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Class Notes 11

Political risk

Momo Deretic
Sauder School of Business
Political Risk
Major Points:
Learn how to anticipate and prepare for risks
related to
Acts of governments
Apply a four-step plan to influence host
government actions to limit political risk
Bolivia nationalizes natural gas
industry

Associated Press
SANTA CRUZ DE LA SIERRA, Bolivia
-- Soldiers guarded natural gas fields
and refineries after Bolivia's leftist
president ordered the nationalization
of the sector, threatening to evict
foreign companies unless they give
Bolivia control over production within
six months.
Analysis vs Strategy
Analysis: When the actions of host
governments are beyond the influence of
individual firms, like the weather.
Risk is exogenous.
Strategy: When the MNEs actions have
an important influence on the host
governments decisions.
Risk is endogenous.
Responses to Exogenous Risk
Anticipate
Prepare
Insure
Litigate/arbitrate
Anticipate: Sources of information
Corruption measures: Transparency International
publishes corruption rankings
Government websites: CIA World Factbook, World
Banks Doing Business Database, etc. (see course
webpage links)
Credit ratings (Moody, Standard and Poor): These
rate the creditworthiness of the government. This
indicates soundness of fiscal and monetary policies.
Once the risk is understood, firms should require higher
returns on investments in risky countries.
Insurance against political risk
Most insurance against political risk is provided by
government export credit agencies.
MIGA (Multilateral Investment Guarantee Agency (An
agency of the World Bank)), EDC (Export Development
Canada), an organization owned by Canadian federal
government)), and OPIC (Overseas Private Investment
Corporation, an independent agency of US federal
government) provide insurance cover against
inconvertibility of funds, expropriation, and political
violence. MIGA also covers non-payment by a foreign
government. The EDC will only insure projects that
benefit Canada, OPIC only U.S. nationals. MIGA
provides insurance to World Bank Members (154
countries).
Risk definitions: Political Risk Insurance (EDC)

Breach of contract risk: The breach of a contractual obligation by a foreign


government or state-owned entity and the ensuing refusal by the government or
entity to honour an arbitral award in your favour.
Non-payment by a sovereign obligor: The refusal or inability of a foreign
government to make scheduled loan payments or to make a payment under a
guarantee.
Expropriation risk (including gradual or creeping expropriation): An act or
a series of acts taken by a foreign government to seize, confiscate or otherwise
expropriate your assets or investments, or foreign government acts that have
had the effect of expropriation.
Political violence risk: Terrorism or other forms of political turmoil aimed at
influencing the policies of the host country government that damage assets or
force you to shut down foreign operations.
Conversion risk: The inability to convert the local currency of a foreign country
into hard currency.
Transfer risk: The inability to transfer hard currency outside a foreign country.
Repossession risk: Measures that a foreign government may take that prevent
you from repossessing or re-exporting physical assets brought into the country
(e.g. machinery, equipment, rolling stock, an aircraft, etc.).
Arbitration facilities
International Centre for the Settlement of Investment
Disputes (ICSID)
ICSID is an agency related to the World Bank that acts as
an arbitrator in disputes between governments and
investors. It typically employs 3-person Tribunals that
make judgements that can result in financial awards to
investors. The Tribunals deliberations are private
(information on the cases is not normally released to the
public).
Chapter 11 of the North American Free Trade
Agreement allows North American foreign investors
to take governments to arbitration when government
decisions result in the expropriation of wealth.
Political strategy: a four-step plan
1. Understand host governments
objectives.
2. Catalogue host governments policy
options.
3. Calculate host governments bargaining
power.
4. Enhance the MNEs strategic position.
1. What do host governments want
from foreign investors?
Job creation
More jobs
Better jobs (high wages)
Technology (intellectual capital) inflow
Tax revenue
Improvement in trade balance (more
exports, capital inflow)
2. How do governments get what they
want from the MNE?
Jobs:
investment incentives
minimum employment
restricted use of expatriates
Domestic content requirements
Improved trade balance:
Export requirements
Domestic content requirements
Technology transfer:
Forced use of local joint venture partners
Domestic content requirements
US Subsidies to Auto Companies
Mercedes in Alabama, 1997: $300 million in tax breaks,
$253 million in direct incentives, $60 million to send
workers to Germany for training
Honda in Alabama, 1999: $158 million for Honda's $400-
million, 1,500-employee plant;
Nissan in Mississippi's: $363 million for $1.4-billion,
5,300-job plant;
Toyota in Texas: $133 million for $800-million, 2,000-
employee plant.
BMW is South Carolina, 1992: $79,000 per job
Toyota in Kentucky, 1987:Total federal and state grants
and incentives exceeded $100 million.
Nissan in Tennessee, 1980: $11,000 per job
3. What gives a government the
bargaining power to get what it wants?
Uniquely valuable country characteristics
A large, protected market
A scarce natural resource
Investment decisions by the MNE that are
irreversible (or very costly to reverse)
4. How can the MNE improve its own
strategic position?
Make friends with powerful people
(lobbying, use local partners, etc.)
Strategic Delay
Make credible threats
Invest in strategic alternatives
Build a reputation for toughness

*credible threats: promised responses that are not bluffs,


the firm really will follow through.
Major takeaways
Host governments are very powerful over
the territory they govern. They are the
gate keepers and MNCs operate in the
host country based on the approval of
these governments, which can be
withdrawn without warning.
MNCs should take precautions when
predicting and calculating the sovereign
risk and be proactive in taking measures
to minimize this risk.

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