Lecture 5

The concept of “political risk”

= the probability of a negative impact on the operations of a foreign company because of

events or developments in the political field in a country where it operates
= determined by the uncertainty derived from the decision of the government and the public
institutions but also of certain political forces or groups (separatist forces and so on)
= the attempt to aggregate in a single expression the multiple dimension of the influence of
politics on economics;

Political risk

Dimenssions:
 expropriation;
 breaking contracts;
 changes in legislation or regulation (because of competing lobbying, PR,
corruption);
 terrorism, military conflict;
 social unrest (strikes, manifestations, etc.);
 restrictions on the foreign exchange market (and the ability for foreigners to
transfer foreign currencies), etc;

The relative importance of different dimensions of political risk

 The problem of expropriations / nationalizations in doing business abroad

Expropriation = the involuntary (forced) giving up of private ownership on certain economic

goods (it includes the expropriations with “compensation”)
Special problem = the case of foreign companies operating in a country (the expropriated
firm “belongs” to another country)

Expropriations (Quan Li, 2005)

1960 – 1990 = 520 major expropriations in developing countries:

→ 423 = made by non-democratic governments
→ 97 = made by democratic governments
But, on average:
4,5 years between expropriations in a non-democracy
3,3 years between expropriations in a democracy

→ democracy does not exclude expropriation

Factors that determine expropriations:

 nationalism = especially in natural resources („resource nationalism”)

 populism = governments that attempt to be more popular by redistributing resources
from particular agents to the majority
 govenment is less democrat, so rulers do not care about consequences (they operate
on short time horizon);
 the lack of an independent juidiciary that can play the role of a “veto player” = the
system of „check-and-balance” that is particular to mature legal systems
 public interest versus private interests
 etc.
 Considerations regarding the decision to expropriate when it is taken by a
government

= it is an analysis of cost-profit
 main costs = loss in reputation, especially in what regards foreign companies
 main benefits = populist policies or an increase of the stock of resources / capital at its
hand

„Indigenization” policies

 Some governments have explicit policies of „indigenization” of the control in certain

companies, such as the compulsion for such companies to be majority owned by local
investors
 usually in certain industries (again, natural resources) but also economy wide
(Zimbabwe and, to a lesser degree, South Africa)

Consequences:
- short term redistribution (take from „haves” and give it to „have-nots”);
- distortion of economic incentives (foreign firms do not invest any more, existing firms
are losing profits, so on);
- the emergence of “favored” individuals and groups, non-interested in the economic
way but only in the political way of getting resources

“Hidden expropriations” (indirect)

= even without a direct and explicit expropriation of a business, certain government measures
may have a strong impact on the ability of a firm to continue to operate in an economy:
 renegotiation of concessions (awarded when entering an economy);
 changing taxation (higher taxes);
 the lack of a legal system of protecting property rights;
 Etc.
 Mechanisms to deal with political risk
(the perspective of firms)

 negotiation with local governments;

 (informal) relationships with political leaders;
 cooperation with local communities (engl. „Corporate Social Responsibility”
projects);
 cooperation with local non-governmental organizations;
 the hedging of operations risk (through financial contracts);
 support for certain political leaders / parties = may involve high risk;
 joint-ventures with local companies;
 Insurance policies.

Concerns of international companies as regards the developing countries in

the close future
 International mechanisms to deal with political risk

= the emergence of economic agents that offer insurance against political risk (associated in
the Bern Union)
 public institutions / financed by governmentsc: Overseas Private Investment
Corporation (USA); COFACE (France); Export Development Corporation (Canada);
export-import banks
 multilateral institutions (African Trade Insurance Agency, Asian Development Bank,
Islamic Corporation for the Insurance of Investment and Export Credit, Multilaterial
Investment Guarantee Agency from the World Bank)
 private companies (insurance and reinsurance):
= sums insured in 2010 for political risk = 65.8 billion USD

Challenges

 the insurance by a state of political risk of investing abroad by national companies =

may alter their prudential approach
 moral hazard = there is somebody else who is supporting the costs → firms will
overinvest in such countries
 the costs may be taken over by the public budget of such a state = it may stimulate
aggressive approaches towards the other state

Foreign investment protection

 two core perspectives:

– foreign investors should be treated as the local investors → national treatment
– foreign investors should be offered preferential conditions in order to make
them invest in the local economy → sometimes, they got an even higher
protection than local investors
 an increasing number of countries sign bilateral agreements to protect their
investments → investors from the other country can sue the local government for
failing to keep its conditions
 Foreign investment protection

 for example, if a foreign investor can prove that a government decision has negatively
impacted his / her business, he can sue the government / invite it to arbitration and can
gain compensation for loss of cash flows
 sometimes, Courts of Justice may even issue orders to block assets or revenues of
governments / state owned companies in order to compensate private foreign investors