Political Risk

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Introduction
 Political risk is the risk that results from political changes
or instability in a country.
 This risk becomes more pronounced when factors of
instability such as wars, riots, social and religious
conflicts or national movements crop up.
 From an economic viewpoint, political risk refers to
uncertainty over property rights.
 Political risk threatens continuance of direct and indirect
investments in the host country as well as exports
towards it as it entails the risk of non-payment.
 It also results from government measures tending to
limit the working and operations of foreign firms.
 Introduction
 Country risk involves the possibility of losses due to
country specific economic, political or social events or
because of company specific characteristics.
 Political risk refers to uncertainty associated with
political activities and events.
 Sovereign risk involves the possibility of losses on
private claims as well as on direct investment. Bank’s
are exposed to this risk.
Introduction
 Political risk involves the possibility of
expropriation, confiscation or destruction of
property by revolution or war.
Types of Political Risk
 Political risk are classified broadly in following
three categories:
1. Country Risk
2. Sector Risk
3. Project Risk
Country Risk
 Country Risk emanates from political, social and
economic instability of a country and manifests in the
form of more or less strong hostility towards foreign
investment.
 The hostility develops during the periods of crisis.
 The political risk takes several forms, such as
nationalization or expropriation without indemnity
(compensation).
 The episodes in this context are nationalization in Iran
(1978), in Libya (1969), in Algeria (1962);
nationalization with indemnity as in Chile in 1971.
 Latent nationalization in terms of compulsory local or
government participation constitutes another variant of
political risk.
Why Country Risk Analysis is Important
 If the country risk levels of a particular country
begins to increase, the MNC may consider
divesting its subsidiary located there.
 It is screening device to avoid conducting
business in countries with excessive risk.
 It is also used by MNC to revise its investment
or financing decisions.
Types of Country Risk

Country risks are of two types:

a) Macro risks -Risks affecting all the MNCs alike.

b) Micro risks- Risks which are firm specific.
Country Risk: Macro
 Forced Disinvestment: Best example of forced
disinvestment is takeover of oil exploration and
oil producing industry. The forced disinvestment
is legal under international law as long as it is
accompanied by adequate compensation. It is
practiced in two forms:
a) Takeovers/ Nationalization
b) Confiscation/Expropriation with or without
compensation.
 Unwelcome Regulations: The purpose of these
regulations is to reduce profitability of the
MNCs. These regulations may relate to tax laws,
ownership, management, repatriation of profits,
re-investment etc.
Country Risk: Macro
 Interface with Operations: Interface with
operations refer to any government activity that
makes it difficult for business to operate
effectively. This risk includes government’s
encouragement of unionization, government’s
expression of negative comments about
foreigners and discriminatory support to locally
owned and operated business. The government’s
generally engage in these activities when they
believe that a foreign company’s operation could
be detrimental to local development or would
harm the political intent of the government.
Country Risk: Macro
 Social Strife: In any country there may be
social strife arising due to ethnic, racial,
religious, tribal or civil tensions or natural
calamities such as drought etc which may
cause economic dislocation. Social strife means
breakdown of government machinery leading
to economic disturbances.
Country Risk: Micro
Micro Risks are on account of
1. conflict of goals between MNCs and
government policies like monetary policy,
fiscal policy, trade policies and economic
protectionism, balance of payment and
exchange rate policy, economic development
policies
2. on account of corruption and bureaucratic
delays.
Sector Risk
 Certain sectors are prone to greater political risk than
others in some countries.
 Included in this category are petroleum, mining,
banking and so on.
 Example, petroleum has been nationalized in various
countries such as Mexico (1938), Libya (1968), Iraq
(1972), Venezuela and Kuwait (1975), Iran (1978) and
Nigeria (1979).
 Likewise nationalization of copper mines took place in
Zaire, Zambia, Chile and of iron mines in Venezuela.
 Banking sector was nationalized in Guinea (1962),
Vietnam (1975) and Iran and Nicaragua (1978)
Project Risk
 At times, neither a country nor a sector may
be a matter of risk; only a project is subject to
risk.
 Often multinationals take up big projects in
foreign countries, like electricity generating
plants, dams, exploration of petroleum fields,
etc.
 A project requires a huge expenditure and the
risk is very high in the beginning.
Project Risk
 In the event of the project turning out to be
successful (for example finding an exploitable
oil field), some governments are very
demanding and in certain situations, in
particular with the change of government, the
latter may even refuse to respect the
engagement of its predecessor.
 Example:
Measures Taken for Salvaging Adverse BOP
 A government may decide to take tough and
restrictive measures vis-à-vis a foreign
company either
1. due to internal economic difficulties
2. due to difficult BOP situation
3. with the intent of exercising directly or
indirectly a control on foreign investments.
Measures Taken for Salvaging Adverse BOP
 Measures necessary for improving the BOP situation
may be:
1. Restrictions on outgoing capital:
capital Limiting repatriation of
dividends, profits, rents etc. For example, dividends
may be limited to a percentage of net investment.
2. Restriction on imports: Excessive tax on foreign
enterprises which imports raw materials or semi
finished products; and high custom duties, import
quotas, more burdensome fiscal measures for importing
firms.
3. Price controls,
controls specially, if the country is subjected to
high inflation.
 All these constraints, apart from restricting outflow of
capital, present considerable difficulties in the
autonomous functioning of multinational enterprises.
Measures Aiming At A Certain Degree of
Control On Foreign Investments
 Sometimes it is observed that foreign
investments welcome in the beginning are
later subjected to severe controls when a
foreign company wants to increase its capacity
of production or augment its stocks.
 One of the variant of the control can be that
the foreign company is asked to integrate local
products in order to foster development of
local industry.
 The host country may make it obligatory that
part of the profits be reinvested in the
company.
Evaluation of Political Risk
 Political Risk may be evaluated:
1. In the enterprise itself.
2. By external consultants
3. By specialized agencies.
 Measurement of Political Risk
 There are many techniques to measure Country
Risk
a) Capital Flight and Political Risk: Capital flight is
one of the good indicator of political risk. Capital
flight occurs on account of government
regulations and controls, taxes, low returns and
high inflation.
b) Econometric Modeling: This model is used by
banks to assess the capacity of the government
to repay loans without default. In this model all
variables are quantified and if the index climbs
the critical value, the country may be referred
as having high country risk.
 Measurement of Country Risk
c) Delphi Method: 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 the dispersion of opinions.
d) Risk Rating Matrix: A MNC may evaluate country
risk for several countries to determine the
location of investment. This is called foreign
investment risk matrix which shows financial risk
intervals ranging from acceptable to unacceptable
and political risk by interval ranging from stable
to unstable. The matrix is based on ratings
provided by rating agencies.
Evaluation of Political Risk
RISK INDEX APPROACH
 Delphi Technique is often employed for
calculating the risk index and involves working
out the following steps:
• Preparing a list of key variables, characterizing
the economic and political situation of the
country;
• Having these variables classified by experts
and associating some points to each variable
on a scale (say 0 to 4 or 0 to 5 etc);
Evaluation of Political Risk
RISK INDEX APPROACH
• Assigning a weight coefficient to these points
to finally get a company index, representing
political index.
• There are agencies like Moody, S&P which
prepare country risk indices on the basis of
political stability and policies of government
towards foreign investment
 Several indices have been developed, for
example BERI (Business Environment Risk
Index), PRI (Political Risk Index), International
Business Index, Economist Intelligence Unit
Index, etc
Evaluation of Political Risk
BERI
 It is an index that evaluates business climate
in a country and retains 15 criteria, noted on a
scale 0 (maximum risk) to 4 (no risk). The
scores of countries on the BERI scale are
based on aggregation of the subjective
assessment of a panel of experts.
Evaluation of Political Risk
BERI
S.N. Criterion Weight
1. Political Stability 3
2. Attitudes towards foreign investment and profits 1.5
3. Eventuality of Nationalization 1.5
4. Balance of Payment 1.5
5. Inflation 1.5
6. Bureaucratic Delays 1
7. Respect of Contracts 1.5
8. Economic Growth 2.5
9. Productivity/Labor 2
10. Quality of professional services 0.5
11. Communication and infrastructure 1
12. Management and local partners 1
13. Short term credit 2
14. Long term credit and venture capital 2
15. Currency convertibility 2.5
 Evaluation of Political Risk
BERI
 The sum of weights is 25. Therefore, the maximum score
can be 100 (=25*4) and minimum 0 (=25*0). As per the
score obtained countries are classified in five groups:
1. Countries with favorable business climate. (86 or more)
2. Countries where nationalistic tendencies are compensated
to some extent, by other groups like financial institutions
etc. (70 to 80)
3. Countries with average risk (55 to 69)
4. Risky countries for foreign countries (41 to 54)
5. Countries where business conditions are unacceptable (less
than 40)
 Evaluation of Political Risk
PRI
 This index is variant of BERI.
 The criteria are classified as internal and external causes of risk.
 Each criterion is noted on a scale of 0 (minimum) to 7 (maximum).
Criteria for Calculating PRI
External Causes of Risk 1.Dependence on big power
2.Negative influence of religious political forces.
Internal Causes of Risk 1.Political division and factions
2.Linguistic, ethnic and religious divisions
3.Repressive measures taken by government to
remain in power.
4.Attitude towards foreigners, nationalism and tendency to
compromise.
5.Social situation, population density & std of life
6. Org. and elements favorable to a govt. of extreme ideology
 Evaluation of Political Risk
 Countries are classified in three categories
depending on the index obtained :
1. Countries with minimum risk (0 to 20)
2. Countries with acceptable risk (21 to 35)
3. Countries with prohibitive risk (greater than 35)
Evaluation of Political Risk
Economic Intelligence Unit (EIU) Index
 EIU calculates and publishes from time to time
a classification of many countries on a risk
scale of 0 (no risk) to 100 (highest risk)
Evaluation of Political Risk
Scenario Approach
 Scenario approach constitutes useful measure to assess
political risk of international business and major steps in this
approach are:
1. Analysis of economic, social and political characteristics of a
country.
2. Research and definition of several possible futures of the
country and then of the project for the defined time horizon.
3. Assessing financial profitability of different investment
strategies in the country.
4. Application of the game theory for making the choice: a
prudent attitude leads to the adoption of minimax criterion,
that is, to minimize the maximum loss.
Evaluation of Political Risk
Profitability Matrix Developed in Scenario Approach

Scenario 1 Scenario 2 Scenario 3

Strategies Durability of the Constraints relating Nation-
current political to the movement alization
regime of funds
Strategy 1
Strategy 2
Strategy 3
 Evaluation of Political Risk
Sociological Approach
 This approach considers that factors of instability of a country may
be cultural as much as socio political. This approach studies the
factors of instability from two angles:
1. Statistical Analysis: Certain factors that are considered to be
revelators of the economic, political and social situation of the
country are analyzed. Hypothesis normally made is that they
follow a normal distribution and there is a need to study their
dispersion from the mean.
2. Segmentation Analysis: As per this approach, groups are identified
that are politically, socially and economically homogenous. These
groups are called segments. The degree of alliance is studied
among these groups. Attempt is made to find out the chance of
each group to retain power. Each segment is represented by circle
whose importance is a function of its weight. . If this study is done
over a number of years, it helps in visualizing the evolution of each
segment over a period.
 Other Factors of Political Risk
 Apart from various factors (related to host
country) affecting political risk, the risk is also
influenced by factors such as
1. Nationality of the parent company
2. The sector of activity
3. The importance of the project
4. Its strategic interest towards the host country
5. Discrimination history of the past.
Political Risk Management
 Risk Management by a multinational
enterprise is required at three stages:
1. Before an investment is made in a foreign
country;
2. During the life of investment, once made;
3. While negotiating for indemnity
(compensation) in case there has been attack
on the investment through nationalization etc.
Political Risk Management
Management of Political Risk before the Investment
Following approaches are adopted:
1. Dichotomic decisions: To invest or not to invest
abroad (go-no-go approach). Some countries are
considered rightly or wrongly to be risky a priori, and
a firm would not invest there.
2. Assigning a risk premium: This approach calls for
assigning risk premium to foreign investments.
3. Sensitivity Analysis: This analysis brings to fore the
major factors influencing cash flows (inflows as well
as outflows) of the project.
Political Risk Management
 In order to avoid litigation, the multinationals try to
incorporate a number of points (as far as possible
favorable to them) regarding conditions concerning:
1. Access to local capital market
2. Taxation applicable to company
3. Right to import raw material and semi finished
products
4. Right to export to other foreign countries
5. Right to capital transfer, interest, dividends, rents
6. Conditions of local participation, insurance and
guarantees.
Political Risk Management
 The multinationals should also try to ascertain if
there are any bilateral agreements or conventions for
protecting investments of the parent company and
the host country.
 These conventions carry some of the important
clauses like
a) Commitment of the state to pay compensation in the
case of nationalization
b) Guarantee of transfer
c) Recourse to impartial arbitrator in the case of dispute
 These bilateral conventions only diminish the political
risk but do not eliminate it completely.
 Political Risk Management
Management of Political Risk during Life of the Investment
Following approaches are adopted:
1. Not to localize the whole production process in the same
country.
2. To integrate local products
3. To have recourse to local debt
4. Plough back funds generated by the subsidiary rather than
bringing new capital from the parent company.
5. To increase the number of local employees
6. To have other local alternative sources of supplies
7. To establish a joint venture with a local enterprise
8. Holding back technical expertise
 Political Risk Management
 Alternatively, a company may have recourse to external guarantees in
form of public and private insurance to cover for these risks.
1. Public Insurances: ECGC and EXIM Bank provide public insurance
against political risk in India. Similarly, in England this is done by
ECGD (Export Credit Guarantee Department) , EXIM Bank in USA,
Ministry of International Trade and Industry (MITI) in Japan and so on.
2. Insurances offered by International Organizations: Multilateral
Investment Guarantee Agency (MIGA) managed by World Bank offer
insurance cover to private investors against certain types of political
risks and help member states to attract and retain foreign investment.
3. Private insurances: These companies are Lloyds of London, New
Hampshire Company and Company Belge d’ Assurance Credit who
insure new investments as well as existing ones not covered or partly
covered by state agencies.
Political Risk Management
Management of Political Risk After Nationalization
Nationalization of a foreign subsidiary causes following
problems:
1. Determination of the amount of compensation (single criterion
based solely on share quotation or multiple criteria, based on a
combination of share quotation and others such as future cash
flows)
2. Modalities of the payment of indemnities (the mode of payment
in terms of due dates and deadlines of payments, rate of
interest to be paid (if any) on delayed refunds, indexing the
interest on future inflation rates in the country and so on)
3. Proceedings before courts or International Centre for
Settlement of Investment Disputes (ICID), the institution
created in 1966, which is part of the World Bank
Political Risk Management by Banks
 In order to protect themselves against payment
defaults export companies take recourse to internal and
external means.
Internal Means:
a) Reduce exports to country with high political risk.
b) Increase margin on the products that it exports towards
the risk country.
External Means:
a) Transferring the risk to some other organization, like
bank, by asking it to furnish confirmed and irrevocable
documentary credit.
b) Sell the credits to specialized organizations/invoicing
companies.