The course work topic : Discuss how political risk can arise for international businesses and critically evaluate different mechanisms that can be used to manage this risk.
some of the topic information we took in the class this is only((( preview )))
Preview
This block represents four weeks of personal study. The block focuses on the important aspect of political risk that adds a unique dimension to the activities of the MNC. Political risk in also referred to as ‘country risk’ albeit in a narrow sense. We proceed by trying to establish the links between political, economic and legal systems, considering definitions of political risk, through to discussing the intricacies of identifying, measuring and managing such risk that presents a challenge to the MNC seeking international investment.
Political risk is a subject in its own right and, as part of a wider module, we can only touch upon some of the key issues associated with it. You will be directed to essential reading in the set text, the reader and online. For students who have a particular interest in the topic, further reading can be found at the end of this block.
Prior to starting on this block, please look at the following on-line articles:
http://www.newstatesman.com/blogs/economics/2012/04/argentina-allowed-seize-ypf
http://www.newstatesman.com/blogs/economics/2012/04/repsol-may-never-get-paid-ypf
Both of these relate to the seizure, or expropriation, by Argentina of the shares owned by Spanish oil company Repsol in the Argentinean company YPF. Expropriation is the most extreme form of political risk and, in general, it has significantly declined in recent years. However, the Repsol case illustrates that the risk has not ‘gone away’ and, if it does come to pass, there are significant difficulties for the MNC in satisfactorily resolving the situation.
Learning Outcomes:
After completing the course of study required for this module, you will be able to:
• Explain the link between political, economic and legal systems and the risk implications of this link
• Define political risk and be able to discuss its implications for the operations of a MNC.
• Evaluate key factors used in the identification, measurement and management of this risk.
• Compare and contrast the effectiveness of various methods of political risk management
• Critically discuss practical application of political risk management principles by MNCs after studying cases in the textbook and selected web sites.
1.1 Introduction: The link between political, economic and legal systems
Read:
Hill et al (2014), chapters 3 & 7
Like the majority of risks facing the majority of organisations, political risk is not a ‘stand-alone’ problem. By that we mean that a number of different aspects contribute to political risk to a greater or lesser extent. Two of the main contributors to levels of political risk facing MNCs in a particular country are the prevailing economic and legal systems. Hill et al (2014) discuss this in detail, but it is worthwhile summarising the main points associated with this.
6.1.1 Economic systems
In the vast majority of countries, but especially developing and transitional economies, there is a very strong link between political ideology and economic systems. Very often, particularly in the face of pressure from organisations such as the World Bank, governments require to be pragmatic and temper their ideological beliefs, however as a general rule:
• In countries where individual goals are given primacy, free market economic systems are fostered, i.e. there is little government interference in business. The USA being an example of this.
• In countries where collective goals are given primacy there is marked state control of markets. An example of this is Venezuela under President Hugo Chavez.
Over the past ten years a feature of the economic landscape for MNCs has been the move in many countries from collectivist economic systems to more free-market systems. This was substantially driven by the fall of the Soviet Union. Although we must be cautious of generalisations, these transitional economies can often be characterised by:
• Deregulation
– Removal of legal restriction to the free play of market systems
– Allowing establishment and operations of private enterprises
• Privatisation
– Transfer of ownership of state owned enterprise to private individuals
• Legal systems
– Laws that support a market economy
6.1.2 Legal systems
Any legal system is the means by which laws, rules and regulations are handled and enforced. Clearly this has a significant impact on MNCs in terms of business practice, business transactions and the independence and impartiality of the legal environment.
There are three main types of legal systems in use around the world, which Hill explains in detail:
1. Common law
2. Civil law
3. Theocratic law
6.1.3 Managerial implications
In the context of this block on political risk and its management, the fine detail of the economic and legal systems is less important than on understanding their implications for MNCs. In general there are two broad implications that you should consider:
1. Political, economic, and legal systems of a country raise important ethical issues that have implications for the practice of international business
2. The political, economic, and legal environment of a country clearly influences the attractiveness of that country as a market and/or investment site
We will now look at the specifics of political risk in more depth
6.2 Political Risk
Reader:
Hood J & Nawaz M (2004), Political Risk Exposure and Management in Multi-national Companies: Is There a Role for the Corporate Risk Manager, Risk Management: An International Journal, Vol. 6(1), pp7-18
van Wyk J (2010), Political Sources of International Business Risk: an Interdisciplinary Framework, Journal of International Business Research, Vol 9(1), pp 103-119
Suggested additional reading
At the time of writing, June 2014, the web links shown below were all active and all contained useful information on various aspects of operating in countries across the world.
As always with web content, you need to be careful about any potential bias associated with the site, but in the main these sources provide you with useful information on a range of risk and reward factors.
The key aspect is an appreciation of the range of factors which the global ‘risk manager’ has to consider and the amount and type of information which is readily available.
https://www.cia.gov/library/publications/the-world-factbook/
http://news.bbc.co.uk/1/hi/country_profiles/default.stm
http://www.amnesty.org/
http://www.deloitte.com/view/en_PG/pg/insights-ideas/itbg/index.htm
http://www.economist.com/countries/
As we have seen, a logical progression for many large domestic firms that have excelled in their respective areas may be to expand their activities abroad. An exposure to “political risk” in its many forms is a consequence of this expansion abroad. This risk is often looked upon as a unique risk of operating abroad. Many international banks talk of “country risk” to denote the risk of operating in foreign countries. “Country risk” and “political risk” are terms that are sometimes used interchangeably. “Political risk” may be used in the wider context, whereas “country risk” is a term that refers specifically to one country. We shall for the most part, refer to this “cross-border” risk as political risk.
In this block we will establish a definition of this risk, explore some of its characteristics, learn how MNCs may identify this risk in their operations and lastly look at management of this risk by MNCs.
“Multinational firms are influenced by political events within host countries and by changes in political relationships between host countries, home countries, and even third countries. The possibility of such events occurring and having an influence on the economic well being of the parent firm is called political risk. Political risk management refers to steps taken by firms to assess the likelihood of unexpected political events, to anticipate how such events might influence corporate well-being, and to protect against loss (or attempt to gain) from such events.” (Eiteman et al, 2009)
This definition sums up the main areas of our study in the block. Political risk is a unique dimension of risk that a MNC has to deal with in addition to the normal risks associated in business activity in one’s home country. We see from the above definition, that the MNC may not only be subject to loss, but in some instances may gain from an exposure to political risk.
Country risk can also be looked upon as the risk of uncertainty, arising from political or economic developments within the country that may influence the ability or willingness of parties in that country to meet their obligations. International lending organisations further classify political risk or country risk as “sovereign risk”, i.e. the other party is part of the public sector or the government itself, or purely commercial risk which means that the other party is a normal commercial enterprise. There may be a degree of comfort for an international bank to lend to a sovereign compared to a commercial organisation. This is especially true for developing countries.
In recent times, there has been a significant increase in the interest in political risk for MNCs. This is true not only for operations of MNCs in developing countries, but also the operations of MNCs operating in developed countries. Governments need to respond to various pressure groups aimed at curbing the power of MNCs. Oil companies for example, may face unfavourable legislation designed to make them pay for damage to the environment. Developing countries may have to respond to populist sentiments or worsening economic circumstances by seeking to renege on contracts signed by previous regimes.
Some authors argue that government intervention in the economy increases the likelihood of political risk for the MNCs. Thus political risk can be viewed as the risk that arises from an exposure to a change in the value of an investment resultant upon a government’s actions. Proponents of free-markets strongly support this view arguing that government intervention creates a number of inefficiencies in the markets that discourage competition, justify the privilege of state-controlled enterprises, promote unnecessary bureaucracy and overall stifle initiative.
The most obvious form of political risk is the threat of expropriation or nationalisation. See the earlier reference to Repsol in Argentina. ‘Expropriation’ refers to the seizure of physical property or other assets of a company or individual either by force without compensation, or by paying some compensation. In cases where compensation is paid, it is normally much below the market or fair value of the assets. It may also be the case that compensation is paid in local currency whose conversion is restricted or unfavourable to the company concerned. ‘Nationalisation’ is also a term used to denote this process. Expropriation is generally regarded as the most extreme form of political risk, although the reality is that its incidence has substantially decreased in recent years. Many governments might like to expropriate the assets of MNCs, but will not resort to such drastic measures due to a very unfavourable situation that such an action may create for that country in the long term. This could be in form of international economic isolation and cessation of support from the International Monetary Fund (IMF) and the World Bank. This support is vital for continued economic progress, especially in developing and transitional countries. Any cessation of IMF/World Bank support may mean an even tougher economic environment for these countries.
There may also be other significant risks in dealing with developing countries, for example restrictions on domestic currency convertibility, trade controls in form of quotas and tariffs, rapid, radical or unforeseen change in labour laws and government support or patronage of local enterprises in preference to the MNC. In the next section, we shall identify, define and explore various types of political risk and discuss their impact on the operation of the MNC.
6.3 Identification, Measurement and Management
The identification of political risk may be a fairly straightforward process, however the measurement and management of political risk tends to be more subjective than objective. It should be borne in mind that, despite the repeated use of quantitative techniques, country risk analysis can turn out to be more of an art than an exact science. Many international bankers who have faced and successfully negotiated the intricacies of international agreements can testify to this. At times, the reality of political risk in a particular country will vary widely depending upon the level of a MNC’s contacts and personal relationships and on the nature of the MNC’s business. For example since the mid-2000s, it is considered that the level of political risk for oil and gas MNCs operating in Russia is much higher than the level of risk for other types of MNCs operating there.
Some authors are of the opinion that there are two ways of measuring political risk. There is the ‘country-specific route’ (called the macro approach depending on country analysis) and the ‘firm-specific route’ (called the micro approach).
Before commencing operations an MNC should undertake a dispassionate and careful analysis of the political risk of operating in a foreign country. Operations in developing countries may require a more thorough analysis of the costs versus benefits, and a large degree of uncertainty may always be present in starting operations in a developing country. This should be weighed against the perceived benefits and calculated returns on investment. It is important for the MNC to take a calculated and educated view of the situation. There is no commercial activity without risk; therefore a degree of risk will have to be accepted. The reality for many MNCs, however, is that they either lack the skills to identify, measure and manage political risk or that they prefer to outsource much of the process. In the UK alone there are a number of companies who are experts in political risk and, for a fee, provide a range of services to MNCs. Students may like to study the information provided by a selection of these companies on their websites:
http://www.exclusive-analysis.com/
http://www.cofaceuk.com/
http://www.crg.com/
Whether MNCs carry out their political risk identification and management in-house or whether they outsource it, some of the important aspects that need to be looked at are discussed below.
6.3.1 Identification and Measurement
Political Stability or Degree of Acceptable Instability
A politically stable country represents less of a risk compared to an unstable one. Most developing countries are inherently unstable in this respect. If they are democracies then they may be nascent democracies where institutions are in the process of development. Quick changes of government sometimes represent an overall change of commercial and economic policies and goals. In the absence of strong and established institutions, it is all too common for new incoming regimes to dismantle institutions, which normally form the backbone of a developed commercial economy. Hence it may be possible for in-coming governments to renege on contracts entered into by past governments.
It may be argued from a purely commercial point of view, that a dictatorship is inherently more stable than an emerging democracy. If there is a long-standing dictatorship with its institutions established over a period of time then a company may have a greater degree of confidence of its contracts being honoured. There is of course always the ethical question of whether a company should deal with unpopular regimes.
To do business in an uncertain international environment, the MNC really needs to decide the acceptable level of instability. There will always be a degree of political risk. Indeed, many MNCs have done rather well dealing with unstable regimes and maintaining their profits by recourse to personal contacts and relationships instead of threatening legal recourse.
Economic Factors
The economic position of a country e.g. balance of payments deficits, GDP per capita, the level of inflation, are recognized indicators of the economic health of a country. These may of course vary from country to country. Measuring this risk factor entails comparing these indicators to those in other countries at a similar stage of development rather than comparison with countries that may be more or less developed. For example, we may say that an inflation rate of 3% is the maximum rate that the economy of a developed country may have. This may not be true for a developing country. Many developing countries have much higher rates of inflation. Perhaps an annual rate of 6% for a developing country is quite acceptable. The trend in rate of inflation may be more important than the prevailing rate. If there are measures in place to sustain the rate at pre-determined, acceptable levels and these measures are being enforced then single-digit inflation may not be such a great problem.
Ratios may be employed to assess the economic health of a country prior to making the investment decision. For example:
Debt service ratio: this takes into account principal and interest payment on a country’s total debt that is divided by foreign exchange earned from the export of goods and services. A normal ‘safe’ zone is principal and interest not exceeding 10% of foreign exchange earned from exports.
Ratio of reserves to imports that is a country’s international reserves divided by expenditure on imports indicates a country’s ability to funds imports during an export slump.
Savings, Development and Social Stability
A good indicator of the level of confidence present is to study the confidence that the people within the country have in the economic plans of their government. How may the MNC judge this? A study of savings and capital accumulation within the country is a good indicator. Is there a healthy level of domestic savings? Are there opportunities for capital accumulation within the country? Does the country have a problem with capital flight? Regular capital flight is a reasonable indicator of failed economic policies and low confidence among investors and savers.
Levels of development indicators are also a good guide in measuring or assessing political risk. If a country relies heavily on the export of primary products for its income then it is very vulnerable to economic shocks, as the price of such produce fluctuates widely. A country’s share of manufactured goods as a percentage of total exports will indicate the stage of progress a country is at. A large industrial base or an intellectual base gives the country a fair degree of stability. A level of education of the general population is another indicator of political risk. An educated populace will have much more opportunity in the global context.
Social stability relates to questions regarding income and wealth. Some of the questions that the MNC may consider could be:
– Is income and wealth concentrated in a few hands?
– Are the living standards adequate?
– Is education readily available?
– Is there racial, ethnic and religious harmony?
Government Budget Deficits
Growing and persistent budget deficits are a warning sign that governments are spending beyond their means. This should be of concern to the MNC whilst evaluating the risk of doing business in a country. Most governments in developed countries have recourse to borrowing on the international capital markets to shore up temporary deficits. This recourse may not be so easily available to the governments of developing countries. In many instances, developing countries need to pay a substantial premium to secure capital from the international capital markets. They may not be able to sustain principal and interest payments on these borrowings. Sovereign lending by international banks to developing countries requires a through assessment of budget deficits.
Transparency and Openness of the Economy
A country with an open economy, where there is transparency and consistency of economic policy, is much more likely to establish confidence among overseas investors in comparison to a closed economy. Market forces of demand very quickly influence an open economy and supply thus needs adjustment on a continuous basis. This is done in a timely fashion so that the potential for any hidden shocks is minimised. This however is not true of a closed economy. There is normally a build up of economic turmoil before a closed economy is willing to accept an adjustment. In many instances this is a delayed and forced reaction to market forces and may have a much more severe impact on investors.
Transparency is critical in establishing confidence of investors. This pertains to commercial laws and dealings. Corruption and nepotism are unfortunate realities of doing business with many countries. Indeed, it’s not only developing countries that are the victims of corruption. Students may wish to have a look at the website of Transparency International, a non-profit, non-governmental organization working to counter corrupt international business and government practices; there is extensive data and research available online. http://www.transparency.org/
6.3.2 Management of Political Risk
We have observed above that there are a number of ways to measure political risk, however there is still much debate about what precisely constitutes political risk and how it should be measured and managed. Proper management of the risk would first involve some idea of what the risk is (measurement). It must therefore be borne in mind that although there is certain recognition among economists and MNCs that political risk exists, its management may not be such a certain task due to problems involved with precisely measuring it.
Avoidance or Management?
The most obvious answer when faced with political risk would perhaps be to avoid it completely and decide not to do business with a particular country. But remember, business in about risk taking, so except for the most extreme situations that require avoidance, the decision would most probably be made on commercial grounds to accept a degree of political risk and attempt to effectively manage such risk. Political risk like other risks may be managed by diversification across various territories.
Insurance
Although, in many instances, insurance provides partial protection from political risk, it is not really a comprehensive solution. For the MNC there may be a choice between seeking commercial insurance from the market and relying on a number of government-backed insurance schemes.
As discussed in Block 5, in the UK the Export Credits Guarantee Department (ECGD) is the official export credit agency. The agency is a government department that has worked closely with exporters and buyers in the UK by helping arrange finance facilities and credit insurance for most international contracts. A range of insurance and facilities is provided to enable UK exporters to compete in overseas markets. Students can access the agency’s web site: http://www.ecgd.gov.uk/ to learn more about the agency’s activities. In the US, insurance facilities are available through the Overseas Private Investment Corporation (OPIC). Their website can be accessed through the following URL: http://www.opic.gov/. OPIC’s political risk insurance and loans help US businesses to invest and compete in emerging markets and developing nations. OPIC insures up to 90 percent of an eligible investment. Therefore the investor bears 10 percent of the risk of loss. Foreign corporations that are at least 95 percent owned by US citizens/corporations are also eligible for OPIC support.
It should be borne in mind that the above insurances are mainly available for political risk and not general business risk. If the overseas venture proves unprofitable due to adverse business circumstances in the country, the MNC will have to bear this risk or arrange insurance for this at commercial rates.
Negotiations
Informal negotiations, using goodwill and personal contacts are many times the best way to deal with political risk. A number of concessions may be won by the astute MNC, by not antagonising the host government with threats of recourse to commercial dispute mechanisms. It is always useful to reach an understanding with a host government before commencing investment operations. This could range from a precise understanding of the rules and regulations under which the MNC would operate, its market position and opportunities and any other obligations that a foreign company may be subject to. Once the political risk materialises, for example subsequent local rules and regulations brought in which may be detrimental to the MNC, negotiations could then form the key to securing concessions for the MNC’s operations. These could range from securing preferential arrangements for the company’s activities to being allowed to bid and compete in lucrative government business.
Design and Structure of Political Risk Strategy
Increasing the cost to the host government if it interferes in the operations of the MNC could minimise political risk. In effect, the MNC is trying to raise the cost to the host government of exercising its ever-present option to expropriate or otherwise reduce the local affiliate’s value to the parent. Such a strategy might include one of keeping the local affiliate dependent on the overseas parent (MNC) for supplies, technology or intellectual input in terms of research and development vital to its continued operations. Although this is a defensive ploy and may be successfully passively employed, its active and obvious employment is questionable as a risk reduction tool. The home country may perceive such tactics and game playing, or as a threat, and retaliate in a number of ways to curb the activities of the MNC. The end result may be a standoff, or in the long-term may work against the MNC in terms of lucrative contracts that may be in the offing and would be offered to competitors less interested in such tactics.
More positive strategies may be developed, for example gradually increasing the share of local stakeholders in the MNC’s overseas operations. These stakeholders may be consumers, suppliers, employees etc. Profits may be earned by a MNC through entering into licensing and management agreements instead of outright Foreign Direct Investment (FDI).
Read:
Both of these reports can be accessed, after login, on the PriceWaterhouseCoopers’ website and are very helpful in gaining an understanding of the management of political risk.
Integrating political risk into enterprise risk management
http://www.pwc.com/extweb/pwcpublications.nsf/docid/EAB01AC994713716852570FF006868B6
How managing political risk improves global business performance
http://www.pwc.com/extweb/pwcpublications.nsf/docid/6C7FE77BCC684D01852571620083BD9A
6.4 Conclusion
Political risk may be defined as a particular exposure to risk that depends upon the actions of a government. Country risk assessment or analysis for a MNC is a decision making tool for investing in foreign countries. We have seen that there are a number of ways in which country risk may be measured and subsequently managed. We have also seen that these methods may not be very accurate and that at times qualitative decisions or indeed even ‘gut feeling’ could be employed – with due caution. Risk is always present in business activities, so we aim for risk management rather than avoidance, which is only a solution in the most extreme of circumstances. Many times political risk may be minimised by a greater share of local stake holding in the activities of the MNC. The premise here is that if there are local stakeholders, governments will be less inclined to proceed on the path of expropriation or nationalization knowing that this will affect local jobs and expertise.
Students may also find it useful to refer back to Block 1 to see how international businesses manage the risk of operations by a mix of corporate strategy and investment decisions.
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