressure International and regional conventionsInternational and regional conventions International conventions re compensationInternational conventions re compensation Guarantees of national treatmentGuarantees of national treatment

Regulations with Differential Effects on ForeignersRegulations with Differential Effects on Foreigners Some may be much harder for foreign companies to Some may be much harder for foreign companies to

comply withcomply with

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Main Types of Political Risks (Continued)Main Types of Political Risks (Continued)d)d) ““Crossfire” ProblemsCrossfire” Problems Activities may lead to international or home country Activities may lead to international or home country

sanctions or consumer boycotts against the country or sanctions or consumer boycotts against the country or firms that deal therefirms that deal there

- - human rights abuses (e.g. imprisonment, torture or murder of human rights abuses (e.g. imprisonment, torture or murder of political opponents; use of prison labor; persecution of minority political opponents; use of prison labor; persecution of minority groups; not abiding by election results)groups; not abiding by election results)

- conflicts with neighboring countries- conflicts with neighboring countries

- lack of concern for the environment, endangered species, etc.- lack of concern for the environment, endangered species, etc.

- disregard for international agreements (e.g. re nuclear non-- disregard for international agreements (e.g. re nuclear non-proliferation)proliferation)

- the misuse of social issues as means of protectionism- the misuse of social issues as means of protectionism

What kind of cross-fire problems associated with Iraq wine-What kind of cross-fire problems associated with Iraq wine-makers in the Bordeaux region faced?makers in the Bordeaux region faced?

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Political RiskPolitical Risk

Empirical RelationshipEmpirical Relationship Most studies examine correlates of expropriationMost studies examine correlates of expropriation

Minor (1993): no link with stabilityMinor (1993): no link with stability

Positive correlations (more risk)Positive correlations (more risk)- extractive, service and key sectors- extractive, service and key sectors- JVs with the host government- JVs with the host government- host countries with pervasive governments - host countries with pervasive governments

(“hands-on”)(“hands-on”)- medium-technology- medium-technology- need for scapegoats- need for scapegoats- “obsolescing bargains”- “obsolescing bargains”

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Empirical Relationship (Continued)Empirical Relationship (Continued)

Negative correlations (less risk)Negative correlations (less risk)

- integrated subsidiaries that depend on rest of - integrated subsidiaries that depend on rest of networknetwork

- low/high tech- low/high tech- lobbying- lobbying

Makhija (1993): information indicatingMakhija (1993): information indicating convergence of MNC actions and government convergence of MNC actions and government economic objectiveseconomic objectives

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Forecasting TechniquesForecasting Techniques

““old hands”old hands” = ask experts for gut instinct, personal = ask experts for gut instinct, personal evaluationsevaluations

- taps expertise, but may be dated, subjective or - taps expertise, but may be dated, subjective or irrelevant irrelevant

““grand tour”grand tour” = send executives for personal visits = send executives for personal visits- access to top decision makers, first-hand exposure, but access to top decision makers, first-hand exposure, but superficialsuperficial- may hear self-interested pleadingmay hear self-interested pleading

quantitativequantitative- Delphi: obtain expert views, aggregate and give to same Delphi: obtain expert views, aggregate and give to same experts for chance to revise their views given what others experts for chance to revise their views given what others think; repeat until consensusthink; repeat until consensus- tends towards “conventional” predictionstends towards “conventional” predictions- econometric: use historical data, macro-orientation, econometric: use historical data, macro-orientation, but low-cost, may be helpful for initial screeningbut low-cost, may be helpful for initial screening

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The Economist MethodThe Economist MethodPolitical Risk Service (PRS) -- 100 pointsPolitical Risk Service (PRS) -- 100 points

33 points 33 points economic factors:economic factors:falling GDP/per capitafalling GDP/per capitahigh inflationhigh inflationcapital flightcapital flightdecline in productivitydecline in productivityraw materials as percentage of exportsraw materials as percentage of exports

50 points 50 points politics:politics:bad neighboursbad neighboursauthoritarianismauthoritarianismstalenessstalenessillegitimacyillegitimacygenerals in powergenerals in powerwar/armed insurrectionwar/armed insurrection

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The Economist MethodThe Economist MethodPolitical Risk Service (PRS) -- 100 pointsPolitical Risk Service (PRS) -- 100 points

17 points 17 points society:society:urbanizationurbanizationraceraceIslamic fundamentalismIslamic fundamentalismcorruptioncorruptionethnic tensionethnic tension

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Political Analysis

Expert qualitative studies- rational actor-type

- what is the logical action given goals- best if unitary actor and major decision

- organizational type- organizations do what they have always done- best for small decisions by bureaucracies

Political bargaining type - who has power and influence where - best for fractionated power environments

Results are best when model fits the characteristics of the decision and the decision-maker

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Example of Rational Actor Analysis: A Focus on Government Foreign Business Relationships

Examination of FDI costs and benefits

- Benefits: Capital inflow, job creation, better jobs (?), tax revenue, improved balance of payment, technology transfer, training, market access

- Costs: Branch-plant Syndrome, sovereignty and National Security

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Government Actions When Interests Are in Conflict (Source: Head)

Issue: division of spoils (assets and future profits)

Actions: limit profit repatriation, taxation, expropriation, force companies’ to sell off all or part of a subsidiary below market value.

Issue: technology transfer/control/

Actions: maximum foreign ownership rules, joint-venture requirements, investment

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Government Actions When interests are in Conflicts (Source: Head) – cont’d

Issue: sourcing of inputs

Actions: tariffs and quota in key imported inputs, domestic control rules

Issue: contribution to balance of payments

Action: export requirements

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Managing Political Risk (counter moves)

Insurance from EDC, etc. JVs with local or foreign partners Local stakeholders Structural dependency Lobbying Planned divestiture with s/t profits Integrate with strategy Security for expatriates General rule: make the costs to the government of an undesirable move to the firm very costly. Provide “incentives” for appropriate government regulations and policies.