Chapter 16

Political Risk Assessment and Management

Defining Political Risk

In order for an MNE to identify, measure, and manage its political risks, it must define and classify these risks. This text classifies these risks as:
Firm-specific Country-specific Global-specific

This method of risk classification differs from the traditional method that classifies risks according to the disciplines of economics, finance, political science, sociology and law.
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-2

Exhibit 16.1 Classification of Political Risks

Firm-Specific Risks Country-Specific Risks Global-Specific Risks

Business risks Foreign-exchange

risks

Terrorism & War

Anti-globalization

Governance risks

Transfer Risk

Cultural and Institutional Risk

movement

Environmental
concerns Poverty

Blocked funds

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

Ownership structure
Human resource norms Religious heritage Nepotism & corruption

Cyberattacks

Intellectual property rights Protectionism

16-3

Assessing Political Risk

At the macro level, firms attempt to assess a host countrys political stability and attitude toward foreign investors. At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations.

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-4

Assessing Political Risk

Predicting firm-specific risk (micro risk):
Assessing the political stability of a country is only a first step The real objective is to anticipate the effect of political changes on activities of a specific firm Clearly, different foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regulations

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-5

Assessing Political Risk

Predicting country-specific risk (macro risk):
Political risk studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activities
Analysis of trends in these metrics leads many to speculate that the future will resemble the past, which is often not the case

Despite this difficulty, the MNE must conduct adequate analysis in preparation for the unknown
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-6

Assessing Political Risk

Predicting global-specific risk:
Global-specific risk is clearly quite difficult to predict (i.e. September 11th)
There are many groups interested in disrupting MNEs operations for the cause of religion, antiglobalization, environmental protection, and even anarchy We can expect to see a number of new indices, similar to country-specific indices, but devoted to ranking different types of terrorist threats, their locations, and potential targets
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-7

Firm-Specific Risks
The firm-specific risks that confront MNEs include:
Business risk
Foreign exchange risk Governance risks

Governance risk is the ability to exercise effective control over an MNEs operations within a countrys legal and political environment For an MNE, it must be addressed for the individual business unit as well as for the MNE as a whole

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-8

Firm-Specific Risks
Corporate governance principles include:
Accountability (transparent ownership, appropriate board size, defined board accountability, and ownership neutrality)
Disclosure and transparency (broad, timely and accurate disclosure, use of proper accounting standards) Independence (dispersed ownership, independent audits and oversight, independent directors) Shareholder equity (one share, one vote)

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-9

Firm-Specific Risks
Negotiating investment agreements:
An investment agreement spells out specific rights and responsibilities of both the foreign firm and host government
The presence of MNEs is as often sought by developmentseeking host governments as a particular foreign location is sought by an MNE An investment agreement should spell out policies on many areas including (among others): The basis of fund flows (fees, royalties, dividends) The basis for setting transfer prices The right to export to third-country markets Methods of taxation
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-10

Firm-Specific Risks
Investment insurance and guarantees: OPIC
MNEs can sometimes transfer political risk to a home-country public agency through an investment insurance and guarantee program
The US investment insurance and guarantee program is managed by the government-owned Overseas Private Investment Corporation (OPIC) OPIC offers insurance for four separate types of political risk: Inconvertibility Expropriation War, revolution, insurrection, and civil strife Business income (resulting from political violence)
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-11

Firm-Specific Risks
Operating strategies after the FDI decision:
Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changes Most MNEs, in their own self-interest, follow a policy of adapting to changing host-country priorities whenever possible
The essence of such adaptation is anticipating hostcountry priorities and making the activities of the firm of continued value to the host country
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-12

Firm-Specific Risks
Host countries may look for control of:
Local sourcing of raw materials and components Facility location Transportation Technology Markets Brand names and trademarks
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-13

Country-Specific Risks: Transfer Risk

Transfer risk is defined as limitations on the MNEs ability to transfer funds into and out of a host country without restrictions. When a government runs short of foreign exchange and cannot obtain additional funds through borrowing or attracting new foreign investment, it usually limits transfers of foreign exchange out of the country, a restriction known as blocked funds.

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-14

Exhibit 16.4 Management Strategies for Country-Specific Risks

Transfer Risk Cultural and Institutional Risk

Blocked Funds
Preinvestment strategy to anticipate blocked funds Fronting loans Creating unrelated exports Forced reinvestment

Ownership Structure
Joint venture

Human Resource Norms

Local management & staffing

Religious Heritage

Intellectual Property
Legal action in host country courts Support worldwide treaty to protect intellectual property rights

Understand and respect host country religious heritage Obtaining special dispensation

Nepotism and Corruption

Disclose bribery policy to both employees and clients Retain a local legal advisor

Protectionism
Support government actions to create regional markets
16-15

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

Country-Specific Risks: Transfer Risk

MNEs can react to the potential for blocked funds at three stages:
Prior to making an investment, a firm can analyze the effect of blocked funds on return on investment, the desired local financial structure etc. During operations a firm can attempt to move funds through a variety of repositioning techniques Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciation
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-16

Country-Specific Risks: Cultural and Institutional Risks

When investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences: Differences in allowable ownership structures

Differences in human resource norms

Differences in religious heritage Nepotism and corruption in the host country

Protection of intellectual property rights

Protectionism
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-17

Country-Specific Risks: Cultural and Institutional Risks

Ownership structure:
Many countries have required that MNEs share ownership of their foreign subsidiaries with local firms or citizens
This requirement has been eased in most countries in recent years

Human resource norms:

MNEs are often required by host countries to employ a certain proportion of host country citizens rather than staffing mainly with foreign expatriates It is often very difficult to fire local employees due to host country labor laws and union contracts

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-18

Country-Specific Risks: Cultural and Institutional Risks

Religious heritage:
Despite religious differences, MNEs have operated successfully in emerging markets, especially in extractive and natural resource industries such as oil, natural gas, minerals and forest products

Nepotism and corruption:

There is clearly endemic nepotism and corruption in many important foreign investment locations Bribery is not limited to emerging markets, as it is also a problem in industrialized nations such as the US and Japan

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-19

Country-Specific Risks: Cultural and Institutional Risks

Intellectual property rights:

Intellectual property rights grant the exclusive use of patented technology and copyrighted creative materials
Courts in some countries have historically not done a fair job of protecting these rights Protectionism: Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competition Industries that are usually protected are defense, agriculture, and infant (emerging) industries Protectionism occurs through the use of tariff and non-tariff barriers
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-20

Global-Specific Risks
Global-specific risks faced by MNEs have come to the forefront in recent years:
Terrorism and war Poverty Anti-globalization Cyber attacks Environmental concerns
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-21

Exhibit 16.7 Management Strategies for GlobalSpecific Risks

Terrorism & War
Support government efforts to flight terrorism and war Crisis planning

Anti-Globalization
Support government efforts to reduce trade barriers Recognize that MNEs are the targets

Environmental Concerns
Show sensitivity to environmental concerns Support government efforts to maintain a level playing field for pollution controls

Poverty
Provide stable, relatively well-paying jobs

Cyber Attacks
No effective strategy except internet security efforts

Establish the strictest of Support government occupational safety standards anti-cyber attack efforts

MNE movement towards multiple primary objectives: Profitability, Sustainable Development, Corporate Social Responsibility
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-22

Illustration of Global-Specific Risks: The Case of Starbucks

Starbucks found itself an early target of the anti-globalist movement. The company appeared to be yet another American cultural imperialist. As global prices for coffee plummeted in the late 1990s, companies like Starbucks were criticized as being unwilling to help improve the economic conditions of the coffee growers themselves
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-23

Exhibit 16.8 Arabica Bean Coffee Prices, 1981-2001

US cents/pound
160 140 120 100 80 60 40 20 0
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: International Coffee Organization (ICO), www.ico.org.

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-24

Illustration of Global-Specific Risks: The Case of Starbucks

Much of the growing pressure on all multinational companies for sustainable development and social responsibility arose directly from consumer segments. In response, the company introduced in 1998 coffee that was cultivated under the canopy of shade trees in host countries (a practice considered ecologically sound). In addition, in 2000, the company introduced Fair Trade coffee in an effort to improve the living standards of coffee growers

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-25

Starbucks coffee buyers work with coffee wholesalers and directly with small farmers and farm cooperatives in procurement

Infrastructure, including schools, clinics, and coffee processing facilities

Supplemental funding for farm credit programs to support farm capital needs

Contributions to CARE, the non-profit international relief organization

Shade Grown Mexico Brand

Partnership formed in 1998, encourages production of shade-grown coffee using ecologically sound growing practices to promote bio-diversity and to financially support farms employing these practices (with Conservation International, CI)

Fair Trade Certified Brand

Partnership in which Starbucks promises consumers that the farmers who produced the coffee beans were paid a guaranteed minimum price that helps support a better life for farm families (with TransFair USA)

Copyright 2004 Pearson Addison-Wesley. All rights reserved.

16-26