CHAPTER 3: The Political and Legal Environments Facing Business What is Political Risk?

It is the risk or uncertainty that certain political decisions or government actions/events in a country could negatively affect the profitability or sustainability of an investment. Political risk is the chance that political decisions, events or conditions in a country will affect the business environment in ways that may adversely affect the operations of MNEs in the host country. 1) Political risk matters the most to any MNE in the world. 2) When companies choose among the 200 countries, they consider political risk to be very important. 3) The lower the political risk, the better the business opportunity and in turn higher the country attractiveness. What is Political Ideology? It is the governments thinking about what it wants to achieve and how. What are the causes of Political Risk? 1) Govt. Actions 2) Civil Strife/Unrest/Disorder. 3) International War. 4) Harmful actions against people. 5) Change in political ideology 1) Govt. Actions: Govt. action can change the country's attractiveness. Governments can put restrictions to the sectors in which business can be done. Govt. puts many acts to impose restrictions on the sectors like FERA and MRTP Act. a) FERA Act (Foreign Exchange Regulation Act, 1973): An act to consolidate and amend the law regulating certain payments, dealings in foreign exchange and securities, transactions indirectly affecting foreign exchange and the import and export of currency, for the conservation of the foreign exchange resources of the country and the proper utilisation in the interests of the economic development of the country. b) MRTP (Monopolistic and Restrictive Trade Practices Act, 1969): MRTP was enacted i) To ensure that the operation of the economic system does not result in the concentration of economic power in hands of few. ii) To provide for the control of monopolies. iii) To prohibit monopolistic and restrictive trade. # Individualistic Orientation vs. Collectivist Orientation: In an Individualistic Orientation, the government gives a free hand and the focus is on political environment. In a free market economy like the USA, the government doesnt intervene much. In a Collectivist Orientation, the government intervenes in economic policies E.g. Japan, South Korea. # 2) Civil Strife/Unrest/Disorder: a) It could be due to economic unrest. b) People unrest can also happen because people are unhappy with the present govt.

c) It affects companys operations and profits. d) It can lead to damage of companys property. E.g. French Revolution 3) International War: a) Damages or destroys the companys local assets. E.g. When Iraq invaded Kuwait, there were many MNEs by virtue of management contracts. Many Indian companies were also operating. b) MNEs are bound to leave the country during war. 4) Harmful actions against people: a) Injurious actions that target the local staff of the company - often involves kidnapping, extortion and terrorism. b) Generally seen in lesser developed countries. 5) a) b) c) Change in Political Ideology (Types of Govt.): Political ideology can change with the change in political government. Every government has a different perception about the MNEs. In case of Monarchy, like Saudi Arabia, when a new prince comes in, chances are that there will be changes in political environment.

What are the types of Government? There are 2 basic types: 1) Totalitarian System 2) Democracy 1) Totalitarian System: a) Communist: China b) Monarchy: Nepal c) Military Rule: Myanmar d) Dictatorship: Pakistan e) Fascism: Pre-WW2 Italy f) Secular: Vietnam, Singapore g) Theocratic: Iran, Afghanistan h) Authoritarianism: Cuba 2) Democracy: India (Mixed Economy = Public + Private + Cooperative Sector). It has a Planning Commission which ensures a planned economy. Indias role model in the past was Russia (Planned Economy), now it is the US (Mixed Economy). What are the impacts of Political Risk? 1) 2) 3) 4) 5) 6) Expropriation or Nationalization. Disruption of property. Unilateral breach of contract. Restrictions on repatriation of profit. Differing points of view. Discriminatory taxation policies.

1) Expropriation or Nationalization: a) A govt. or political faction unilaterally takes ownership of the companys local assets. This is because the host countries felt that MNEs are exploiting resources in the host country and there is no impact on the economy of the country. Compensation to the company, if at all forthcoming is generally a trivial percent of the assets value. This event was common in the 1960s and 1970, but is rare today. However in any event the losses are immense. b) Sometimes the companys assets are taken over by the host country with or without adequate compensation. It is generally a hostile takeover, a mandate and not a choice which is given to the company. It generally happens in developing countries for natural resources like oil, diamond when the host country feels that there is no value addition. E.g. Cuba, Chile, Venezuela, Uganda, Zambia, Ethiopia, Iran 2) Disruption of property: a) Kidnapping, thefts occur. b) Strikes happen resulting in loss of profit (opportunity loss) in addition to property getting damaged. 3) Unilateral breach of contract: a) Decision of a government to repudiate the original contract that it had negotiated with the foreign company. The revision penalizes the firm and rewards the nation by reallocating the profits of the local operations. b) In addition this extends to government approval of a local companys choice to breach its contracts with its foreign partner. c) In some countries the new govt. might not honour the previous management contracts / leases. 4) Restrictions on repatriation of profit: The govt. arbitrarily sets limits on the gross amount of profits a foreign company can remit from its local operation. 5) Differing points of view: Differing interpretation of labour rights and environmental obligations create backlash problems in the foreign companys home market. 6) Discriminatory taxation policies: A foreign company bears a higher tax burden than the local firm, or in some cases, the more favoured foreign company, due to its nationality. How to access political risk? Managers use 3 approaches to predict political risk: 1) Analyzing past trends. 2) Taking expert opinion. 3) Examining the social and economic conditions that might lead to such political risk. (Semi-Analytical approach) 4) 1) Analyzing past trends: Companies cannot help but get influenced by past patterns of political risk. Management can make predictions based on past patterns. Predicting risk using past trends holds many dangers. However political situations may change rapidly for better or worse as far as foreign

companies are concerned. E.g.: a) China Govt. control: More subsidies to SEZs but no transparency (Govt. controls the judiciary). Compliance for intellectual property rights is very low. China has high political risk. b) Dubai: It is volatile geographically. High political risk. c) FDI into US fell sharply after 2001 terrorist attack in NY because foreign firms saw the US as less safe than before. d) Expropriation of property occurred frequently in the 1970s and early 1980s, but it has been less important in recent years. e) In Pakistan, initially democracy ruled and then dictatorship where as in India it has always been democratic in spite of change in governments. 2) Expert Opinions: Companies may rely on experts opinion about a countrys political situation, with the purpose of ascertaining how influential people may sway future political events affecting business. 360 degree feedback is important. Companies read the statements made by political leaders both in and out of office to determine their philosophies on business in general, foreign input to business, the means of affecting economic changes and their feelings toward given foreign countries. Managers visit the country and listen to a cross section of opinions. Embassy officials and foreign and local business people are useful sources of opinions about the probability and direction of change. Journalists, academicians, middle level local govt. authorities and labor leaders usually reveal their own attitudes, which often reflect changing political conditions that may affect the business sector. Companies may determine opinions more systematically by relying on analysts with experience in a country. These analysts might rate a country on specific political conditions that could lead to problems for foreign businesses. A company also may rely on commercial risk assessment services, such as those published by Business International, Economist Intelligence Unit, and Euro Money etc. In this method companies should examine views of govt. decision makers and then get a cross-section of opinions and use expert analysts. 3) Economic and Social Perspective (Semantic Technique/ Semi-Analytical Approach): There are two economic parameters i.e. aspiration level and achievement level. Aspiration level of people spreads with education, TV, Internet where as the achievement level increases with income level. Differences in aspiration level and achievement level leads to frustration. If disparity between the two is very high year after year, then the frustration level increases. Higher the frustration level, higher the political risk in terms of unrest. Companies may examine countrys social and economic conditions that could lead to the peoples level of aspirations and the countrys level of welfare and expectations. If there is a great deal of frustration in a country, groups may disrupt business by calling general strikes and destroying property and supply lines. E.g. Export Credit Guarantee Corp: gives ratings for the countrys risk. What are the types of legal systems? The legal system addresses all the disputes.

1) Common Law: Based on equity. It is the oldest system originated from the UK, then spread through the commonwealth countries. It is based on jurisprudence. 30 countries follow common law system. Less written report, more importance on interpretation. To have a full detailed agreement is better, since there is no confusion. E.g. India 2) Civil Law: Judges apply the law more than interpretation. 3) Code Law: Started in Roman Empire, and then spread to European countries. Agreements refer to code laws. E.g. Japan, China, South Korea 4) Theocratic Law: Based on religious concepts. Prevalent mostly in Islamic countries. Evolves from the teachings of religious leaders. E.g., Interest, insurance is not allowed. 5) Mixed: Combination of these laws. E.g. some states within US follow code, some follow common law. What are the types of Political Risk? There are four types of political risk: 1) 2) 3) 4) Systemic. Procedural Distributive Catastrophic

1) Systemic Political Risk: This risk arises when there is a change in the political ideology or government of a country. These kinds of risks are inherent in the system. Domestic and International companies face political risks created by shifts in public policy or change in political ideology. These regulations alter the business system for all companies, so not necessarily meant for only foreign companies. Then again, a government may target its public policy initiatives toward a specific economic sector that it believes foreign companies unduly dominate. Systemic changes do not necessarily create political risks that reduce potential profits. E.g. In 1990, the newly elected Argentina govt. began a radical program of deregulation and privatization of the state centered economy. 2) Procedural political risk: Companies procure from best sources from different countries to have comparative advantage. Globally competent supply chain is required from most competitive/best sources. The three main objectives of supply chain are: a) Lowest cost. b) Shortest time. c) Quality and reliability. Operations in a host country require permission and a proper procedure is to be followed for that. There can be certain delays in obtaining those permissions and hence MNEs have to be ready to take the delays in their stride or should know how to deal with it. Normally supply chain is never short term until there is a war situation. As we get raw materials from across the world, it has to cross borders, so the company faces different levels of risk. Some countries are more corrupt and the company faces many hurdles. The risks are higher in less developed countries. Every day people, products and funds move to different locations in the global market. Each move creates a procedural transaction between units, whether within a company or country. Political actions sometimes create frictions that interfere with these

transactions. Government corruption, labour disputes and a partisan judicial system can significantly raise the cost of getting things done. Corruption among custom officials can push a foreign firm to agree to pay for special assistance, if it wants to clear goods through customs. 3) Distributive Political Risk: MNE and host country cannot do without each other. While the MNE controls the country operations and aims for maximum profitability, the country receives technology, employment and earns taxes. But if the host country feels that the MNE is capable of doing much more than at present and mostly much of it is going currently to other countries rather than to the host country then host country wants to have a larger share from the MNEs economic gain for its own people and their economic growth. Thus taxation changes can come in. Many countries see foreign investors as agents of prosperity. As foreign investors achieve greater success, some countries question the distributive justice of the rewards, wondering whether they are getting their fair share. Countries then aim to claim a greater share of rewards but in ways that do not provoke the company to leave. They do so by revising their tax codes, regulatory structure and monetary policy to capture greater benefits from foreign companies. MNE should help the host country government by giving more tax, so that their debt reduces and investment in infrastructure increases. E.g. US holds the highest degree of political risk in the world for cigarette companies on matters of taxation, regulation, business practice and liability. 4) Catastrophic Political Risk: These types of risks arise from flash points like ethnic discord, civil disorder or war. Those random political developments adversely affect the operations of all companies in a country. While uncommon, their impact disrupts the business environment for all firms. What is privatization? Govt. starts certain industries for economic growth. After infrastructure is established, the govt. need not be in the sector. It can reduce its stake in these sectors and give it to private players. Foreign companies are allowed to increase exports, improve quality etc. Since Govt. is keen, it may allow foreign countries to enter the sector. This capital reduces the debt of the govt., employment increases, technology advances. MNEs get entry, competition remains unchanged. On privatization, some employees lose jobs, but companies become vibrant due to increased exports and technology. However the selling stake in PSUs has been opposed by communists, because it will lead to loss of jobs. What is the role of the Government? 1) Maintain the countrys sovereignty and unity 2) Maintain the countrys security (No aggression from neighbours, keeping the integrity of borders) 3) Law and Order (No discrimination, economic safety, independent judiciary) 4) Economic development (Infrastructure, Education) 5) Business Friendly policies (No discriminatory taxes- foreign companies should not be made to pay more taxes, open sectors, allowing new companies to start businesses, IPR, tax concessions) A countrys political environment has enormous implications to managers and companies. A political system is the complete set of institutions, political organizations, interest groups, the relationships between those institutions and the political norms and rules that govern their functions. The purpose of a political system must agree, is that it integrates different groups

into a functioning, self sustaining and self governing society. Ultimate test of a political system is its ability to unite a society in the face of divisive pressures of competing ideas and outlooks. What are the various Groups of countries? 1) EU (27 including Romania) 2) MERCUSOR (4 including Brazil, Uruguay, Argentina, Paraguay. Venezuela still trying) 3) ASEAN (Singapore economically mightiest, Indonesia, Malaysia, Thailand, Philippines, Myanmar, Vietnam, Cambodia, Brunei, Laos) 4) GCC (6 including Saudi Arabia, Oman, Dubai, Sharjah, Abu Dhabi, Bahrain, Kuwait) 5) SAARC (India, Sri Lanka, Pakistan, Bangladesh. Afghanistan trying to enter) 6) NAFTA (3 including Canada, US, Mexico) Russia, Japan, South Korea, Australia, New Zealand, China dont come under any of the above. What are the aspects of International Arbitration? If you have a dispute then it is better not to go to court as it increases expenses and create bitterness between the two parties. One can go for arbitration through out-of-court settlement. The aspects are: a) An arbitrator is appointed by both parties b) Arbitration is governed by law. There are a set of procedures present. Neither countrys rules apply. International arbitration laws are to be followed. c) Venue of arbitration should be neutral ground and pre-decided. d) There is no escalation. The decision of the arbitrator is final. Indian Arbitration Act of 1940 has all the details. Distinguish between Rule of Law and Rule of Man. In rule of law it is democracy, larger number of people in decision making, less risk, follows rules of book. There is transparency. E.g. India In rule of man it can be communist, monarchy or dictatorship. It is unpredictable, can suddenly change, high political risk. E.g. China, ruled by agency CPC What is IPR? It is regarding patents, copyrights. The PLC is changing, as well as the business cycles. The only way to get competitive advantage is through innovation, thus IPR is becoming important. China does not believe in IPR. Innovation belongs to the state according to them and this is against MNEs. But MNEs are attracted to China because of the huge market of 1.4 billion people (23% of World population), low labour cost and the business-friendliness of the Govt. IPR compliance is under WTO. Contract R & D MNEs thrive on innovation and normally it takes place in the home country. US, Japan etc are quite expensive for R& D but at the same time, lot of R & D is to be done. Companies need to take the critical decision as to where to do their R & D. The relatively lesser important R & D things can be outsourced. When the standalone things are outsourced, it is known as modular outsourcing. Thus the features are: 1) They should outsource it to important markets (where demand is high and they can customize and give the product) 2) The country to which outsourcing is done should have a good IPR rating 3) Good infrastructure should be present.

The advantages are: 1) By outsourcing you can understand that market well. 2) It is less expensive 3) It helps to build relationships with the host country 4) Low cost of manpower 5) The ease of segmenting the outsourcing into critical and non-critical. The disadvantage is that technology diffusion takes place. What are the strategic aspects relating to a countries political and legal environment? 1) Marketing related laws: a) Advertising (not using children in ads) b) No comparative ads c) Ads of tobacco are banned 2) Marketing behavior: a) Product liability: Huge penalty if your product fails. E.g. Brake fail in a car, toxins in a toy b) Local content: How much will be allowed to manufacture. Govt. pushing for backward integration.