Business & Finance Fin 4604- Country Risk Report Assignment

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Political Risk and FDI In assessing investment opportunities in a foreign country, it is important for a parent firm to take into consideration the risk arising from the fact that investments are located in a foreign country. A sovereign country

can take various actions that may adversely affect the interests of MNCs. In this section, we are going to discuss

how to measure and manage political risk, which refers to the potential losses to the parent firm resulting from adverse political developments in the host country. Political risks range from the outright expropriation of foreign

assets to unexpected changes in the tax laws that hurt the profitability of foreign projects.

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Political risk that firms face can differ in terms of the incidence as well as the manner in which political events

affect them. Depending on the incidence, political risk can be classified into two types:

The communist victory in China in 1949 is an example of macro risk, whereas the predicament of Enron in India,

which we will discuss shortly, is an example of micro risk.

Depending on the manner in which firms are affected, political risk can be classified into three types:

Examples of transfer risk include the unexpected imposition of capital controls, inbound or outbound,

and withholding taxes on dividend and interest payments. Examples for operational risk, on the other

hand, include unexpected changes in environmental policies, sourcing/local content requirements, minimum wage law, and restriction on access to local credit facilities. Lastly, examples of control risk include restrictions imposed

on the maximum ownership share by foreigners, mandatory transfer of ownership to local firms over a certain

period of time (fade-out requirements), and the nationalization of local operations of MNCs.

1. Macro risk, where all foreign operations are affected by adverse political developments in the host country.

2. Micro risk, where only selected areas of foreign business operations or particular foreign firms are affected.

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1. Transfer risk, which arises from uncertainty about cross-border flows of capital, payments, know-how, and the like.

2. Operational risk, which is associated with uncertainty about the host country’s policies affecting the local

operations of MNCs.

3. Control risk, which arises from uncertainty about the host country’s policy regarding ownership and control of

local operations.

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Recent history is replete with examples of political risk. As Mao Ze-dong took power in China in 1949, his

communist government nationalized foreign assets with little compensation. The same happened again when Castro took over Cuba in 1960. Even in a country controlled by a noncommunist government, strong nationalist

sentiments can lead to the expropriation of foreign assets. For example, when Gamal Nasser seized power in Egypt

in the early 1950s, he nationalized the Suez Canal, which was controlled by British and French interests. Politically, this move was immensely popular throughout the Arab world.

Expropriations of foreign-owned assets peaked again in the 1970s, with as many as 30 countries involved in

expropriations each year. Since then, however, expropriations had dwindled to practically nothing. This change

reflected the popularity of privatization, which, in turn, is attributable to widespread failures of state-run

enterprises and mounting government debts around the world. As Exhibit 16.9 shows, expropriations picked up

the pace again in the mid-2000s. Hajzler and Rosborough (2016) reported that a total of 162 expropriation acts

occurred across 44 countries during 1990–2014, with 44 percent of these taking place in resource-based industries such as mining. Venezuela alone reportedly accounted for almost 25 percent of the expropriation acts during this

period. Examples include the 2007 nationalization of ConocoPhillips’ oil production ventures in Venezuela.

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EXHIBIT 16.9 Expropriation Acts by Sector, 1990–2014

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Another well-known episode of political risk involved Enron. In 1992, the Enron Development Corporation, a

subsidiary of the Houston-based energy company, signed a contract to build the largest-ever power plant in India,

requiring a total investment of $2.8 billion. Severe power shortages have been one of the bottlenecks hindering India’s economic growth. After Enron had spent nearly $300 million, the project was canceled by Hindu nationalist

politicians in the Maharashtra state where the plant was to be built. Subsequently, Maharashtra invited Enron to

renegotiate its contract. If Enron had agreed to renegotiate, it may have had to accept a lower profitability for the project. As can be seen from the Enron fiasco, the lack of an effective means of enforcing contracts in a foreign

country is clearly a major source of political risk associated with FDI.

Political risk is not easy to measure. When Enron signed the contract to build a power plant in India, it

perhaps could not have anticipated the victory of the Hindu nationalist party. Many businesses

domiciled in Hong Kong were nervous about the intentions of Beijing in the post-1997 era. Difficult as it may be, MNCs still have to measure political risk for foreign projects under consideration. Experts of political risk analysis

evaluate, often subjectively, a set of key factors such as:

Source: Hajzler, Christopher, and Jonathan Rosborough. “Government Corruption and Foreign Direct Investment Under the Threat of Expropriation.” Bank

of Canada Staff Working Paper 2016-13, 2016

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The host country’s political and government system: Whether the host country has a political and administrative

infrastructure that allows for effective and streamlined policy decisions has important implications for political risk. If a country has too many political parties and frequent changes in government (like Italy, for example),

government policies may become inconsistent and discontinuous, creating political risk.

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Track records of political parties and their relative strength: Examination of the ideological orientations and

historical track records of political parties would reveal a great deal about how they would run the economy. If a party has a strong nationalistic ideology and/or socialist beliefs, it may implement policies that are detrimental

to foreign interests. On the other hand, a party that subscribes to a liberal and market-oriented ideology is not

very likely to take actions to damage the interests of foreign concerns. If the former party is more popular than the latter party and thus more likely to win the next general election, MNCs will bear more political risk.

Integration into the world system: If a country is politically and economically isolated and segmented from the rest of the world, it would be less willing to observe the rules of the game. North Korea, Iraq, Libya, and Cuba are

examples. If a country is a member of major international organizations, such as the EU, OECD, and WTO, it is

more likely to abide by the rules of the game, reducing political risk. In the same vein, as China joins the World Trade Organization (WTO), MNCs operating in China may face less political risk.

The host country’s ethnic and religious stability: As can be seen from the civil war in Bosnia, domestic peace can

be shattered by ethnic and religious conflicts, causing political risk for foreign business. Additional examples are provided by Nigeria, Rwanda, Northern Ireland, Turkey, Israel, Sri Lanka, and Quebec.

Regional security: Real and potential aggression from a neighboring country is obviously a major source of political risk. Kuwait is an example. Countries like South Korea and Taiwan may potentially face the same risk

depending on the future course of political developments in East Asia. Israel and its Arab neighbors still face

this risk as well.

Key economic indicators: Often political events are triggered by economic situations. Political risk thus is not

entirely independent of economic risk. For example, persistent trade deficits may induce a host country’s government to delay or stop interest payments to foreign lenders, erect trade barriers, or suspend the

convertibility of the local currency, causing major difficulties for MNCs. Severe inequality in income distribution

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Page 461MNCs may use in-house experts to do the analysis. But often, MNCs use outside experts who provide

professional assessments of political risks in different countries. For example, Morgan Stanley offers an in-depth analysis of country/political risks using a variety of data sources, including government and private sector

publications, statistics provided by international organizations, newspaper articles, and on-site due diligence in

countries with government officials and the private sector. Similarly, government agencies provide political risk

analysis that can be useful to companies and investors. Exhibits 16.10 and 16.11 provide such analyses

conducted by the Australian government for two countries: Vietnam and Turkey. The exhibits provide an example

of how political risk analysis may be conducted. Credendo, a Belgian export credit agency, publishes country risk ratings, including ratings of expropriation and government action risk.

(e.g., in many Latin American countries) and deteriorating living standards (as in Russia after the collapse of

the Soviet Union) can cause major political disturbances. Argentina’s protracted economic recession and the eventual collapse of the peso–dollar parity led to the freezing of bank deposits, street riots, and three changes of

the country’s presidency in as many months in 2002.

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EXHIBIT 16.10 Political Risk Analysis: Vietnam

Sovereign Rating: Moody’s: B1, Outlook: Stable; S&P: BB−, Outlook: Stable

Political Strengths

Political Weaknesses

Political & Governance Indicators

Economic Strengths

Political stability with Communist Party in government since end of the country’s civil war in 1975

Widespread support for the CPV (Vietnam Communist Party) reflects its success in raising living standards and creating and

maintaining security

Inconsistent and evolving regulations

Unreliable legal system and corruption

A lack of financial transparency, insufficient protection for minority owners, and poor corporate governance

World Bank Ranking—Ease of doing business

Freedom House—Political rights and civil liberties

Transparency International Ranking—Corruption Perception Index

OECD country risk rating (Scale: 0–7, 0 is least risk, 7 is highest risk)

68th/190

Not Free

117th/180

5

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Sovereign Rating: Moody’s: B1, Outlook: Stable; S&P: BB−, Outlook: Stable

Economic Weaknesses

Economic Indicators

Transformation to market oriented economy since late 1980s

High GDP growth facilitated by foreign investment

Well educated and cheap labor force

Sizable natural resources and advantageous location

Membership in TPP trade agreement

Large fiscal deficits and weak banking system

Plethora of state-owned enterprises and less diversification

Industry and credit policies favor state-owned enterprises

Lack of infrastructure

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Sovereign Rating: Moody’s: B1, Outlook: Stable; S&P: BB−, Outlook: Stable

Source: www.efic.gov.au, World Bank, and IMF, 2018 figures.

GDP ($US bn)

GDP per capita ($US)

Real GDP growth (15-year average, %)

Fiscal balance (% of GDP)

Public debt (% of GDP)

Foreign direct investment (% of GDP)

Current account (% of GDP)

External debt (% of GDP)

Foreign reserves (% of GDP)

241

2,482

6.8

−4.7

57.8

7.3

2.2

49.7

26.3

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EXHIBIT 16.11 Political Risk Analysis: Turkey

Sovereign Rating: Moody’s: Ba3, Outlook: Negative; S&P: B+, Outlook: Negative

Political Strengths

Political Weaknesses

Political & Governance Indicators

Economic Strengths

Transition to democracy at the end of 1970s

Significant liberalization and stabilization by a drive to join European Union

Rapid decline in poverty incidence

Instability fuelled by conflict between the army and the civilian government

Strained relations between religious conservatives and secular modernists

Proximity to war-torn Syria

World Bank Ranking—Ease of doing business

Freedom House—Political rights and civil liberties

Transparency International Ranking—Corruption Perception Index

OECD country risk rating (Scale: 0–7, 0 is least risk, 7 is highest risk)

43rd/190

Partly Free

78 /180th

5

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Sovereign Rating: Moody’s: Ba3, Outlook: Negative; S&P: B+, Outlook: Negative

Economic Weaknesses

Economic Indicators

Key dimensions of economic performance on par with central and eastern European countries

Was able to weather the recent global economic crisis

Debt is highly sought after by foreign investors

Healthy growth forecast

Mounting macroeconomic imbalances and major reliance on foreign financing

Widening current account deficit, surging credit growth and building inflation pressures

High business cycle and currency risk

Lira is a volatile emerging market currency

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The collapse of the Soviet Union in the late 1980s forced Vietnam to transform from central planning and autarky to market orientation and international re-integration. Overall, this has been very successful. GDP growth has

averaged nearly 8 percent a year, with foreign investment a key driver. Per capita income has risen from US$100 in

1990 to nearly US$2,482 in 2018. Vietnam has a number of attractions for investors and exporters: a large, young, and rapidly growing population; a labor force that is relatively well educated and cheap; sizable natural resources;

an advantageous location; and a high level of political and social stability. Vigorous policy stimulus and spending

helped Vietnam avoid the worst of the global financial crisis. But the authorities are now facing a fiscal deficit topping 6 percent of GDP, accelerating inflation, and a weakening banking system. On the other hand, Vietnam is

Sovereign Rating: Moody’s: Ba3, Outlook: Negative; S&P: B+, Outlook: Negative

Source: www.efic.gov.au, World Bank, and IMF, 2018 figures.

GDP ($US bn)

GDP per capita ($US)

Real GDP growth (15-year average, %)

Fiscal balance (% of GDP)

Public debt (% of GDP)

Foreign direct investment (% of GDP)

Current account (% of GDP)

External debt (% of GDP)

Foreign reserves (% of GDP)

769

9,445

2.6

−1.9

30.4

1.7

−5.7

56.7

12.0

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benefiting from the growing integration in global value chains. Standard & Poor views the country’s external

foreign currency debt as speculative grade with a BB-rating and a stable outlook, and Moody’s rating for the same is B1. Public debt is equivalent to 58 percent of GDP and contingent liabilities—in the banking sector and state-

owned enterprises—are large.

The Vietnamese Communist Party (CPV) has been in government since the end of the country’s civil war in 1975.

The party has a firm grip on power, which ensures a high degree of political stability. Although the party’s communist ideology has become less important over time, it led to a plethora of state-owned enterprises, which

span most sectors and account for nearly 40 percent of GDP. Foreign investors face a number of challenges,

including: inconsistent and evolving regulations, an unreliable legal system, a weak banking system, corruption, and industry and credit policies that favor state-owned enterprises.

transparency.org

Provides data about the Corruption Perceptions Index.

We next introduce the Corruption Perceptions Index (CPI) compiled annually by Transparency

International, a global civil organization. The CPI provides a composite measure of perceived corruption in the public sector based on surveys and assessments from many institutions, such as the World Bank, Economist

Intelligence Unit, and World Economic Forum. The level of perceived corruption in a particular country may serve

as a useful gauge for the uncertainty about the rule of law and political risk, broadly defined, that MNCs and

international investors may face in the country. Exhibit 16.12 presents the CPI for 2020. The index ranges from

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0 (highly corrupt) to 100 (highly transparent). According to the CPI 2020 that surveyed 180 countries, Denmark

and New Zealand are the most transparent countries in the world, followed by Finland, Singapore, Sweden, Switzerland, Norway, the Netherlands, Germany, and Luxembourg. Australia, Canada, Hong Kong, and the United

Kingdom tie and rank 11th. The United States ranks 25th, behind Japan (19th) and France (23rd). Taiwan ranks

28th, Qatar (30th), and Botswana (35th). Most developing countries rank much lower. For example, Malaysia ranks 57th, South Africa 69th, China 78th, India and Turkey both 86th, Brazil 94th, Indonesia 102nd, Mexico

124th, Russia 129th, and Nigeria 149th. Somalia, Syria, and South Sudan were found to be the least transparent

countries in the world.

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EXHIBIT 16.12 Corruption Perceptions Index 2020

Rank Country/Territory Score

1 Denmark 88

1 New Zealand 88

3 Finland 85

3 singapore 85

3 sweden 85

3 switzerland 85

7 Norway 84

8 Netherlands 82

9 Germany 80

9 Luxembourg 80

11 Australia 77

11 Canada 77

11 Hong Kong 77

11 United Kingdom 77

15 Austria 76

15 Belgium 76

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Rank Country/Territory Score

17 Estonia 75

17 Iceland 75

19 Japan 74

20 Ireland 72

21 United Arab Emirates 71

21 Uruguay 71

23 France 69

24 Bhutan 68

25 Chile 67

25 United states of America 67

27 seychelles 66

28 Taiwan 65

29 Barbados 64

30 Bahamas 63

30 qatar 63

32 spain 62

33 Korea, south 61

33 Por tugal 61

35 Botswana 60

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Rank Country/Territory Score

35 Brunei Darussalam 60

35 Israel 60

35 Lithuania 60

35 slovenia 60

40 saint Vincent and the Grenadines 59

41 Cabo Verde 58

42 Costa Rica 57

42 Cyprus 57

42 Latvia 57

45 Georgia 56

45 Poland 56

45 saint Lucia 56

48 Dominica 55

49 Czechia 54

49 Oman 54

49 Rwanda 54

52 Grenada 53

52 Italy 53

52 Malta 53

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Rank Country/Territory Score

52 Mauritius 53

52 saudi Arabia 53

57 Malaysia 51

57 Namibia 51

59 Greece 50

60 Armenia 49

60 Jordan 49

60 slovakia 49

63 Belarus 47

63 Croatia 47

63 Cuba 47

63 sao Tome and Principe 47

67 Montenegro 45

67 senegal 45

69 Bulgaria 44

69 Hungary 44

69 Jamaica 44

69 Romania 44

69 south Africa 44

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Rank Country/Territory Score

69 Tunisia 44

75 Ghana 43

75 Maldives 43

75 Vanuatu 43

78 Argentina 42

78 Bahrain 42

78 China 42

78 Kuwait 42

78 solomon Islands 42

83 Benin 41

83 Guyana 41

83 Lesotho 41

86 Burkina Faso 40

86 India 40

86 Morocco 40

86 Timor-Leste 40

86 Trinidad and Tobago 40

86 Turkey 40

92 Colombia 39

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Rank Country/Territory Score

92 Ecuador 39

94 Brazil 38

94 Ethiopia 38

94 Kazakhstan 38

94 Peru 38

94 serbia 38

94 sri Lanka 38

94 suriname 38

94 Tanzania 38

102 Gambia 37

102 Indonesia 37

104 Albania 36

104 Algeria 36

104 Côte d’Ivoire 36

104 El salvador 36

104 Kosovo 36

104 Thailand 36

104 Vietnam 36

111 Bosnia and Herzegovina 35

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Rank Country/Territory Score

111 Mongolia 35

111 North Macedonia 35

111 Panama 35

115 Moldova 34

115 Philippines 34

117 Egypt 33

117 Eswatini 33

117 Nepal 33

117 sierra Leone 33

117 Ukraine 33

117 Zambia 33

123 Niger 32

124 Bolivia 31

124 Kenya 31

124 Kyrgyzstan 31

124 Mexico 31

124 Pakistan 31

129 Azerbaijan 30

129 Gabon 30

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Rank Country/Territory Score

129 Malawi 30

129 Mali 30

129 Russia 30

134 Laos 29

134 Mauritania 29

134 To g o 29

137 Dominican Republic 28

137 Guinea 28

137 Liberia 28

137 Myanmar 28

137 Paraguay 28

142 Angola 27

142 Djibouti 27

142 Papua New Guinea 27

142 Uganda 27

146 Bangladesh 26

146 Central African Republic 26

146 Uzbekistan 26

149 Cameroon 25

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Rank Country/Territory Score

149 Guatemala 25

149 Iran 25

149 Lebanon 25

149 Madagascar 25

149 Mozambique 25

149 Nigeria 25

149 Tajikistan 25

157 Honduras 24

157 Zimbabwe 24

159 Nicaragua 22

160 Cambodia 21

160 Chad 21

160 Comoros 21

160 Eritrea 21

160 Iraq 21

165 Afghanistan 19

165 Burundi 19

165 Congo 19

165 Guinea Bissau 19

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At the end of the 1970s, Turkey was under martial law and handicapped by protectionism, triple-digit inflation, and financial crisis. It has since undertaken significant democratization, liberalization, and stabilization by a drive to

join the European Union. Trade liberalization introduced by the late president Turgut Ozal in the 1980s helped to

open up the economy. On key dimensions of economic performance such as per capita income, business climate, creditworthiness, and growth, Turkey is about on par with other Central and Eastern European countries. The

Rank Country/Territory Score

165 Turkmenistan 19

170 Democratic Republic of the Congo 18

170 Hait i 18

170 Korea, North 18

173 Libya 17

174 Equatorial Guinea 16

174 sudan 16

176 Venezuela 15

176 Yemen 15

178 syria 14

179 somalia 12

179 south sudan 12

Source: Transparency International. All rights reserved.

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Turkish economy really only began to demonstrate its full potential in the wake of a 2002 IMF-led stabilization

program, which helped put in place policies that: sharply reduced inflation from 70 percent per annum to single digits, restored fiscal solvency, and unleashed GDP growth of almost 7 percent pa over 2002–2007. Turkey was able

to weather the global financial and economic crises reasonably well. Its debt is highly sought after by foreign

investors. And despite the lack of an investment-grade sovereign rating (S&P: B+, Fitch: BB, and Moody’s: Ba3), the country’s sovereign bond spreads are roughly in line with those of investment-grade emerging markets such as

Russia (BBB−) and Brazil (BB).

But for all this progress, significant vulnerabilities remain. Mounting macroeconomic imbalances and a reliance on

foreign financing are key economic challenges. The main near-term economic challenges are a widening current account deficit, surging credit growth, and building inflation pressures. Turkey also faces a sizable external

financing requirement, which makes it vulnerable to domestic and international setbacks. In the political sphere,

instability is fueled by conflict between the army and the civilian government and between religious conservatives and secular modernists. Exporters and investors in Turkey face high business cycle and currency risk; Turkish GDP

growth has recently experienced a large bust and rebound, and the lira is a volatile emerging market currency.

Let us now turn to the issue of how to manage political risk. First, MNCs can take a conservative

approach to foreign investment projects when faced with political risk. When a foreign project is exposed

to political risk, the MNC can explicitly incorporate political risk into the capital budgeting process and adjust the project’s NPV accordingly. The firm may do so either by reducing expected cash flows or by increasing the cost of

capital. The MNC may undertake the foreign project only when the adjusted NPV is positive. It is important here

to recognize that political risk may be diversifiable to some extent. Suppose that an MNC has assets in, say, 30 different countries. Because the political risks in different countries may not be positively correlated, the political

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risk associated with a single country may be diversifiable to some extent. To the extent that political risk is

diversifiable, a major adjustment to the NPV may not be necessary. This consideration also suggests that MNCs can use geographic diversification of foreign investments as a means of reducing political risk. Put simply, don’t put

all your eggs in one basket.

Second, once an MNC decides to undertake a foreign project, it can take various measures to minimize its

exposure to political risk. For example, an MNC can form a joint venture with a local company. The idea is that if the project is partially owned by a local company, the foreign government may be less inclined to expropriate it

since the action will hurt the local company as well as the MNC. The MNC may also consider forming a

consortium of international companies to undertake the foreign project. In this case, the MNC can reduce its exposure to political risk and, at the same time, make expropriation more costly to the host government.

Understandably, the host government may not wish to take actions that will antagonize many countries at the same

time. Alternatively, MNCs can use local debt to finance the foreign project. In this case, the MNC has an option to repudiate its debt if the host government takes actions to hurt its interests.

Third, MNCs may purchase insurance against the hazard of political risk. Such insurance policies, which are available in many advanced countries, are especially useful for small firms that are less well equipped to deal with

political risk on their own. In the United States, the Overseas Private Investment Corporation (OPIC), a federally

owned organization, offers insurance against (i) the inconvertibility of foreign currencies, (ii) expropriation of U.S.- owned assets overseas, (iii) destruction of U.S.-owned physical properties due to war, revolution, and other violent

political events in foreign countries, and (iv) loss of business income due to political violence. OPIC’s primary goal

is to encourage U.S. private investments in the economies of developing countries. Alternatively, MNCs may also purchase tailor-made insurance policies from private insurers such as Lloyd’s of London.

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When the political risk faced by an MNC can be fully covered by an insurance contract, the MNC can subtract the

insurance premium from the expected cash flows from the project in computing its NPV. The MNC then can use the usual cost of capital, which would be used to evaluate domestic investment projects, in discounting the

expected cash flows from foreign projects. Lastly, it is pointed out that many countries have concluded bilateral or

multilateral investment protection agreements, effectively eliminating most political risk. As a result, if an MNC invests in a country that signed the investment protection agreement with the MNC’s home country, it need not be

overly concerned with political risk.

Bhagwat, Brogaard, and Julio (2021) examined over 1,000 bilateral investment treaties signed by 139 unique

countries over several decades and found that the volume of M&A deals increased significantly between 2 countries after they signed a bilateral investment treaty. However, the effect of the treaties differed across countries and deals

depending on factors such as political risk.

One particular type of political risk that MNCs and investors may face is corruption associated with the

abuse of public offices for private benefits. Investors may often encounter demands for bribes from

politicians and government officials for contracts and smooth bureaucratic processes. If companies refuse to make grease payments, they may lose business opportunities or face difficult bureaucratic red tape. If companies pay, on

the other hand, they may risk violating laws or being embarrassed when the payments are discovered and reported

in the media. Corruption can be found anywhere in the world. But it is a much more serious problem in many developing and transition economies where the state sector is large, democratic institutions are weak, and the press

is often muzzled. U.S. companies are legally prohibited from bribing foreign officials by the Foreign Corrupt

Practices Act (FCPA). In 1997, the OECD also adopted a treaty to criminalize the bribery of foreign officials by companies. Bribery thus is both morally and legally wrong for companies from most developed countries. Another

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particular risk that companies may face is extortion demands from Mafia-style criminal organizations. For example,

the majority of companies in Russia are known to have paid extortion demands. To deal with this kind of situation, it is important for companies to hire people who are familiar with local operating environments, to strengthen local

support for the company, and to enhance physical security measures.