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political risk assessment

Page history last edited by Brian D Butler 8 years, 8 months ago

 

see also:

 

 

 

 

political risk assessment

 

 

“Political risk can be viewed as governmental or societal actions and policies, originating either within or outside the host country, and negatively affecting either select groups of, or the majority of foreign business operations and investments.”

(Simon, 1982)

 

 

 

see also: international country risk guides

 

political risk assessment for international business and how it is used in management of foreign investments.

 

Risk of:

 

Contract Repudiation

Inconvertibility

Expropriation

War Damage

Civil Strife Damage

Terrorist Acts

Sea Piracy

Kidnapping, Rescue, Evacuation

Civil Strife (esp. ethnic)

 

 

Models for political risk assessment

 

Euromoney

BERI PRI

S. J. Rundt

Economist Intelligence Unit (EIU)

IHS Energy Group

Eurasia Group

ICRG international country risk guides

 

 

Predictions for 2008

http://economist.com/theworldin/displaystory.cfm?story_id=10125436

 

The terrorist attacks of September 11th 2001 had surprisingly little impact on business decisions. True, the attacks produced a growth industry in doom-laden predictions about the end of globalisation. But those contemplating foreign investments carried on more or less regardless, as before paying scant attention to political risk. They based their business decisions on other things, such as a country’s economic prospects, labour costs and overall business environment. Besides, multinational companies have traditionally been a hardy breed, operating in the most inhospitable climates.

 

But there are signs that things are changing. Political risk has started to flash on the corporate radar. Surveys suggest that businessmen see political risk as a much greater threat than in the recent past. A recent survey of global executives by the Economist Intelligence Unit, a sister company of The Economist, found this was especially so for emerging markets, where executives identified political risk as the main constraint on investment. All the main forms of political risk (the danger of political violence, protectionism, geopolitical tensions and government instability) were seen as increasing. In the case of the rich countries, there was widespread concern about rising protectionism, about the threat of terrorism in America and Britain and about the impact of geopolitical tensions (from possible conflict with Iran to frictions between the West and Russia).

 

Why this heightened sense of political risk? In part it may be psychological—a sluggish reflection of an extreme risk-aversion in Western societies. Worries about the threat that terrorism poses for business are out of proportion with the real risk, which in most parts of the world remains minuscule. Fear of litigation, especially in America, may also be part of it: crippling legal claims are possible if a company’s management is shown not to have “prepared” for some nasty mishap abroad.

 

But to a great extent the increased perception of political risk simply reflects reality. The signs of a protectionist backlash against foreign investment are multiplying: witness, in America, the regulation of foreign acquisitions in the name of national security; or, in Europe, the defence of “national champions” and the outcry against emerging-market sovereign wealth funds; and, in Russia and Latin America, the new barriers to foreign investment and the expropriation of assets in the oil industry and elsewhere. International investment is most likely to flourish in a climate of international political calm. Yet a host of geopolitical risks threatens to disrupt global economic activity.

 

 

Although perceptions of political risk have increased, these do not yet appear to be having a significant impact on decision-making. For now, they are trumped by the perceived good opportunities for investment. But this could change in 2008. Economic and financial risks are rising again. The danger is that these could interact with stronger political-risk perceptions and sharply chill the climate for international investment.

 

 

 

 

Questions about the models:

 

I was wondering if there was some way in which you could use the ICRG risk ratings when conducting "site selection" for an investment? 

 

For example, if I were looking at an investment in either Puerto Rico or the Dominican Republic, and if both of the investments had the same expected cash flows, and the same cost of capital.  So, without considering different levels of country risk, both projects would have the same Net Present Value (NPV), and I would be indifferent to the location.  But, if you factor in the risk difference between two countries, it might make a difference, and you might choose to invest in one country rather than another.  In this simple example where the investment was identical, it is easy to see that the "more risky" country should be avoided.....but what if the NPV's of the two projects are slightly different....then....how much additional risk should be factored into the discount rate when doing an NPV analysis?    I was wondering....has there been any research into figuring out exactly how the ICRG risk rating could be incorporated into the discount rate (which measures risk in finance) when choosing between investments?

 

Follow up question:  I noticed that the ICRG ratings include both political and economic risk...but in our class we only covered the political risk aspects....is that because you feel the economic variables are less important?  or, because they are "self explanitory"?

 

In general, I am trying to figure out how to apply this model of risk evaluation to the financial decisions that a company may face when conducting an FDI decision.

 

Answers

The categories of political risk and economic risk are separated out by ICRG for their consulting purposes because the management of socio-political risk is quite different than that for economic or financial risk.  Especially, there is political risk insurance but no such insurance for either financial or economic risk.  So, both measurement and management techniques are different.

 

No effort (as of now) has yet to be made to connect the ICRG ratings with NPV in any systematic way.  Sounds like a good PhD thesis topic though, but would take some time and concerted effort.

 

 

 

 

 

Relating Political Risk to FDI

 

FDI

 

 

What a company can do to lessen political risk in an FDI investment

 

In this essay, I will assume that I am the Country Risk manager of a foreign investment bank considering opening an office in the USA.  I am going to assume in this essay that I am concerned about the ICRG variable of terrorism, and how it might have an impact on our proposed investment decision. 

 

 

As an investment bank, it seems likely that New York (downtown Manhattan, near Wall Street) would be the prime location for us to set up business.  This is because of the close proximity to other trading banks, the availability of human resources, and so on.  But, because the US, and financial firms in New York in particular seems to have become an international targets for terrorism (symbolism of hitting the US where it hurts most), I would be concerned about the terrorism threat involved in setting up operations in NYC.   Specifically, I might be afraid of purchasing real state in the financial district near Wall Street (by the old world trade center). 

 

 

In order to alleviate this risk, there a number of options that I would consider.  First of all, I would consider avoiding the risk all together, perhaps by relocating to another areas such as mid-town, or even setting up shop across the river in New Jersey.  By avoiding Wall Street, we could reduce some of the “target” risk associated with symbolic terrorism.

 

In addition to choosing other “safer” locations, we might also consider purchasing an insurance policy against terrorism.  We might look to groups such as MIGA of the World Bank, or even private insurance companies such as Lloyds of London to see if we can secure terrorism insurance to protect our company financially against the threat of terrorism. 

 

Another alternative may be to look to the derivatives markets to see if there are any innovative plays using options that might rise in value if NYC real estate were to suddenly lose in value.  Purchasing a put option against the fall of real estate in NYC might be an option to mitigate some of the risk .  Other financial or insurance options could also be considered.

 

 

 

What a government can do to lessen investors fears of political risk

 

 

 

 

In this essay, I will assume that I am a government official from Jamaica, working in the trade promotion authority office, and am seeking to alleviate some concerns that potential FDI investors have with regards to Jamaica’s ICRG factor of “Socioeconomic conditions”, which looks at factors such as unemployment, consumer confidence and poverty. 

 

When looking at this variable, foreign investors might be scared as they see a risk rating of 6 out of 12, a relatively high rating for risk in this category. 

 

As a trade promotion civil servant, I would be concerned that potential foreign investors may shy away from investing in Jamaica.  Although I may not be in a position of power in the government to eradicate poverty, I am in a position where I could frame the discussion so that the potential investor could see the situation in another light. 

 

For example, a major industry in Jamaica is tourism.  A large FDI project might be a resort or hotel chain that is considering developing a large stretch of land and converting it into luxury hotels, condos, golf courses, etc.  But they may be afraid of investing in Jamaica for fear of risk due to poor socioeconomic conditions in the country (social unrest could lead to riots, or retaliation against foreign businesses, for example).

 

In order to attract FDI, the first step is to be open about the existence of a condition.  In this case, the Jamaican government can’t hide the fact that cities such Kingstown are poor, and are sedated with gang violence as a result of unemployment, and drug industry.  

 

On the other hand, however, the government may focus the FDI attention toward the area of island that is more suited to tourism and golf course development. Rather than focusing on poor socioeconomic conditions on the island as a whole, the Jamaican government official may focus attention to the relatively well educated workforce that lives around this particular local community.  This way, by segregating the island and dividing it up into little “zones” it is easy to show how the general numbers of the country as a whole do not apply to the region of the investment.

 

Also, I may spin it another way…the labor for the hotel will be less expensive, and the local people more grateful for the opportunity to work for such a well known, international brand.

 

Another approach that I would take would be to focus the investor’s attention on the potential rewards of investing in Jamaica.  Yes, it is true that Jamaica has some political risk that needs to be considered when making an FDI investment, but sometimes you have to be willing to take a little risk if you are going to enjoy the largest returns.  If I were the trade promotion authority, who was looking for FDI, I would focus on the relative returns, and use that context to frame the issue of political risk. 

 

A final step could be to steer the FDI investor toward international organizations that offer insurance for political risk events.  If the company were from the US, we might recommend OPIC, or MIGA of the World Bank, among others.   With our guidance, we might be able to assist them to alleviate their fears of political risk, and to encourage investments.

 

 

 

 

Importance of Law and Order in attracting FDI

 

 

Any country which wishes to attract foreign investment will need to first reassure investors that contracts will be honored, and that the courts will be fair and predictable in their judgments.  For this reason, there is generally a positive correlation between the rule of law and the investment profile of a nation.

 

In general, we would expect to see countries with a better system of law and order to also have a more positive environment for investment.  This is because foreign investors will have more faith that the laws will be predictable, and that new administrations coming into power will not bring with them new laws which will change the competitive landscape for the business.  In general, any environment that reduces the unknown, or variability of laws will attract more foreign investment than a country that has flimsy courts, and randomness to their laws. 

 

 

But when looking specifically at the ICRG ratings of “law and order” and “investment profile”, I found it curious to see that the relationship between these two specific variables was not perfectly correlated. 

 

 

For example, we see: 

 

 

·         Canada : law and order 6.0/6 (perfect score);  investment profile 12/12 (perfect score)

·         USA       : law and order 4.5/6 (slightly lower);  investment profile 12/12 (but still perfect)

·         Mexico : law and order 3.0/6 (much lower);  investment profile 10.5/12 (but still pretty good)

 

What is happening is that the “investment profile” ratings already contains many relevant factors such as  “contract viability/expropriation, profits repatriation,  and payment delays”, all of which cuts right to the heart of the contract enforcement and rule of law in dealing with international investors. 

 

So, foreign investors risk profile is already considered in this ICRG variable, and does not need to be repeated in the “law and order” category.

 

My belief is that the “law and order” category is more geared toward internal enforcement of the law within the country, and less to do with how reliable the country is in its dealings with foreigners ( the ability of foreign corporations to enforce contracts, get paid, and conduct business in the multinational context). 

 

Another explanation is that “law” and “order” are different, and affects the international investor differently (this is why ICRG separates them).   

The category of “law” may be much more important to the international investor, as it looks at the strength and fairness of the legal system, and the extent to which laws are predictable, enforceable, and based on the matter of precedent. 

By “order”, the ICRG matrix looks for factors such as the willingness of the population to self-regulate and to willingly follow the rules and it may not affect the ICRG “investment profile” as strongly.   So, when you are comparing USA and Canada, it is clear that both countries have very strong, and predictable courts of law, but that Canadians are generally more “self-regulating” that Americans.  This excess of order, however, has very little impact on the “investment profile” for FDI considerations.  This explains why the US gets a perfect investment profile score in the ICRG standings, but is only 4.6 out of 6 in “law and order”.  

 

 

Mexico, on the other hand, has a relatively low score for “law and order”, but still maintains a good rating for “investment profile”.   As discussed above, I believe that this apparent paradox can be explained with two factors.  (1) is the fact that much of the legal concerns for foreign investors is already captured in the investment profile, so it does not need to be repeated in the “law and order” category, and (2) that the country might have a good reputation for honoring contracts (law), but a poor reputation for self-regulation (order).  Because foreign investors generally ignore the disorder around the investment, and are looking instead for a “diamond in the rough”, they may not mind a poor score in domestic order so long as they are relatively secure that the country will honor the foreign contracts and not subjugate them to any form of discrimination.  In this matter, Mexico scores well. 

 

 

 

Example of measuring Political Risk: USA

 

the measure of political risk is the chance that FDI or business might get interrupted by actions in the political arena.  One topic of particular consideration when discussing the USA is that of war, and particularily of Iraq and Afghanistan. In this section, I will analyze how the issue of “war” could affect the political risk of the USA, and about how it could affect international business, and what impact that “war”  could have on restrictions on operations, how it might interrupt Oil Industry supplies, and how there is a potential for international trade and investment sanctions.

 

 

 

Country: USA, External Conflict, War, November 2007

Today’s score: 2.5/ 4.0

 

 

It is important to note that “war” should be separated from “terror” in the ICRG analysis. In my analysis, the threat of terror may increase as the US engages in war in Iraq, but this does not affect the risk rating under the “war” category, which should only measure the risk that war would have an impact on business and investment in the USA, either by forcing a change in policy, or by an interruption in business activity. 

 

The USA is currently involved in open conflict in both Iraq and in Afghanistan. These two conflicts influence the risk level of conducting business, and investing in the USA.  As the situation stands today, I give the USA a score of 2.5 out of four, which indicates a fairly substantial level of risk. 

 

But, the war itself in Iraq or Afghanistan alone would likely not warrant a score lower than 3.5 out of 4.0.  This is because the impact of the war is relatively low on the business risk for investors in the US itself.  Because the war is outside of the US borders, the impact of the war on the US business environment is significantly lower than it would be on Iraq or on its neighbors.  Since the war is on foreign shores, and has a very low impact on day to day life in the US, I believe that the risk to international investors conducting business in the USA is relatively low (as it would be for Canada or Australia who are also involved in Afghanistan).  If the risk factor were to be based just on these two conflicts, I believe that the US would have a risk factor around 3.5 out of four.

On the other hand, there is additional risk that needs to be factored into the ICRG rating for the US.  The risk should not just be based on the current conditions of the current wars, but also lies in the uncertainty of the potential for future conflict.  Because the “war on terror” is so broadly defined, it is difficult to define the limits to this “war”.   Because there is uncertainty about what the limits, or end date of the war, the risk of potential impact on the business is increased.  Uncertainty increases risk.

 

For example, what if the “war on terror” were to expand in the future to include the other two “axis of evil” countries?  What might happen in Pakistan if General Musharraf were to loose power, and if consequently the control over the nuclear arsenal were to fall into the “wrong hands”?  Would the US feel compelled to enter the conflict to protect that nuclear arsenal?  In each of these areas, it is difficult to know the limits of the US war on terror, and when and if the open military action would stop.  Without a clear definition about where this war is going, it is necessary to increase the risk rating, and decrease the score from 3.5 to 2.5 out of four.

 

 

Country: USA, External Conflict, War, November 2008

1 year score: 2.5/ 4.0

 

 

One year from now, I predict that the ICRG risk factor of “war” will still have a rating of 2.5 out of four.  One year from today, it is highly likely that the USA will still be involved in open conflict in both Iraq and in Afghanistan. These two conflicts will continue to influence the risk level of conducting business, and investing in the USA. 

 

On the positive side, in November 2008, there will be a major election in the USA in which the Presidency, all seats of the House of Representatives, and one-third of the Senate will be up for election.  As the election nears, there will be added pressure on the politicians to present a plan for how to improve the situation in Iraq or to exit Iraq all together. This should exert pressure on the politicians and will limit the uncertainty around the “war on terror” in the short term.  This can be seen already as President Bush was forced in September to reverse the earlier troop surge as he is facing mounting political pressure from fellow Republicans who are up for election next year. With popular support for the war at a minimal level, it becomes difficult to predict how the US population would react if the war were to continue for much longer, without any clear signs of potential victory.

 

Candidates vying for the presidency in 2008 will have to contend with weak public opinion about the direction of the war.  Many Americans are tired of war, and are looking for leaders that can clearly define an acceptable exit strategy from Iraq.  If the Democrats win the White House, it becomes more likely for a faster exit from Iraq, and a stronger emphasis on diplomacy with the international community, and less emphasis on pre-emptive (go-it-alone) policy . 

 

However, this does not mean that the political risk of “war” risk will significantly reduce over the coming year.  This timeframe is just too short for an election to have that much of an impact.  No matter who wins the elections, even if it is the Democrats, there will continue to be areas of open conflict which the US will continue to be apart of.  Afghanistan will continue to be an open conflict, and it is unlikely that the US will be able to withdraw from Iraq within one year.  War with Iran will continue to be a possibility, as will war with North Korea or even Pakistan. 

Because of this uncertainty, it is recommended that the ICRG variable of “war” should continue as 2.5/4. 

 

 

Country: USA, External Conflict, War, November 2012

5 year score: 3.0/ 4.0

 

 

Five years from now, I predict that the ICRG risk factor of “war” will improve to a rating of three out of four.  Although it is likely that the USA will still be involved in open conflict in Afghanistan, I predict that the US will have significantly reduced its combat role in Iraq. The main reason for the exit, I believe, will be due to a lack of political support for long term war on behalf of the US public.  The economist intelligence unit predicts that if the Democrats were to win the 2008 election in the US, that a “substantial withdrawal of troops would be very likely”.

 

Five years from now (2012) will be another election year in the USA.  Because of this fact, it is again likely that democratic pressures will be exerted on politicians to wrap-up any war efforts, and it is unlikely that public support will be sufficient to draw out they Iraq war beyond a 5 year horizon.

 

But, beyond Iraq, I believe that the risk of war over the next 5 years will continue because of future potential for armed conflict in support of “war on terror”.  The broad definition of the war on terror will contribute to continued risk due to war.

 

The risk to business in relation to “war” and the USA goes well beyond the direct impact of physical risk to business assets.  The additional risk is political. The reason for the political risk is that it is hard to predict how other nations would react to the US if they were to engage in another unilateral military campaign.

 

If the US were to unilaterally decide that it could preemptively go to war with another nation to protect its self interests (or defend itself preemptively), then it becomes difficult to predict how other nations (especially European allies) would react.  If the US were to unilaterally go to war with a country such as Iran, I wonder if here would there be support from European allies?  If not, would there be trade repercussions?  The dangers to the economic interests of business dealing with the US are unknown. This increases the economic, trade and investment risk due to the ICRG variable of “war” and the USA.

 

Even though the direct risk due to the Iraq war should reduce over the next 5 years, I contend that the risk of further escalation and the potential for European trade retaliation is palpable, and should factor into the ICRG rating for the USA. My conclusion is a score of 3.0/4.0.

 

 

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