political risk.docx

THE BUSINESS SCHOOL, JU ECONOMIC AND POLITICAL RISK

ECONOMIC RISK

Submitted by:

Sumanyu Gupta

55-MBA-2012

ECONOMIC RISK

1


1. MEANING AND DEFINITION OF ECONOMIC RISK

Economic risk can be described as the likelihood that an investment will be affected by

macroeconomic conditions such as government regulation, exchange rates, or political

stability, most commonly one in a foreign country. In other words, while financing a project,

the risk that the output of the project will not produce adequate revenues for covering

operating costs and repaying the debt obligations.

Economic risk is, however, a nebulous term with various definitions. In a nutshell, economic

risk refers to the risk that a venture will be economically unsustainable, due to various

reasons vitiating from an alteration in economic trends to fraudulent activities which ruin a

project’s outcome. Before starting with the projects, it is important to consider economic risk

for determining the likelihood of potential risks being outweighed by the benefits.

Economic risks can be manifested in lower incomes or higher expenditures than expected.

The causes can be many, for instance, the hike in the price for raw materials, the lapsing of

deadlines for construction of a new operating facility, disruptions in a production process,

emergence of a serious competitor on the market, the loss of key personnel, the change of a

political regime, or natural disasters.

Additionally, it is worth noting that from a societal standpoint, losses are much more

lucrative than gains, as governmental bodies will do anything it takes, according to recent

research, to avoid losing or resorting to an inferior position.

ECONOMIC RISK

Countries often impose restriction on business activities on the grounds of national security,

conserving human and natural resources, scarcity of foreign exchange, to curb unfair trade

practices, and to provide protection to domestic industries. The balance of payment(bop)

position of a country greatly influence economic restriction imposed on international business

activities, therefore it has been discussed at length.

2. PRINCIPAL ECONOMICS RISKS:

2

http://en.wikipedia.org/wiki/Raw_material


Principal Economic Risks in international markets are summarized here:-

Import restriction In order to protect domestic industries, national governments often

impose selective restriction on import of goods. Such restriction vary from total ban on

imports to quota restriction. Firms with operation in countries with import restriction often

have to source locally, available inputs at higher costs, compromising on the product quality.

Local content requirement Trade policies often make provision for local content

requirement for extending export incentives or putting a country-of-origin label. For instance,

the European economic community (EEC) discourage assemblers and termed them as ‘screw

driver operation’ imposing a local content requirement of 45 per cent. For all car

manufacturers in member countries, NAFTA impose 62 per cent as local content

requirement.

Exchange controls In view of the scarcity of foreign exchange, countries often adopt

stringent exchange control measures. It adversely affects the repatriation of profits and sales

proceeds to home country. Certain countries do have multiple exchange rates for international

transaction. For instance Myanmar has three exchange rate for their currency Kyat (Kt), i.e,

the official rate (Kt 6.4:US$1), the market rate (Kt 1100-1400:US$1), and an import duty

rate(Kt 450:US$1).

3. WHY ECONOMIC RISK MATTERS?

Economic risk is one of the reasons for international investing carrying higher risk as

compared to domestic investing. Bondholders and shareholders generally put up with the risk

undertaken by international companies. Investors dealing in sale and purchase foreign

government bonds are also exposed.

Moreover, economic risk can also provide additional opportunities for investors. For

example, foreign bonds allow investors to involve themselves circuitously in the foreign

exchange markets as well as the interest rate environments of various countries. However, the

foreign regulatory authorities can impose different requirements on the sizes, types, timing,

credit quality, disclosures of bonds, and underwriting of bonds issued in their countries.

3


4. HOW IT WORKS/EXAMPLE:

For example, let's assume American Company XYZ invests $1,000,000 in a manufacturing

plant in the Congo. Aside from the business risk associated with making the plant profitable,

Company XYZ is exposed to economic risk.

The political environment could shift quickly, perhaps prompting the Congolese government

to seize the plant or significantly change laws that affect Company XYZ's ability to operate

the plant.

Likewise, hyperinflation could make it impossible to pay workers, or exchange

rate circumstances could make it unprofitable to move profits out of the country.

5. EXAMPLE OF ECONOMIC RISK

The economic risk can be looked upon in a variety of ways, with a wide range of modeling

systems. In a simple example, let us presume a planned housing development. In this case,

the economic risk is that the gains from the development will not cover the development

costs, leaving the developer in debt. This can take place due to downturns in the real estate

market, lack of interest in the housing, unexpected cost overruns, and various other factors.

6. TYPES OF ECONOMIC RISK

Assessment of economic risks is crucial in assessing the overall risk of the project. Economic

risks have a direct impact on the revenues and expenses amount and accordingly the

company’s profits. The main types of economic risks are the following

4

http://www.investinganswers.com/financial-dictionary/forex/exchange-rate-1351

http://www.investinganswers.com/financial-dictionary/forex/exchange-rate-1351

http://www.investinganswers.com/financial-dictionary/economics/hyperinflation-4800


Risk of rising prices for raw materials and energy. Increasing prices for material

resources increases the cost of manufactured products. If company operates in a

competitive market and product prices can not be raised rising of costs leads to a

decrease in profitability.

Risk of minimum wages increasing. Labor costs increasing also increases

production costs. The government may increase the mandatory minimum of workers

wages, and this can lead to an increase in the size of all wages in the economy.

Risk of production prices reduction. Decrease in market prices for the company

production also leads to a decrease in profitability, even if the costs remain stable.

5

Economic risks

Risk of rising prices

of raw material

Risk of minimum

wages increasing

Risk of production

price reduction

Risk of higher taxes and duties

Foreign currency exchange

risk

other risks


Interest rate risk (credit risk). If company uses credit resources to project, the rising

of interest rates on loans can have a significant negative impact on financial

performance.

Risk of higher taxes and duties rates. This risk can be called economic-legal risk.

The growth of existing taxes rates or introducing of new taxes leads to a decrease in

profits. The risks of new duties on exports and imports introducing can also be

attributed to this category of economic risks. New export or import duties may even

lead to the companies which conduct export or import activity termination.

Foreign currency exchange risk, which is also very important in the import-export

business or upon receipt of foreign currency loans.

7. ECONOMIC RISK FACTORS

Along with the political risk factors as mentioned above, economic risk factors should also be

taken into consideration when assessing the country risk. Some of the economic factors that

have been identified for consideration are as follows:

1. Exchange rates: As explained in the earlier chapters a strong currency will reduce the

demand for the country's exports, increase the volume of products imported into the country

and hence reduces the country's production and consequently the national income. On the

other hand a weak currency will reduce the amount of funds available for the business.

2. Inflation rate: Inflation affects the country's interest rates and also the currency value.

Inflation also affects the purchasing power of the consumers and hence their demand for the

MNC products. Further, a high level inflation may lead to a decline in the economic growth

of the country.

3. Interest rates: High interest rate prevailing in the country will slow the growth of the

economy and consequently reduce the demand for the MNC products. On the other hand,

lower interest rates stimulate the growth of an economy and consequently increase the

demand for the MNC products.

4. Resource base: The resource base of a country comprises its national, human and financial

assets. It is but natural that a nation endowed with all these resources is a better economic

6


choice than a country that is devoid of these resources. On the contrary, countries rich in

natural resources like Argentina or Mexico are more risky than South Korea or Taiwan. This

is due to the excellent quality of human resources that are available in these countries and the

extent to which these resources are put into optimum utilization.

5. Financial factors: The financial factor:that affecta country's economkcondltlonsare no

doubt difficult to forecast. Sornethnespolitical uncertainiyof acounirywill haven

refluxelfecton the economic conditions whkh will restilt in a reduction in spending hy the

consumers and hence a reduction in the cash flows of an MNC. The financial factors should

include GDP growth, inflation bends. deficit in the budget of the counhy, items( rate,

unemployment kvel, relianceon theexport income,thebalanceof trade,foreign exchange

control etc.

7


POLITICAL RISK

Submitted by:

Soubhika Sharma

53-MBA-2012

1. INTRODUCTION TO POLITICAL RISK:

MNC’s long-term investment involves essentially, among other things, the assessment of

political risk in the host country. If such risk is unusually large, an MNC may not go for

investment in the host country despite large cash benefits. However, if it is within reasonable

limits, efforts are made to manage it in order to make the investment a successful venture.

8


1.1 MEANING OF POLITICAL RISK:

There is no precise definition of political risk. However, according to Thunell (1977),

“political risk is said to exist when sudden and unanticipated changes in political set-

up in the host country lead to unexpected discontinuities that bring about changes in the very

business environment and corporate performance”.

For example, if a rightist party wins election in the host country and the policy towards

foreign investment turns liberal, it would create a positive impact on the operation of the

MNCs. On the other hand, if a leftist party comes to power, it will have a negative impact on

the operation of the MNCs. It is the negative impact that is normally the focus of attention of

the transnational investors.

Political risk is a sudden and unanticipated change in the political set-up.

2. FORMS OF POLITICAL RISK:

For a long period, political risk was narrowly interpreted in terms of expropriation of assets

but for the past few decades, political risk has come to have a wider coverage of including

also risk from ethnic, racial, religious or civil strife, political corruption and blackmail, etc.

Stephen Kobrin (1982) classifies political risk as

Macro or country-specific risk, and

Micro or firm-specific risk.

The macro political risk affecting all foreign firms in a country emerges on account of

expropriation, ethnic and other strife, currency inconvertibility, and refusal of debt, etc. The

micro-political risk affecting a particular industry or firm emerges on account of conflict

between bona fide objectives of the host government and the operation of MNC or on

account of corruption which has become a way of life in many countries. Some of these

forms need some explanation and are discussed in the sections which follow.

A. Expropriation

Expropriation means seizure of private property by the government. Confiscation is

similar as expropriation. But the difference between the two is that expropriation involves

payment of compensation, while confiscation does not involve such payments. International

law provides protection to foreigners' property. It provides also for compensation in case of

unavoidable seizure but the process of compensation is often lengthy and cumbersome. A

9


firm usually requires going-concern value tied to the present value of lost future cash flows.

On the other hand, the expropriating government prefers the depreciated historical book value

which is lower in the eyes of the firm. The reason behind expropriation has been mainly

political turmoil or specific political ideology. In the post-War period, foreign and domestic

firms were nationalized in China and Eastern Europe after the imposition the communist

regime. The same factor was responsible for nationalization of private sector firms in Cuba in

1960. However, sometimes it is economic compulsion which motivates expropriation. The

Swedish government nationalized the ship-building industry at a time when this industry was

hit hard by world-wide recession (Walters and Monsen, 1981). An estimate reveals that

around 12 per cent of all foreign investment made in 1967 was nationalized within less than a

decade (Jodice, 1980). There are still subtler forms of expropriation. For example, when

Colonel Qadaffi headed Libya in 1969, wages as well as taxes were revised upward. Bank

accounts of ESSO were seized, and the government acquired majority interest in foreign

enterprises (Schnitzer, et al., 1985). They are the instances of domestication which is a subtler

form of expropriation.

B. Currency inconvertibility

Sometimes the host government enacts a law prohibiting foreign companies from taking their

money out of the country or exchanging the host-country currency for any other currency.

This could more appropriately be called a financial form of political risk as the reasons are

both economic and political. Economic factors are concerned with the balance of payments

problem while the political factor manifests itself in drastic changes in the internal politics of

the country. The government of Nigeria imposed such restrictions in order to serve its

economic and political objectives.

C. Credit risk

Refusal to honor a financial contract with a foreign company or to honor a foreign debt

comes under this form of political risk. The reason is sometimes economic as when Mexico

expressed its inability to repay its debt in the early 1980s but sometimes the political reasons

are more prominent. When Khomeini came to power in Iran, the government refused to pay

its debt on the ground that the loans were signed during Shah's regime (Micallef, 1981)

D. Risk from ethnic, religious or civil strife:

10


Macro-political risk arises also on account of war and violence and racial, ethnic, religious, or

civil strife within a country. Some recent examples of such risks are the slaughter in Bosnia

and Herzegovina, the break-down of local authority in Somalia and Rwanda, and the upsurge

of Islamic fundamentalism in Algeria and Egypt. Such developments become a major

political risk for the MNCs operating in these countries.

E. Conflict of interest

The interest of the MNCs is normally different from the interest of the host government. The

former manifests in the maximization of corporate wealth, while the latter is evident in the

welfare of the economy in general and of the citizens in particular. It is the conflicting

interest that gives rise to the micro political risk. To elaborate the nature of conflict it may be

said that the government of the host country desires to have a sustainable growth rate, price

stability, comfortable balance of payments, etc. but the policy of the MNCs operating there is

sometimes found to be interfering with the smooth implementation of this policy. For

example, transfer of funds by MNCs may influence the money supply and may cause

inflation or deflation in the country. The MNCs may adopt transfer-pricing techniques that

may cause loss of tax revenue. Similarly, the payment of an exorbitant amount of royalty, etc.

by the subsidiary may worsen the balance of payments.

It is not simply the economic issues but also non-economic issues, such as national

security, etc. that are the source of conflict. The US government did not permit the Japanese

to purchase Fairchild Industries on grounds of national security.

F. Corruption

Corruption is endemic in many host countries, as a result of which MNCs have to face

serious problems. McNulty (1994) gives an example of Cambodia where greedy bureaucrats

created problems for the foreign firms. The foreign firms in Kenya had to sell a part of the

equity to powerful politicians there (Eiteman, et al., 1995). Transparency International has

surveyed 85 countries and has brought out the Corruption Perception Index. Many countries

rank high on this index. This is perhaps the reason that in February 1999, 34 countries

including the OECD members and five others signed a convention to ban bribery of foreign

public officials in international business transactions (The Economic Times, 1999).

3. EXISTENCE OF POLITICAL RISK:

11


Political scientists, economists and entrepreneurs have a definite opinion about the existence

of political risk. But none is sure what constitutes it and how to measure it? Since firm is

going to invest in a foreign country, therefore firm perceives opportunity with a perspective

of political risk in its own way. Finance consultants and analysts analyze the country risk

from country’s perspective which is specific to a country. Thus political risk perception from

the firm’s perspective is likely to differ from the country's point of view.

There are rating agencies such as Moody and other agencies in U.S. and other countries

which prepare country risk indices that attempt to quantify the level of political risk in each

country. These indices are based on political stability and policies of the government towards

foreign investment. The measurement of these two aspects of the government is subjective.

Political stability means frequency of changes in government, the level of violence in

the country, number of armed insurgencies, wars, etc. The basic purpose of political stability

indicator is to determine how long this government will be in power and whether the

government is capable to enforce its foreign investment guarantees. It is usually implied that

greater the political stability, the safer is the country for investment.

In some countries, the government can expropriate either legal title to property or the stream

of income it generates then the political risk is said to exist. Political risk also exists if

property owners may be constrained in the way they use their property. If the private

companies are constrained to compete with the state owned companies, again the political

risk exists. Political risk also exists if the state itself requires particular percentage of equity

participation in the corporation being started.

These are risk assessment agencies which provide political risk indices (rating) in respect of a

country for the investment purpose. These political risk indices try to assess the political

stability of the country. In making these indices, those factors are analyzed from which the

threat to the nation state emerges. The factors from which the political instability emerges can

be classified in three broad categories.

A. ECONOMIC FACTORS: inflation, unemployment, fiscal deficit, trade policies,

large external debt, etc.

B. GEOGRAPHICAL FACTORS:

i. Border disputes,

ii. Natural calamities

C. SOCIOLOGICAL FACTORS:

12


i. Religious diversity,

ii. Diverse languages,

iii. Ethnicity,

iv. Political factors

If we look at the world, the political instability in various countries has centered on ethnicity,

national identity and religion. Conflicts in Sri Lanka, India, Middle East, Ireland, Yugoslavia,

Russia, and Bosnia are all examples of ethnic conflicts, religious and national identity

turmoil. Similarly conflicts by introducing historical boundaries have also been responsible

for political instability. Arab-Israel conflict is religion based conflict. If there is civil strife,

dogmatic politics, the investors shun the markets, and international bankers do not lend in

these countries.

A. ECONOMIC FACTORS:The political stability depends on the economic conditions of the economy. Therefore, these

indices also include economic factors, such as inflation, trade deficits, current account deficit,

and balance of payment deficit, budget deficits, unemployment rate, fiscal deficits, growth

rate and per capita GNP. The basic purpose to analyze these indicators is to ensure financial

strength of the country and to assess the chances of expropriation. In general, if a country has

better economic outlook, the less likely is the political instability and social turmoil.

The economic outlook of the government towards a market oriented system or a monitored

system is an important determinant of economic stability. More importantly its attitude

towards MNCs is an important determinant of political risk.

B. GEOGRAPHICAL FACTORS:Every nation exists in a geographical configuration. If a country is surrounded by hostile

environment (neighbors), the greater degree of political risk exists. Most of the countries in

Africa, Iraq, India and Israel have hostile environment surrounding around the country.

There are certain countries which are prone to natural calamities. The greater are

possibilities of calamities, the greater is the political risk. For example, Ethiopia is prone to

famines, and Bangladesh is prone to rains and sea storms. Due to the natural calamities, the

government loses credibility resulting in social tensions.

C. SOCIAL FACTORS:

13


Social tensions usually emerge from four factors: Religious pluralism, diverse languages,

diverse ethnic groups and dogmatic political environment.

If in a country, many religions are practiced, there is every likelihood of emergence of

fundamentalist tendencies among religious groups. India is a case in point. Similarly diverse

languages also lead to linguistic fundamentalism. This would lead to social and political

tensions. In India, the states were created on linguistic basis because of linguistic

fundamentalism.

If a country has many ethnic groups in its population, then every ethnic group strives

to assert for political supremacy resulting in political instability. Conflicts in Srilanka,

Afghanistan and Bosnia are examples of ethnic strife.

Political dogmatism is also a cause of political instability leading to greater political

risk.

4. MEASUREMENT OF POLITICAL RISK

The political risk index tries to incorporate all these economic, geographical and social

aspects, so that political risk may be indicated in a concise manner. These indices measure

over all business climate of a country.

On the basis of the above type of analysis, BERI (Business Environment Risk

Information) categorizes nations in four categories as per four level, of risk perceptions:

(I) Low risk countries

(ii) Medium risk countries,

(iii) High risk countries, and

(iv) Prohibitive risk countries.

A. CAPITAL FLIGHT AND POLITICAL RISK:

Some of the finance consultants believe that Capital flight is one good indicator of the degree

of political risk. By capital flight we mean the export of savings by a nation's citizens because

of the fears about the safety of their capital. It is very difficult to measure capital flight

accurately because it is not completely observable. Apparently one can use the item errors

and omissions on the balance of payment to assess the extent of capital flight. Capital flight

occur for several reasons. These reasons are:

1. Government Regulations and Controls: Sometimes governments try to control

and regulate the use of savings to channelize the resources to a particular sector. In

14


this case, government enacts the rules for using capital. The return on investment is

fixed by the government.

2. Taxes: If the government imposes heavy taxes on returns from investment the net

returns becomes low. The capital flight occurs in search of better returns.

3. Low Returns: if the economy itself is providing low returns, the capital flight

would occur.

4. High Inflation: The countries having high inflation also face capital flight, because

domestic hedging against inflation becomes difficult therefore the citizens try to

hedge through a foreign currency which is less likely to depreciate.

5. Political Instability: Perhaps the most powerful motivation to capital flight comes

from political instability because no one is sure about the return on investment.

B. ECONOMETRIC MODELINGEconometric modeling can also be used to assess the sovereign (political) risk. This type of

risk is being assessed by banks to assess the capacity of the government to repay the loans

without default. Basically econometric modeling requires quantification of the variables

discussed above. If the subjective variables are quantified on different scales, then

econometric modeling is done as follows:

Suppose y, refers to a particular level of risk measured as an index given economic,

geographical and social variables then we can write:

y1=a+b X1+c X2+d X3+et.................................................................(1)

Where X1, is the variable capturing economic factors,

X2is a variable capturing geographical factors and

X3 is the variable that captures sociological factors.

In this equation, 'e' is error term following normal distribution with zero mean and constant

variance, 'a' is the intercept of the regression line indicating the minimum level of political

risk that will exist in the absence of other factors, and 'b', 'c' and 'd' are slope parameters

which provide the sensitivity of political risk index to the economic, geographical and

sociological factors.' With the help of above equation we can identify a critical level above

which if the index climbs, the country may be referred as having political risk.

C. DELPHI METHOD:

15


The Delphi Method involves the collection of independent opinions on country risk from

various experts without group discussion. The MNC can average these country risk scores

and assess the degree of disagreement by measuring dispersion of opinions.

D. RISK RATING MATRIX: An MNC may evaluate country risk for several countries to determine location of

investment. One approach to compare political and financial ratings among countries,

advocated by some foreign risk managers. This is called foreign investment risk matrix,

which shows the financial risk intervals ranging across the matrix from acceptable to

unacceptable. It also shows political risk by interval ranging from stable to unstable. The

matrix is based on ratings provided by rating agencies.

POLITICAL RISK INDICES AND THEIR USE:

Although the political risk indices are derived through sophisticated models but their

usefulness is limited because political instability by itself does not contribute to political risk.

There may be changes in government, the multinationals continue to come in the country and

establish production and distribution centers. The basic weaknesses of these indices is that

these are too general. These indices also assume that the political risk effect all the firms

alike. This reflects the systematic risk imparted to already existing risks. However, the

evidences do not support this. It has been seen that except for those countries which changed

political system to communism or dictatorship (totalitarian governments), the political risk

susceptibility depends on industry, size, composition of ownership, level of technology, the

degree of vertical integration with other affiliates. It has been observed that expropriation or

creeping expropriation is more likely to occur in the core sectors of the economy such as oil

explorations, extractions, mining, etc. or the industry of national importance, or utility and

financial sectors of the economy than in the manufacturing sector. This is because, the first

type of industries have a larger bearing on the economy and have political overtones while

the later adds to the national efforts to increase output in the country.

Moreover different firms are affected differently from the same event, e.g. suppose

that there are two subsidiaries one using imports to produce goods while the other is

producing import substitutes; now if trade restrictions are imposed, the interest of import

using industry is hurt whereas the interest of import-substituting industry is served. Thus

16


broader indices can serve only a limited purpose. Actually specific operating and financial

characteristics of an company will largely determine its susceptibility to political risk.

In majority of the countries, expropriation is always considered to be an extreme step

and is used very selectively. Even the revolutionary governments expropriate foreign

investment selectively. In general, the greater are the perceived benefits to the host economy

from foreign investment and the more expansive is its replacement by purely local operation

and smaller is the political risk.

EVALUATION OF POLITICAL RISK Assessment of political risk is an important step before a firm undertakes to do business

abroad because if such risks in a country are very high, the firm would not like to operate in

that country. If the risk is moderate or low, the firm will operate in that country but with a

suitable political-risk management strategy, but no such strategy can be formulated until one

assesses the magnitude of the political risk. The assessment may be either qualitative or

quantitative.

QUALITATIVE APPROACH:

Qualitative approaches involve interpersonal contact. People are often available who are

well-acquainted with the political structure of a particular country or region. They may be

persons within the enterprise, particularly those who are posted in that area or academics, or

journalist or employees of foreign offices of the government of the host country. This

approach has become common despite the fact that different persons may present different

versions of the same fact. Kraar (1980) has mentioned the experience of Gulf Oil that hired

persons from government and universities to know whether investment in Angola would be

safe. The experts said "yes" and the investment turned out to be a successful venture even in

the Angolan Marxist regime.

Sometimes a company sends a team of experts for on-the-spot study of the political

situation in a particular country. This step is taken only after a preparatory study yields a

favourable result. This method gives a more reliable picture but is always subject to

availability of correct information from the local people in the host country.

The qualitative approach involves also the examination and interpretation of diverse

secondary facts and figures. On the past trends of events, future trends are assessed (Kramer,

1981). For this purpose, companies maintain exclusively a risk-analysis division. Exxon has

17


been found doing this job in terms of specific influence groups, such as politicians, labour

unions and the military that influence the political stability of the country (Schnitzer, et al.,

1985).

QUANTITATIVE MODELS Quantitative tools are also used to estimate political risk. American Can uses a computer

programme, known as 'primary risk investment screening matrix' involving about 200

variables and reducing them to two numbers. It represents an index of economic viability as

also an index of political stability. The variables include, in general, frequency of changes in

government, level of violence in the country, number of armed insurrections, conflicts with

other nations, and economic factors such as inflation rate, external balance deficit, growth

rate of the economy, etc.

Stobaugh (1969) uses a decision-tree approach to find out the probability of

nationalisation. He begins his analysis from the very contention whether there will be a

change in the government. If there is change, the new government may or may not go in for

nationalisation. If it goes in for nationalisation, the question that arises is whether it will pay

adequate compensation. Thus in each possible event, there are many possible sub-events.

Probabilities of the occurring of events are indicated along the tree branches. Probabilities are

multiplied along the branches and then they are summed up.

Example: There is 50 per cent probability of change in government and 50 per cent

probability for no change in government. If the government changes, there is 40 per cent

probability for nationalisation and 60 per cent probability for no nationalisation. Again, if

there is nationalisation, there is 60 per cent probability for adequate compensation and 40 per

cent probability for inadequate compensation. With these figures, the probability of

nationalisation without adequate compensation would be:

0.5 x 0.4 x 0.4 = 0.08

Knudsen (1974) uses comparatively measurable variables and not very subjective

ones. Notable among his variables are: degree of urbanisation, literacy rate, degree of labour

unionism, national resource endowment, infant survival rate, calorie intake, access to civic

amenities, per capita GNP, etc. Basing on these variables. he measures the national

propensity to expropriate. It is found that Knudsen's measure identified successfully the

nationalisation in some Latin American countries.

18


Haner (1979) uses a scale from zero to seven in order to rate political risk. He groups

the factors leading to political risk into two parts—internal and external. The internal factors

are fractionalisation of political spectrum, fractionalisation of social spectrum, restrictive

measures required to retain power, xenophobia, socio-economic conditions, and strength of

radical left government. The external factors on the other hand, are dependence on a hostile

major power, and negative influence of regional political forces.

After adding up the rating points, if the total is 19 or below, he is of the view that the

political risk is minimal. If the total lies between 20 and 34, the risk may be acceptable but if

the total lies between 35 and 44, the risk is supposed to be very high. Lastly, if the total

exceeds 44 rating points, it is not advisable to make any investment in that country.

Again, Euromoney (1993) takes into account three types of indicators for rating. The

first is the economic indicator which comprises debt service ratio, current account

deficit/GNP ratio and external debt/GNP ratio. This indicator has 40 percent weight. The

second indicator known as the credit indicator embraces debt service record and ease of

rescheduling. It has 20 percent weight. The third is the market indicator which has 40 per cent

weight. It includes access to the bond market, sell-down of short-term papers and access to

the forfaiting market. The Euromoney formula ranks countries from the highest to the lowest

risk. For ranking, the highest figure in each category receives full marks for weighting while

the lowest receives zero. The scores for other figures are calculated proportionately according

to the following formula:

Final score = [weighting/ (maximum figure — minimum figure)]

x (intermediate figure — minimum figure)

Simon (1982) provides a predictive analysis which he calls an early warning system. The

technique involves the selection of lead indicators that would presage the emergence of a

particular political risk. For example, continued demonstrations and riots may lead to internal

disorder and to overthrow of the government. The early warning may be country-specific or

industry-specific. In both cases, the lead indicators are monitored and the results are

communicated to the management for evolving adequate strategy. Though there are some

other rating methods, MNCs should not rely heavily on the ratings because they do not

include an in-depth analysis which is necessary for investment decision. Individual countries

must be assessed in detail.

19


5. FACTORS DETERMINING THE EXTENT OF POLITICAL RISK

FOR A COMPANY

To analyze the extent of political risk, the factors that contribute to the general level of risk

are required to be analyzed. The important factors that contribute to the general level of risk

can be classified in to two categories:

(A) Country Related Factors, and

(B) Company Related Factors.

The factors in these categories have been indicated below:

(A) COUNTRY RELATED FACTORS

Country-related factors can be classified into three categories:

(1) Economic Factors

(a) Fiscal discipline,

(b) Controlled exchange rate system,

(c) Wasteful government expenditure,

(d) Resource base,

(e) Country's capacity to adjust to external shock

(2) Geographical factors

(a) Border disputes,

(b) Prone to natural calamities

(3) Social factors

(a) Religious diversity,

(b) Lingual diversity,

(c) Ethnic diversity,

(d) Political dogmatism

(B) COMPANY RELATED FACTORS:

Company related factors are related to:

(a) Nature of industry,

(b) Type of operations,

(c) Level of technology, research and development,

(d) Degree of competition,

(e) Form of ownership,

(f) Nationality of management

20


A. COUNTRY RELATED FACTORS

1. ECONOMIC FACTORS

a. Fiscal Discipline:

One of the important indicators of fiscal discipline is the fiscal deficit as a percentage

of gross national product. The higher is this ratio, the more the government is

promising to its population relative to the resources it is obtaining from them. The

fiscal gap can force governments to resort to the expropriation or create a politically

risky situation.

b. Controlled Exchange Rate System:

The controlled exchange rate system compounds the balance of payment problem and

thereby makes fiscal discipline difficult. The 'control' should not be confused with

'regulations'. By controlled system we mean the government using currency controls

to fix exchange rate, i.e. the pegging of the currency. In controlled exchange rate

systems, usually the domestic currency is overvalued, which implied subsidizing the

imports. The risk of tighter exchange control leads to capital flight because there is a

greater risk of devaluation. The controlled exchange rate system provides the

economy little flexibility to respond to the changing relative prices.

c. Wasteful Government Expenditure

Wasteful public spending is potential indicator of financial problems. This spending

refers to the unproductive spending in the economy. In this case, even the borrowings

from abroad are used to subsidies consumption in the economy. In this case, the

government has less savings to draw on to pay foreign debt and therefore resorts to

exchange controls and higher taxes. This would inject inflation and capital flight into

the economy.

d. Resource Base

When the natural resource base of an economy is strong, the country is less likely to

be engulfed into economic instability. The nations are different in their natural

technological and financial resources; therefore political risk assessment also requires

analysis of the resource base. This is because shortage or abundance of resources can

21


cause economic, political or social instability. For example, excess of population

relative to other resources would cause unemployment leading to social and political

tensions.

e. Country's Capacity to Adjust to External Shocks

If a country has vast resource base, the country will process greater capacity to

respond to external shocks. The national spirit of population is also important factor to

adjust to external shocks. Cuba and Iraq are two countries where the national identity

was responsible for bearing external shocks.

Another important characteristic of a nation that makes it resilient against

external shocks is the sustained growth model being adopted for growth in the

economy. If the development is internalized, i.e. it does not depend on foreign aid or

foreign flow of funds, and then the economy becomes insulated to external shocks.

2. GEOGRAPHICAL FACTORS

As we have already discussed that the nations are living in a particular geographical

configuration and that if the environment around the nation is hostile, greater level of

political risk exists. More number of border disputes implies greater degree of political risk.

Similarly, if a nation is more prone to calamities, (historical data), greater is the political risk.

3. SOCIOLOGICAL FACTORS

In sociological factors, we include religious diversity, lingual diversity, ethnic diversity and

political dogmatism. Greater is religious diversity, the greater will be chances of social

discontent because every religious group try to assert its supremacy over others. Similarly the

diversity in language and ethnic groups create social tensions. India is an example of

religious, language and ethnic diversity. Most of the social tensions in the country are due to

these diversities. Afghan problem is also due to ethnic and tribal diversity.

Political dogmatism among various political groups also creates political instability in

the country resulting in higher political risk.

B. COMPANY RELATED FACTORS:

a. Nature of Industry:

22


The nature of the industry also determines the political risk. We observe in the world

that some industries are subject to more government regulations as compared to

others. This is because these industries are seen as being important to development

and therefore the government wishes to control it. The pricing of the product of these

industries affect population in general, therefore it is necessary to control these for

political hold on population. Some industries are crucial and strategic to some

countries; therefore these industries attract more regulation.

b. Level of Operation

The companies with complex, globally integrated operations appear to be relatively

safe from government intervention. These operations are difficult to take over and

regulate. Suppose the parent company control the source of supply of a technology or

raw material, it is not possible for the government to regulate this operation.

c. Level of Technology and Research and Development

High and sophisticated technology companies and those companies having high

degree of research and development content are difficult to be regulated. This is

because these qualities are quite individual and have been developed over a long

period of time after substantial efforts.

d. Level of Competition

The companies having little competition are also not regulated because the host

government is unable to replace them.

e. Form of Ownership

The company's ownership is also an important component of its vulnerability to risk.

Local ownership is usually viewed favorably by governments, thus wholly owned

subsidiaries are at greater risk while joint ventures with the locals are less risky.

f. Nationality of Management

If the management is entirely foreign, the company is more vulnerable to political risk

than a company having mixed nationals in the management or locals in the

management.

The fact that the degree of risk in any situation is a function of both the country and

company specific risks, the company while assessing the risk needs to take into account both

types of risks.

23


6. DEVELOPING A PROCESS FOR DEALING WITH POLITICAL

PROCESS: Six Steps to Political Risk Management

Political risk process can be thought of as comprising both assessment and management of

risk. The process evaluates a company to estimate the degree of risk that exists in any

situation and then decide how to deal with the risk. If the risk element is high at a particular

location, then a commensurate return (risk adjusted) is expected. If higher returns are not

available to offset high risks, the company is likely to forego the opportunity of investment.

Only in the situation when risk is compensated with commensurate return, the project is

undertaken.

Process of management of political risk can be thought of consisting of following six steps:

STEP 1: IDENTIFY THE RISK:

The purpose of identifying the risk is to identify the policies and activities of the government

which are most likely to affect company's operations.

STEP 2: EVALUATE RISK:

This step evaluates the likelihood of government policies and activities and the extent to

which these are going to affect the company's operations. There are consultants and political

risk assessment services which provide information on different countries the estimates of

political risk.

STEP 3: SELECT MANAGEMENT TECHNIQUE:

Management techniques are to be selected to counter the effect of government's policies and

activities. In this step, the decision is made on as to how to deal with the risk that have been

identified. The selection of the technique requires a complete understanding of functional

area of management. One should bear in mind that if the selection is not proper it is usually

non-reversible after implementation. There are different approaches to meet the challenge.

The company should choose that approach which seeks to protect the best interest of the

company.

There are many countries which provide insurance against political risk to their own

companies. Overseas Private Insurance Corporation (OPIC) is a U.S. government agency

which provides insurance against expropriation, war or currency's non-convertibility.

24


STEP 4: IMPLEMENT DECIDED TECHNIQUE:

The purpose of this step is to start encountering the political risk through management

policies so that damage is limited.

STEP 5: EVALUATION OF THE DEGREE OF SUCCESS: The purpose of this step is

to evaluate the effectiveness of company's political risk management. This step provides

opportunity to reassess the likelihood of various kinds of risk and appraise the effectiveness

of the risk management technique. Political risk management should be an ongoing process

because political situation embodies change and therefore the companies have to be vigilant

against the political changes that affect operations of the companies.

STEP 6: Re-evaluation and correction after evaluation of the degree of success, corrective

measures are to be thought and implemented. Again the risk assessment is required to be

done. The process of protecting against political risk is a continuous one as shown in Figure1.

The figure shows the six steps to manage and evaluate and re-adjustment of policies to meet

the challenge of political risk:

Fig: 1

7. ASSESSING ECONOMIC/FINANCIAL HEALTH OF A NATION

To assess the economic health of a nation, macroeconomic variable are watched before

making a decision to invest in an economy. In the short run following macro variables

25


indicate the health of the economy. If the following characteristics are observed, the economy

is not healthy.

A large fiscal deficit

A comparatively high rate of Inflation

A lot of government investments providing low rate of return

Price controls

Financial repression i.e. ceiling on interest rates

Fixed exchange rate system

Inefficient production system and prevalence of large excess capacity

In the long run, if economy has to develop, following economic structure is required to be

developed to make economy healthy:

Risk and reward structure is to be built; if it already exists, then in the long run the

economy is expected to grow healthy

A legal structure that stimulates the existence and perpetuation of free markets

Minimal regulation and distortions

Incentive structure to save and invest

flexible exchange rate system

policy co-ordination with trading partners

open economy

The data on the above variables are collected and analysed and the health of the economy is

assessed.

8. MANAGEMENT OF POLITICAL RISK

The political risk management strategy depends upon the type of risk and the degree

of risk the investment carries as also upon the timing of the steps taken. For example, the

strategy adopted prior to the investment will be different from that adopted during the life of

the project. Again, it will be different if it is adopted after expropriation of assets.

1. Management Prior to Investment

26


Investment will prove viable if political risk is managed from the very beginning, even before

the investment is made in a foreign land. There are four ways to manage it at this stage.

a. Integration of risk in capital budgeting

The factor of political risk is included in the very process of capital budgeting. Firstly, the

discount rate is increased but the problem is that it penalises the flows

in the earlier years of operation, whereas the risk is more pronounced in the later years.

Secondly, the risk can be reduced through reducing the investment flow from the parent to

the subsidiary and filling the gap through local borrowing in the host country. In this strategy,

it is possible that the firm may not get the cheapest funds, but the risk will be reduced. The

firm will have to make a trade-off between higher financing cost and lower political risk.

b. Negotiating agreements with the host government

If the investing company enters into an agreement with the host government over different

issues prior to making any investment, the latter shall be bound by that agreement and will

not back out so the risk will be lower.

27


c. Planned divestment

Planned divestment means gradual shift of control of business to local shareholders. If the

company plans an orderly shifting of ownership and control of business to the local

shareholders and it implements the plan, the risk of expropriation will be minimal. In fact, the

plan of divestment is negotiated with the host government at the very beginning of

investment.

d. Insurance of risk

The investing firm can take out insurance against political risk. It can be purchased either

from governmental agencies or from private financial service organisations, or from private

property-centred insurers. The programmes for insurance are either multilateral or bilateral in

character. Foreign Credit Insurance Association and Overseas Private Insurance Corporation

are the bilateral agencies located in the USA. On the other hand, Multilateral Investment

Guarantee Agency (MIGA) is an affiliate of the World Bank created on the pattern of the

Inter-Arab Investment Guarantee Corporation. Set up in 1988, it issues guarantees against

non-commercial on private investment flowing from one member country to another. The

non-commercial risks or the political risks covered by MIGA are concerning currency

transfer, expropriation, war and civil disturbances, and breach of contract by the government.

It also acts as an reinsurer. MIGA's coverage is wider and more flexible than that of the

bilateral agencies. Besides, there are private property-centered insurance agencies, such as

American International Group (AIG), Insurance Company of North America (INA), etc. They

offer different types of coverage, although their range is not so wide as that of MIGA.

2. Risk Management during Lifetime of the Project

Management of risk during the pre-investment phase lessens the intensity of risk but does not

eliminate it. So the risk management process continues even when the project is in operation.

There are a few ways to handle the risk in this phase.

a. Joint-ventures and concession agreements

In a joint-venture agreement, local shareholders participate who have a political lobby to

pressurise the government to take a decision in their favour or in favour of the enterprise. In

case of concession agreements that are found mainly in mineral exploration, the government

28


of the host country retains ownership of the property and grants lease to the producer. The

government is interested in earning from the venture and so it does not cancel the agreement.

However, this is not a permanent solution. When the technology becomes standardised, the

host government often cancels the agreement. Again, if a new government is formed, there is

every possibility for the cancellation of the agreement concluded by the previous regime.

b. Political support

International companies sometimes act as a medium through which the host government

fulfils its political needs. As long as political support is provided by the home-country

government, the assets of the investing company are safe. However such a relationship may

change and the political alliance may be disturbed when new government is formed. So the

maintenance of political support is the key to managing political risk.

c. Structured operating environment

Political risk can be reduced through creating a linkage of dependency between the operation

of the firm in a high-risk country and the operation of other units of the same firm in other

countries. If the unit in a high-risk country is dependent on sister units in other countries for

the supply of technology or raw material or for marketing of its products, or in other words,

so long a dependency is maintained, the former is normally not nationalised because the high-

risk unit will not be in a position to operate without the imported technology or raw material.

In fact, this was an important reason that the international oil companies operated in the

Middle East without fear for a long time but when the host governments in the Middle East

came to possess the necessary skill, many of those companies were nationalized.

d. Anticipatory planning

It is a fact that the investing company takes the necessary precautions against political risk

prior to or after the investment but it is of utmost importance that the measures to be taken

should be set in place well in advance. Gonzalez and Villanueva (1992) call it crisis planning.

They give an example of the Philippines during the Marcos regime. Years before the 1986

revolution, the foreign companies began to foresee the fall of Marcos. They began assessing

every move of the opposition and took the necessary measures well in advance.

3. Risk Management Following Nationalisation

29


Despite care taken by the international firms to minimise the impact of political risk, there are

occasions when nationalisation takes place. In such cases, the investing company tries to

minimise the effects of such a drastic measure, through many courses of action.

a. Negotiation

The investing company negotiates with the host government on various issues and

willingness to support the policy and programmes of the latter. Sometimes the investing

company foregoes the majority control in order to placate the host government (Hoskins,

1970).

b. Political and economic pressure

After failure of negotiation with the host government, the investing company tries to put

political and economic pressure. Embargo on trade is one of the examples but there are

occasions when such pressures deepen the rift. Thus the firm should be cautious before

resorting to such measures.

c. Arbitration

If nationalization is not reversed through negotiation and politico-economic pressure, a firm

may go in for arbitration. It involves the help of a neutral third party who mediates and asks

for the payment of compensation. There are, of course, cases where the host government does

not honour the verdict of the arbitrator.

d. Legal course of action

When arbitration fails, the only way out is to approach the court of law. International law

suggests that the company has, first of all, to seek justice in the host country itself. If it is not

satisfied with the judgment of the court, the company can go to international court of justice

for fixation of adequate compensation. However, there are occasions when the host

government does not honour the verdict of the court. For example, the Cuban Government

failed to pay compensation to US companies it had expropriated during 1959-1961

(Globerman, 1986).

9. APPROACHES TO POLITICAL RISK MANAGEMENT

There are two approaches to political risk management:

30


(1) Defensive approach, and

(2) Integrative approach

(1) DEFENSIVE APPROACH:In this approach, the company tries to protect its interests by locating crucial aspects of the

company beyond the reach of the host governments. This is intended to minimise the firm's

dependence on host or make the host government's intervention costlier. The protection is

also embedded in policies of all functional areas of management. Some important strategies

in these functional areas are discussed below:

a. Financial Strategies

To protect against the hostility of the host government following steps should be taken:

Maximise debt investments

Raise capital from variety of sources including host government, local banks and third

parties

Enter into joint venture with host government or with the local third party

Obtain host country's guarantees for investment

Minimise local retained earnings

If possible transfer pricing should be resorted

b. Management Policies:

To insulate the information about the company functioning following steps should be

considered:

Minimise the role of host nationals at strategic points and limit locals to low and

junior levels

Train and educate the host country nationals at the head quarter to inculcate loyalty

If host country's nationals are at key positions, try to replace them with third country

nationals first so that the hostility of the company is not evidenced

c. Logistics

If the political risk is assessed, then

Locate the crucial segment of the company's process outside the country but near the

country

31


Concentrate on research and development in the home country making the subsidiary

dependent on the parent

Balance the production of goods among several locations, thus reducing dependence

on single location

d. Marketing' Management

In the case of marketing policies following steps are suggested:

Control markets where ever and whenever possible

Maintain control over distribution network including transportation of goods

Maintain a strong single global trade mark

e. Government Relations

In this approach the company must know its own strengths and weaknesses and try to

negotiate with the government to defend its interests. The competitive strength of the

company should not be compromised.

(2) INTEGRATIVE APPROACHThis approach aims at integrating the company with host economy to make it appear local. In

this background the strategies in the functional areas of management would aim at integrating

the company with the host economy. The important strategies to be adopted. are:

a. Financial Strategies:

Following strategies are required to be adopted for financing the projects in the host country:

Raise equity from the host country and involve local creditors

Establish joint ventures with locals and government

Ensure that internal pricing among subsidiaries and between headquarters and

subsidiaries is fair.

b. Management:

Following strategy may be adopted for integrating the company with the host country:

Employ high percentage of locals in the organisation

Ensure that the expatriate understood the host environment

Establish commitment among local employees

32


c. Operations Management

In operations management, following steps are required to be taken:

Maximise localisation in terms of sourcing, employment and research and

development

Use local sub-contractors, distributors, professionals and transport system

d. Marketing Management

In the case of marketing policies following steps are suggested:

Share markets with domestic players as collaborators, or market products through

local marketing companies

Appoint local distributors and use local network including transportation of goods

Maintain a strong single global trade mark

e. Government Relations

The company, for developing good and cordial relationship may adopt following strategy:

Develop and maintain channels of communication with member of political elite

Be willing to negotiate agreements that seem fair to host governments keeping in

view the company's interest

Provide expert opinion when ever asked for

Provide public services

CHOOSING THE RIGHT MIXThe defensive and integrative approaches have advantages and disadvantages.

A global firm emphasizes on defensive approach because this fits into their structure, whereas

the multi-domestic company emphasize on an integrative approach. Using largely defensive

techniques tends to encourage a global or geocentric view of the firm. In contrast if largely

the integrative approach is used, this encourages a fragmented and localized polycentric view

of the firm. Some companies may use one or the other or some company may combine the

two approaches. Appropriateness of a specific mix of risk management approaches depends

on the situation a company faces and the country in which the risk management is required to

be done. Figure 2 suggests an analysis of a company's competitive strengths and weaknesses

combined with an analysis of the political environment, leading to decisions regarding a

desired mix of defensive and integrative approaches. This is followed by bargaining and

33


negotiating with the government and finally structuring corporate activities to reflect

agreements reached.

Fig 2

The major concern of the company is to ensure the firm specific advantages. These are the

strengths that allow it to operate successfully. The strengths vary from company to company

and can include a wide variety of attributes, e.g. the use of well known brand name, control

of a particular technology, well developed distribution systems, and well trained international

manager's access to low cost of financing, and familiarity with a particular country of the

region.

The best way to protect firm specific advantages depends on the particular country

that is being considered. The decision as to which risk management approaches are preferred

should be made in terms of both the company's competitive position and the political

environment in a specific country. Generally more positive the political environment, the

more integrative approaches should be applied and the more negative the environment, the

more likely defensive approaches will be appropriate.

A company can decide on its preferred means of political risk management, but this

does not necessarily mean that it will be able to implement all of its preferred approaches.

34


Negotiation with the host government is often necessary before a final decision is made about

how a company's activities will be structured. In such negotiations, the company must be

willing to make concessions but not compromise its competitive position.

Contractual agreement are also a part of a company's risk management. Companies

generally try to reach agreements with host interests to minimise the likelihood of being

affected by unwanted political activities. These cannot be relied on totally, because the

agreements may not be enforceable and there may be no clear mechanism for dispute

settlement.

10. NEGOTIATING WITH THE HOST GOVERNMENT

Since negotiation with the host government is a part of the risk management policy, therefore

these should be done carefully remembering that these can be time consuming and frustrating

because the two sides often see the same situation very differently. In this section, some of

the view points are discussed for improving the negotiation process.

In all the economies, FDI is an important component of economic development

process and in particular for LDCs. But in all the economies the presence of foreign

subsidiaries is looked as foreign presence and foreign influence. Therefore, a serious concern

of the governments is to regulate the activities of foreign subsidiaries if not fully at least

partially.

In general, the MNC's objective of FDI is to establish operations that fit its overall

strategy and provide a reasonable return in a relatively risk free environment. The host

government's objective is a positive contribution to its development objective. The objective

of the firm and the host country may not be in conflict, the aim of the negotiation should be to

establish the means by which each party can accomplish its objectives and find ways in

which operations can be mutually beneficial.

Although, it is true that the MNC's objectives need not be in conflict with those of the

host, the different views of the same situation by the host and the MNC often make it seem

that their objectives are in conflict. To reach an agreement with the host and to achieve its

own objectives, the MNC needs to understand how the host views a particular situation. In

any negotiation, MNC must know its strengths and the view of the host government so that

the best possible agreement could be reached.

35


A. MNC'S VIEWS AND ITS STRENGTH FOR NEGOTIATION

FDI is always looked as positively adding to the development efforts. MNCs help nations in

the following manner:

a. FDI Provide Capital for Development

MNCs add capital to the overall capital mobilising effort of the host government for growth

and development. This capital is attracted from abroad. Sometimes large concessions and

subsidies are announced by governments to attract this capital.

b. MNCs Introduce Modern Technology

In developing countries often the technology adopted by MNC is not available locally,

therefore the MNCs enrich the countries with new technology.

c. MNCs Provide Business Skill to Industry

In most of developing countries, business know-how is not available, and the MNCs

introduce this know-how through their entry in the economy.

d. MNCs Provide Access to Foreign Markets

MNCs exert influence and control over many markets, therefore it is possible for them to

export from production location in a developing country to the markets that these MNCs

control.

e. MNCs make Positive Contribution to Balance of Trade

The products and services of many MNCs are import substitutes, therefore, the pressure on

imports are reduced resulting in the improvement in balance of trade.

f. MNCs adds to the Efforts of Employment

MNCs local operations provide employment for the host country nationals thus adding to the

government's effort for increasing employment.

g. MNCs Provide much Needed Foreign Exchange

36


Many developing countries have limited amounts of foreign currency which they need to pay

for imports. Through exports and investments the MNCs provide foreign exchange to the

economy.

h. MNCs add to the Tax Revenue Collection

MNCs are subject to local corporate tax law and tariffs, and their employees, both local and

foreign-pay income taxes. These payment contribute to government revenue.

i. Development of Entrepreneurs

Developing countries in general lack in sufficiently skilled local entrepreneurs. MNCs

believe that they provide an example as well as a starting place for host country nationals

who are potential entrepreneurs.

These are the strong arguments in favour of foreign direct investment which can be

placed while negotiating and these prove that the MNC's investment is extremely positive.

But the host have a different view of the investment. Host's view point and its negotiating

strength is being discussed below.

B. HOST COUNTRY'S VIEW

Host governments also see point in the above arguments, but they also see negative side of

the investment. The negative aspects of the investment are being explained below:

a. Increased Dependence on Foreign Sources

Although the provision of needed resources such as capital, technology, and expertise appears

positive but may be seen as increasing local dependence on the outside world. In addition to

this, MNCs are seen aligned with the elite group of the country and thus these tend to

strengthen the status quo of the social structure rather than work for a social change.

b. Decreased Sovereignty

The supply of the needed resources makes the host country dependent on MNCs and

consequently results into the loss of control by the host government. Particularly for smaller

countries, the possible harmful impact can be on economic, social and political system, e.g.

the MNCs encourage west values, consumerism or may support a particular party. Due to

increased consumerism, the savings in the economy is decreased.

c. Exploitation of the Host Country

37


MNCs are often found using non-renewable resources, repatriating valuable foreign exchange

to its parent and generally profiting at the expense of local community.

d. Obsolete Technology

It is believed that the technology provided by MNCs is either outdated or too advanced.

Sometimes it is felt that the MNC is getting rid of its old technology by instituting a

subsidiary in a developing country.

e. Inappropriate Technology

All local technologies embed local factor endowments therefore the technology is most suited

to that nation only where it has been invented. Now if this technology is exported to another

nation, the technology will be inappropriate. For example, the American technology will be a

labour saving because labour is difficult to be found where as the technology which employs

more labour will be more appropriate for India.

f. Displacement of Local Firms

The MNCs enter markets after evaluating their competitive advantages against domestic

firms and therefore the local firms feel uncomfortable. These firms can not compete with the

MNC therefore forego investments or search new markets for investments. There is flight of

capital from domestic economy to foreign economies.

g. Outflow of Foreign Exchange

The apparent foreign exchange benefits from investment and exports can be more than offset

over time, because once the investment is done, thereafter the repatriation starts and the much

needed foreign exchange starts flowing towards the parent thus putting pressure on foreign

reserves.

Since the perceptions of the government is different from that of the MNCs, therefore

MNC, must understand the concerns of the government and negotiate in the light of above

perceptions without compromising the competitive position of company

The host government wants the potential contribution of FDI to improve economic

conditions, trade balance, increased employment, and increased power but fears the potential

negative consequences such as loss of sovereignty, technological dependence and control of

key economic sectors. This can lead to conflicting emotions; therefore the relationship is that

of love and hate. The host government's policies are so designed, that on one side the

38


government tries to attract foreign investment and on the other it tries to regulate the

activities of the MNCs.

The outcome of a negotiating process is partial and the outcome favouring a particular

party depends on how much each party needs the other and how much control each side can

exert on the other. If the government has many options of getting foreign investment, then

government is strong on its wicket, but if the company can provide a particular service or

product and there are no offering with the government then the company has a favourable

climate for negotiation. The bargaining position a particular company or country should

adopt, depends on the structure of incentives and restrictions enumerated below:

The bargaining posture which an MNC or government can take, depends on how one side

needs the other. The different postures can be:

1. When both sides are weak, the negotiation would be quite, mutually adjusting and

little room for taking a stand.

2. When one side is relatively strong, the party will be assertive, competitive and aims

at dominating.

3. When one side is relatively weak, it will adopt cooperative and accommodative

posture and aims at satisfying the other party.

4. When the relative strengths of the two parties are unclear, the parties would adopt

compromising, bargaining posture and aims at trade offs.

5. When both the sides are strong, the parties would adopt collaborative, informative

posture, which aims for integration of concerns.

39


Another important factor that affects the process and outcome of negotiations is the

relationship between the home government and the host government. A positive relationship

between the two governments is likely to make negotiations smoother. Interest of the home

government coincide with that of the MNC, therefore in the event of unwanted political

activities by the host government, the home government will support the MNC and would try

to influence the host in respect of the unwanted activities.

Although the interest of the MNC and home country coincide but here also there is a

conflict. Investing abroad does not mean investing at home, therefore some groups would be

adversely affected at home. For example, had the investment been done at home, more jobs

would have been created. The government and people of the home country also often expect

the firm to act in the best interest of the home nation rather than in the best interest of the

firm.

40


BIBLIOGRAPHY:

1. International Financial Management.............................Vyuptakesh Sharan

2. International Financial Management................................A.K. Seth

41

political risk.docx

Documents