BUSE 608

International Business
KAAU, 2011-12

Introduction to BUSE608 Introduction to International Business

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BUSE 608

International Business
KAAU, 2011-12

Topic 3: Political and Economic Risk

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Learning Outcomes
Understand the post-war trends in political economy which have shaped the current international business environment Identify and evaluate the key political/legal and economic risks facing international businesses Analyse the advantages and disadvantages of the Single European Currency from an international business perspective Critically assess the political/legal and economic risks specifically in developing countries

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Political Risk
Political and economic risk are linked because economic and legal systems are a function of political ideology, so
political systems in different countries have a major bearing on the degree of risk facing international businesses

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Political Risk
Political systems can be assessed according to two related dimensions The degree to which they emphasise collectivism as opposed to individualism The degree to which they are totalitarian or democratic

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Political Risk
Collectivist societies stress the primacy of collective goals over individual goals In collectivist political systems, the needs of society as a whole are, therefore, viewed as being more important than individual rights Individualistic societies stress that individuals should have freedom in their economic and political pursuits Individualism, therefore, translates into an advocacy for democratic politics and free market economics

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Political Risk
Totalitarianism is a form of government in which one political party exercises absolute control and opposing political parties are prohibited Totalitarian regimes can exist at either end of the political spectrum, so they can be extremely left-wing or rightwing In democratic societies citizens periodically elect individuals to represent their views, and those politicians form governments to make decisions on behalf of the electorate

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Political Risk
Collectivist societies normally operate under totalitarian regimes, although there are exceptions, e.g. Japan Individualistic societies normally operate under a system of democratic government, although there are exceptions, e.g. Russia?

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Political Risk
The post-war trend has been towards individualism and democracy, key examples being: the break-up of the Soviet Bloc; the spread of democracy in Asia and Latin America The main reasons for this trend have been: totalitarian regimes have failed economically; IT communications developments have lessened the ability of governments to control information available to their domestic citizens; emerging middle-classes have pressed for democratic reforms

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Political Risk
Hill argues that the optimal politico-economic system is a state in which individual aspirations can be fulfilled without government interference, in which there is democracy, and in which there is a free market economy with a lack of barriers to trade and investment While there are many examples which would support this view, as Hill would categorise the USA there are significant exceptions, particularly in Asia such as Japan, South Korea, Taiwan and China

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Government Intervention
The post-war trend of the lowering of barriers to trade and investment, promoted by GATT and the WTO, has had a significant impact on international business However, many countries still intervene in international trade and investment If the argument in favour of open markets is so compelling, why do they do it?

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Government Intervention
Reasons for government intervention in trade and investment are as follows: Protecting jobs and (infant) industries For national security Furthering foreign policy objectives Protecting consumers Influencing human rights/environmental issues

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Government Intervention
Forms of intervention: Tariffs a tax levied on imports Subsidies a government payment to a domestic producer Import Quotas - restrict the amount of goods which can be imported Voluntary Export Restraints (VER) impose limits on exports from a particular country (e.g. Japanese cars into the USA in the 1990s)

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Government Intervention
Local Content Requirements calling for a proportion of manufacturing to be produced domestically, and for a proportion of the inputs to the product/service to be sourced locally Anti-Dumping Policies to prevent products to be sold at below production costs in other markets Administrative Policies to make it difficult for imports to enter a country

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Politico-Legal Risk
Critical aspects of politico-legal risk include: Protection (or non-protection) of Property Rights Protection (or non-protection) of Intellectual Property Rights Contract Law Product Safety and Product Liability Protection

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Political Risk Summary

Political ideology will influence economic and trade policies and, therefore, it is critical that the degree of political risk in particular countries is assessed by international businesses Despite the trend towards free trade and investment, many governments still impose barriers which have a negative impact on international businesses and the political risks to international business will be greater where there is a high degree of government intervention

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Economic Risk
Economic risks may originate from political risks, because economic/trade policies have a political derivation Economic risks may arise from the mismanagement of a countrys economymanifested by factors such as: Levels of inflation Levels of government debt both affecting the value of the international businesss assets and profits in that country

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Economic Risk
Economic risks can be categorised as follows: Costs not present in domestic business Foreign exchange risks Operations risks

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Costs of International Business

Additional costs: Trading costs e.g. import duties, distribution agents Travel/relocation costs e.g. use of expatriate managers Local market costs e.g. government regulations, product/service modifications

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Foreign Exchange Risks

Transaction Exposure currency uncertainty due to the time lag between contract and settlement Economic Exposure exporters/importers vulnerable to currency movements due to economic policy effects Translation Exposure in translating earnings and assets from foreign currencies into domestic currencies

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Operations Risks
The critical factors are as follows: Government policies on trade and investment by international businesses in their country Infrastructure quality utilities and transportation networks Labour supply and quality Raw material/components supply and quality

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The Single European Market

This was established in 1992, with the following forecast benefits: Lowering the cost of doing business in Europe Giving European firms the opportunity to gain economies of scale Increasing competition, and therefore benefitting the consumer

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The Euro
The Euro was established as a Single Currency within the European Union in 1999, and other currencies were withdrawn on 1/1/2002 The Single Currency had been adopted by 12 out of the then 15 EU member countries, with the UK a significant exception In 2004 there were 10 new countries joining the EU (and two more in 2007) taking the number of Euro Zone member states to 15

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Advantages of the Euro

For businesses, elimination of foreign exchange risks (within the European Union) For consumers, greater price transparency and increased competition which should drive prices lower The potential for the development of a panEuropean capital and financial market

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Disadvantages of the Euro

Loss of national sovereignty in terms of implementing appropriate monetary policies Forcing countries outside the optimal currency area to adopt disadvantageous economic policies Creating political pressures which may, paradoxically, militate against political unity

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Euro Notes
The early experience of the Euro was a significant fall in value against the dollar but, since 2002/3 strengthened to above its starting level, reaching a high of about $1.60 in July 08 The strengthening of a currency means that exports from the particular country/zone become more expensive in other markets, reinforcing the point that, in this case, while its existence has removed currency risks within the zone, externally they still prevail

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Economic Risk in Developing Countries

The process followed by countries in transition in moving towards democratic political systems and free market economies has involved the following: Internal economic liberalisation abolition of price controls and scaling down of subsidies Introduction of competition through deregulation and privatisation, and allowing inward FDI Establishment of the rule of law property protection and contract enforcement

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Economic Risk in Developing Countries

Taking the Soviet Bloc as a representative example, the pace and intensity of this process has varied enormously The success of the process has also shown significant variations, with Russia a good example of the potential benefits to international businesses against the reality of the considerable risks which remain in such economies in transition

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The Russia Example

Mid 80s Beginning of market liberalisation as an attempt to revive faltering Soviet Union Economy with improving links with the West Early 90s Pressures for political reform brought the downfall of Communist rule and break-up of their Soviet Union into independent republics

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The Russia Example

Mid 90s Further economic liberalisation, including allowing private enterprise, dismantling state controls, privatising state owned enterprises So, Russia (with its 150m people) - and its vast oil and gas reserves - became a potentially attractive market for Western companies BUT

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The Russia Example

Late 90s Privatisation has remained slow and the still large State owned sector has needed increased government financial support Corruption remained rife Business law remained inadequate The country defaulted on much of its foreign debt, and inflation was a major problem 30% of its population remained below the official subsistence level

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The Russia Example

Now Political stability has increased (under Putin) with the political leadership taking on a more pro-active international role The government has, however, increasingly centralised its political control and has intervened significantly in business affairs, the imprisonment of the head of the oil and gas corporation, Yukos, being a prime example

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The Russia Example

The political and economic changes initiated in Russia in the early 1990s prompted many international companies to enter the Russian market The potential offered by this significant market must, however, be assessed in relation to the remaining risks and many Western firms are still sceptical about the risk:reward ratio of investing in such an uncertain climate

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Analysis of Political and Economic Risk

Prior to conducting business transactions with other countries, international businesses should thoroughly assess the political and economic risks which exist in these markets Franklin R Root, in Entry Strategies for International Markets provides a model by which international managers may evaluate the political and economic risks in individual countries which can be set out as follows

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Economic Risk Summary

Economic risk to international businesses may be linked to the political ideology of the country in question Specific economic risks exist in relation to: costs not present in domestic business; foreign exchange; and operations The Euro is a prime example of an attempt to lessen the degree of currency risk which companies face in conducting international business Economic risk may be significantly greater in developing countries, particularly if they are economically mismanaged

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Overall Summary
Internationally businesses face a plethora of risks both politico-legal and economic, with many of the latter deriving from the political beliefs and resulting policies of the particular government Such risks may be evaluated using the Root model which identifies hurdles and decision points in relation to entering foreign markets

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