International Financial Management

Assignment on

Political Risk-Concept,
Measurement and Management
of Political Risk

Submitted to
Submitted by

Prof. Raj Kumar

Shreya Baranwal

Professor
MIBA IV Sem.

Roll No.37

Faculty of Management Studies, BHU

What Does Country Risk Mean?
A collection of risks associated with investing in a foreign country. These risks
include political risk, exchange rate risk, economic risk, sovereign risk and
transfer risk, which is the risk of capital being locked up or frozen by
government action. Country risk varies from one country to the next. Some
countries have high enough risk to discourage much foreign investment.

Country risk can reduce the expected return on an investment and must be
taken into consideration whenever investing abroad. Some country risk does
not have an effective hedge. Other risk, such as exchange rate risk, can be
protected against with a marginal loss of profit potential.

United States is generally considered the benchmark for low country risk and
most nations can have their risk measured as compared to the U.S. Country
risk is higher with longer term investments and direct investments, which are
investments not made through a regulated market or exchange.

What Does Political Risk Mean?

The risk that an investment's returns could suffer as a result of political
changes or instability in a country. Instability affecting investment returns
could stem from a change in government, legislative bodies, other foreign
policy makers, or military control.

Political risk is also known as "geopolitical risk", and becomes more of a factor
as the time horizon of an investment gets longer.

Political risks are notoriously hard to quantify because there are limited
sample sizes or case studies when discussing an individual nation. Some
political risks can be insured against through international agencies or other
government bodies.

The outcome of a political risk could drag down investment returns or even go
so far as to remove the ability to withdraw capital from an investment.

Political risk is a type of risk faced by investors, corporations, and

governments. It is a risk that can be understood and managed with reasoned
foresight and investment.

Broadly, political risk refers to the complications businesses and governments

may face as a result of what are commonly referred to as political decisions—
or “any political change that alters the expected outcome and value of a given
economic action by changing the probability of achieving business
objectives.”. Political risk faced by firms can be defined as “the risk of a
strategic, financial, or personnel loss for a firm because of such nonmarket
factors as macroeconomic and social policies (fiscal, monetary, trade,
investment, industrial, income, labour, and developmental), or events related
to political instability (terrorism, riots, coups, civil war, and insurrection).”
Portfolio investors may face similar financial losses. Moreover, governments
may face complications in their ability to execute diplomatic, military or other
initiatives as a result of political risk.

A low level of political risk in a given country does not necessarily correspond
to a high degree of political freedom. Indeed, some of the more stable states
are also the most authoritarian. Long-term assessments of political risk must
account for the danger that a politically oppressive environment is only stable
as long as top-down control is maintained and citizens prevented from a free
exchange of ideas and goods with the outside world.

Understanding risk as part probability and part impact provides insight into
political risk. For a business, the implication for political risk is that there is a
measure of likelihood that political events may complicate its pursuit of
earnings through direct impacts (such as taxes or fees) or indirect impacts
(such as opportunity cost forgone). As a result, political risk is similar to an
expected value such that the likelihood of a political event occurring may
reduce the desirability of that investment by reducing its anticipated returns.

There are both macro- and micro-level political risks. Macro-level political risks
have similar impacts across all foreign actors in a given location. While these
are included in country risk analysis, it would be incorrect to equate macro-
level political risk analysis with country risk as country risk only looks at
national-level risks and also includes financial and economic risks. Micro-level
risks focus on sector, firm, or project specific risk.

What is political risk and what can a multinational company do to

minimize exposure?

For multinational companies, political risk refers to the risk that a host country
will make political decisions that will prove to have adverse effects on the
multinational's profits and/or goals. Adverse political actions can range from
very detrimental, such as widespread destruction due to revolution, to those
of a more financial nature, such as the creation of laws that prevent the
movement of capital.

In general, there are two types of political risk, macro risk and micro risk.
Macro risk refers to adverse actions that will affect all foreign firms, such as
expropriation or insurrection, whereas micro risk refers to adverse actions that
will only affect a certain industrial sector or business, such as corruption and
prejudicial actions against companies from foreign countries. All in all,
regardless of the type of political risk that a multinational corporation faces,
companies usually will end up losing a lot of money if they are unprepared for
these adverse situations. For example, after Fidel Castro's government took
control of Cuba in 1959, hundreds of millions of dollars worth of American-
owned assets and companies were expropriated. Unfortunately, most, if not
all, of these American companies had no recourse for getting any of that
money back.

There are a couple of measures that can be taken even before an investment
is made. The simplest solution is to conduct a little research on the riskiness
of a country, either by paying for reports from consultants that specialize in
making these assessments or doing a little bit of research. Then you will have
the informed option to not set up operations in countries that are considered
to be political risk hot spots.

While that strategy can be effective for some companies, sometimes the
prospect of entering a riskier country is so lucrative that it is worth taking a
calculated risk. In those cases, companies can sometimes negotiate terms of
compensation with the host country, so that there would be a legal basis for
recourse in the event that something happens to disrupt the company's
operations. However, the problem with this solution is that the legal system in
the host country may not be as developed and foreigners rarely win
cases against a host country. Even worse, a revolution could spawn a new
government that does not honor the actions of the previous government.

If one goes ahead and enters a country that is considered at risk, one of the
better solutions is to purchase political risk insurance. Multinational
companies can go to one of the many organizations that specialize in selling
political risk insurance and purchase a policy that would compensate them if
an adverse event occurred. Because premium rates depend on the country,
the industry, the number of risks insured and other factors, the cost of doing
business in one country may vary considerably compared to another.

However, be warned: buying political risk insurance does not guarantee that a
company will receive compensation immediately after an adverse
event. Certain conditions, such as trying other channels for recourse and the
degree to which the business was affected, must be met. Ultimately, a
company may have to wait months before any compensation is received.

Evaluating Political Risk For International Investing

Many investors choose to place a portion of their portfolios in foreign
securities. This decision involves an analysis of various mutual funds,
exchange-traded funds (ETF), or stock and bond offerings. However, investors
often neglect an important first step in the process of international investing.
When done properly, the decision to invest overseas begins with a
determination of the riskiness of the investment climate in the country under
consideration. Country risk refers to the economic, political and business risks
that are unique to a specific country, and that might result in unexpected
investment losses.

The following are two main sources of risk that need be considered when
investing in a foreign country.

• Economic risk: This risk refers to a country's ability to pay back its
debts. A country with stable finances and a stronger economy should
provide more reliable investments than a country with weaker finances
or an unsound economy.
• Political risk: This risk refers to the political decisions made within a
country that might result in an unanticipated loss to investors. While
economic risk is often referred to as a country's ability to pay back its
debts, political risk is sometimes referred to as the willingness of a
country to pay debts or maintain a hospitable climate for outside
investment. Even if a country's economy is strong, if the political climate
is unfriendly (or becomes unfriendly) to outside investors, the country
may not be a good candidate for investment.

Measuring Economic and Political Risk

Just as corporations in the U.S. receive credit ratings to determine their ability
to repay their debt, so do countries. In fact, virtually every investable country
in the world receives ratings from Moody's, Standard & Poor's (S&P), or the
other large rating agencies. A country with a higher credit rating is considered
a safer investment than a country with a lower credit rating. Examining the
credit ratings of a country is an excellent way to begin the analysis of a
potential investment.

Another important step in deciding on an investment is to examine a country's

economic and financial fundamentals. Different analysts prefer different
measures, but almost everyone looks at a country's gross domestic product
(GDP), inflation and Consumer Price Index (CPI) readings when considering an
investment. Investors will also want to carefully evaluate the structure of the
country's financial markets, the availability of attractive investment
alternatives, and the recent performance of local stock and bond markets.
(For more insight, see The Consumer Price Index: A Friend To Investors and
The Importance Of Inflation And GDP.)

Sources of Information on Country Risk

There are many excellent sources of information on the economic and political
climate of foreign countries. Newspapers, such as the New York Times, the
Wall Street Journal and the Financial Times dedicate significant coverage to
overseas events. There are also many excellent weekly magazines covering
international economics and politics; the Economist is generally considered to
be the standard bearer among weekly publications.

For those seeking more in-depth coverage of a particular country or region,

two excellent sources of objective, comprehensive country information are the
Economist Intelligence Unit and the Central Intelligence Agency (CIA) World
Fact Book. Either of these resources provides an investor with a broad
overview of the economic, political, demographic and social climate of a
country. The Economist Intelligence Unit also provides ratings for most of the
world's countries. These ratings can be used to supplement those issued by
Moody's, S&P, and the other "traditional" ratings agencies.

Finally, the internet provides access to a host of information, including

international editions of many foreign newspapers and magazines. Reviewing
locally produced news sources can sometimes provide a different perspective
on the attractiveness of a country under consideration for investment.

Developed Markets, Emerging Markets and Frontier Markets

When considering international investments, there are three types of markets
from which to choose.

• Developed markets consist of the largest, most industrialized

economies. Their economic systems are well developed, they are
politically stable, and the rule of law is well entrenched. Developed
markets are usually considered the safest investment destinations, but
their economic growth rates often trail those of countries in an earlier
stage of development. Investment analysis of developed markets
usually concentrates on the current economic and market cycles;
political considerations are often a less important consideration.
Examples of developed markets include the U.S., Canada, France, Japan
and Australia.

• Emerging markets experience rapid industrialization and often

demonstrate extremely high levels of economic growth. This strong
economic growth can sometimes translate into investment returns that
are superior to those that are available in developed markets. However,
emerging markets are also riskier than developed markets; there is
often more political uncertainty in emerging markets, and their
economies may be more prone to excessive booms and busts. In
addition to carefully evaluating an emerging market's economic and
 financial fundamentals, investors should pay close attention to the
country's political climate and the potential for unexpected political
developments. Many of the fastest growing economies in the world,
including China, India and Brazil, are considered emerging markets.

• Frontier markets represent "the next wave" of investment

destinations. Frontier markets are generally either smaller than
traditional emerging markets, or are found in countries that place
restrictions on the ability of foreigners to invest. Although frontier
markets can be exceptionally risky and often suffer from low levels of
liquidity, they also offer the potential for above average returns over
time. Frontier markets are also not well correlated with other, more
traditional investment destinations, which mean that they provide
additional diversification benefits when held in a well-rounded
investment portfolio. As with emerging markets, investors in frontier
markets must pay careful attention to the political environment, as well
as to economic and financial developments. Examples of frontier
markets include Nigeria, Botswana and Kuwait.

Important Steps When Investing Overseas

Once country analysis has been completed, there are several investment
decisions that need to be made. The first choice is to decide where to invest,
by choosing among several possible investment approaches, including:

• Investing in a broad international portfolio

• Investing in a more limited portfolio focused on either emerging markets
or developed markets
• Investing in a specific region, such as Europe or Latin America
• Investing only in a specific country(s)
It is important to remember that diversification, which is a fundamental
principle of domestic investing, is even more important when investing
internationally. Choosing to invest an entire portfolio in a single country is not
prudent. In a broadly diversified global portfolio, investments should be
allocated among developed, emerging and perhaps frontier markets. Even in
a more concentrated portfolio, investments should still be spread among
several countries in order to maximize diversification and minimize risk.

After the decision on where to invest has been made, an investor has to
decide what investment vehicles he or she wishes to invest in. Investment
options include sovereign debt, stocks or bonds of companies domiciled in the
country(s) chosen, stocks or bonds of a U.S.-based company that derives a
significant portion of its revenues from the country(s) selected, or an
internationally focused exchange-traded fund (ETF) or mutual fund. The
choice of investment vehicle is dependent upon each investor's individual
knowledge, experience, risk profile and return objectives. When in doubt, it
may make sense to start out by taking less risk; more risk can always be
added to the portfolio at a later date.

In addition to thoroughly researching prospective investments, an

international investor also needs to monitor his or her portfolio and adjust
holdings as conditions dictate. As in the U.S., economic conditions overseas
are constantly evolving, and political situations abroad can change quickly,
particularly in emerging or frontier markets. Situations that once seemed
promising may no longer be so, and countries that once seemed too risky
might now be viable investment candidates.

Overseas investing involves a careful analysis of the economic, political and

business risks that might result in unexpected investment losses. This analysis
of country risk is a fundamental step in the process of building and monitoring
an international portfolio. Investors that use the many excellent sources of
information available to evaluate country risk will be better prepared when
constructing their international portfolios.

Components of political risk

 Political Stability

 The Political System

 The Group in Power

 Opposition Groups

 The Government System

 Relations with major trading partners

 Relations of company’s home country with another countries

Political Risk and FDI

 Unquestionably this is the biggest risk when investing abroad.

  “Does the foreign government uphold the rule of law?” is a more
important question than normative judgements about the
appropriateness of the foreign government’s existing legislation.

 A big source of risk is the non-enforcement of contracts.

Two types of risk are:

Macro Risk

 All foreign operations put at risk due to adverse political

developments.

Micro Risk

 Selected foreign operations put at risk due to adverse political

developments.

Three types of Political Risk

 Transfer Risk

Uncertainty regarding cross-border flows of capital.

 Operational Risk

Uncertainty regarding host countries policies on firm’s operations.

 Control Risk

Uncertainty regarding expropriation.

Hedging Political Risk

 Geographic diversification

 Simply put, don’t put all of your eggs in one basket.

 Minimize exposure

 Form joint ventures with local companies.

  Local government may be less inclined to expropriate assets
from their own citizens.

 Join a consortium of international companies to undertake FDI.

 Local government may be less inclined to expropriate assets

from a variety of countries all at once.

 Finance projects with local borrowing.

 Insurance

 The Overseas Private Investment Corporation (OPIC) a U.S.

government federally owned organization, offers insurance
against:

1. The inconvertibility of foreign currencies.

2. Expropriation of U.S.-owned assets.

3. Destruction of U.S.-owned physical properties due to war,

revolution, and other violent political events in foreign
countries.

4. Loss of business income due to political violence.