Political Risk Definition Example Essays

Identify the main types of political risk encountered by multinational corporations and discuss how these risks can be minimized.

Introduction

The controversy between the Kazak government and the Italian oil company ENI about the exploitation of Kashagan´s oil fields is only one out of many cases, in which political violence acts or governmental decisions threatened foreign investments of a multinational enterprise (MNE). In April 2006, the Dacion and Jusepin oil fields, operated by ENI and the French company Total, were taken over by the Venezuelan government, because they rejected to change their business operations into joint ventures with the state-owned oil company PDVSA (Ferrari and Rolfini 2008).

Stated by Kesternich and Schnitzer (2009) some recent empirical studies identified that for MNEs political risk is one of the most important factors when considering a foreign investment. Foreign investments nowadays seem to be even more risky in terms of pollution that result in natural catastrophes such as caused by BP (Heller 2011), cultural conflicts or political disturbances for which Lybia (Yang 2011) represents a recent example and an increasing social disparity (Bloch, Koepplinger and Wolfrum 2007).

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However, the increased range of new opportunities, access to resources and lower costs through globalization draws companies to expand in foreign markets, nevertheless they find that politics of foreign countries add significant complexity and risk to their business performance (PriceWaterhouseCoopers and Eurasia Group 2006). As stated by Choudhry and Akhter (1995) “The growth of nationalist sentiments and the globalization of the world market have changed the parameters of the relationship between business and governments.”. However, foreign investment opportunities not only mean a higher level of risk but also can improve the global business performance such as the capitalization of opportunities resulting from political change or protection of new and existing global investments and operations of an MNE when managed appropriately (PriceWaterhouseCoopers and Eurasia Group 2006) In the following paper a definition of the term political risk is provided first, followed by an outline of the key political risks encountered by MNEs. In the second part recommendations about how to minimize such political risks are being discussed, before rounding off the picture with an overall conclusion.

Definition of the term “political risk”

Political risk can be defined as the entirety of conditions, decisions or events of governmental or political nature, which directly or indirectly (Hamada et al 2004) prevents or interferes with foreign business transactions, cause change of contractual agreements or even results in partially or wholly expropriation (Yaprak and Sheldon 1984). Such risks can be either classified in macro or micro risks (Albaum and Duerr 2008). Macro political risk on the one hand is country-specific and potentially influences all businesses situated in the host country such as terrorism, environmental regulations or civil war (Chapman 2006). On the other hand micro political risk affects for example the operations or the ownership of assets of a specific industry, company or project (Engineering Economist 2000). Within this framework Hamada et al (2004) suggests a categorization of political risk in three main types that are encountered by MNEs: expropriation, political violence and transfer risk and will be outlined in particular in the following section.

Outline of the main types of political risk encountered by multinational corporations.

Expropriation Risk

Expropriation or nationalization risk relates to losses caused by actions approved or taken by the host government in an arbitrary or even discriminatory way, which deprive the MNE of its control or even ownership of its investment. Expropriation without any compensation might result, in case of debt, bankruptcy if the MNE might not able to fulfil the obligations of its lenders (Yannaca-Small 2004). One type of statutory interference could be direct expropriation by entirely physical seizure or formal assignment of the legal title or patent rights (Ferrari and Rolfini 2008). The most threatening type of expropriation for MNEs according to Hoffman (2007, p.48) “…takes place over time in a series of so called creeping acts that collectively result in an expropriatory act.”. Creeping expropriation is the type of risk, by which the host government deploys a combination of additional fees or taxes and other devices and charges to increase its share of the companies or projects profits after the company has made its investment (Hoffman 2007). Furthermore, host governments also try to renegotiate contractual agreements with MNEs or even change policies once the investment has been made (Gatignon and Anderson 1998, Williamson 1996). In the 1970s for example, IBM and Coca-Cola both left India because of the statutory restrictions that came up after they already made initial investments. IBM left India because the government demanded it to share its technological innovations with local competitors and Coca-Cola was required 1. to transfer 60% of its equity to an Indian company 2. to unveil its secret formula and 3. to use twofold trademarks for the Indian consumers so that they would acquaint themselves with a local emblem. All of the governmental demands were utterly rejected by Coca-Cola. The company feared expropriation by unveiling its secret formula once the new trademark would become accepted and left the country as well (Minor 2011).

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INTRODUCTION

There exists various types of Political Risks which are main consideration from long time for an International Investor to invest in India and China. According to Jeffrey D. Simon, "Poltical risks refers to those political and social developments that can have an impact upon the value or repatriation of foreign investment or on the repayment of cross- border lending"(Ronald L. Solberg, ch6,p.118).

By measuring Poltical Risk an investor can just check out the country's intention behind paying its debts, so for an International investor its a very important factor to analyze all the political risks before investing in India and China.

Classification Of Risks For An International Investor :

  1. Sovereign Risk
    • Transfer Risk
    • Political Risk

  2. Duration Risk

  3. Counterparty Risk

  4. Industry Risk

  5. Product and Contract-related Risk

This classification is done according to(Ronald L. Solberg 1992, pg. 17-21)

Now we have to classify the different types of Political Risks and compare them and study that till which extent does they affect International Investor to invest in India and China.


POLITICAL RISK :

It can be defined as a way to assume that whether the assests of a foreign investor would become non functioning or would produce lesser profits due to some specific reasons like national strikes, war or major changes in the policies of the government of the country.(Ronald L. Solberg,1992)


Types Of Political Risks:

Political risks that an International investor might face can be classified in different ways. It can be classified according to the situation or condition , method or mode in which they take place. (Eun & Resnick 2007,p.410).

According to the situation/condition , political risk can be classified as ,

    1. Macro Risk, it refers that it haapens when there is a major change in the political system of the country where investment is being done.

Example : After the change in the government of China in the year 1949, ruling communist party nationalized the foreign assests in China with a very less compensation to the investors.(Eun & Resnick 2007,p.410-411)

    2. Micro Risk, it refers to the risk which affects limited sectors of foreign investment.

Example : In 1992 , Enron spent $300 million to set up a power plant in India but due to the change in the ruling party of the state it affected the agreement of the company and company would have to accept the offer of the govt. which would result in less profits , so this project is still in a dispute.

(Eun & Resnick 2007.p.411)

According to method/mode in which political events take place, political risks can be classified as ,

  1. Transfer Risk, is the risk for the investors in transfer of capitals across the border .(Eun & Resnick 2007,p.411).

  2. Operational Risk, are the risks which affects the working of MNC's at a local level because of changes in various laws and policies. (Eun & Resnick 2007,p.411).

  3. Control Risk, are the risks which arises due to some rules imposed by the government on foreign investors such as minimum share holding of a MNC in local firms and the local firms being nationalized.(Eun & Resnick 2007,p.411).

There are some other relevant political risk factors:

  • Terrorist attack, it highly affects the country's stable economy. Example: Recent attaks in Mumbai, India at TAJ Hotel which badly affecte the Indian stock exchange.


  • Blockage of fund transfers, a subsidiary on a foreign investor always tranfer their funds to headquarters in their home country for some reasons, but in some cases the host country's government can block the transfer of funds due to which the investors have to invest the money locally which would result in lesser profits.


  • War, there are many countries which are involved in conflicts and are always in situation of war with their neighbouring countries so it affects the security of the employees recruited by the foreign companies in the host country and it also affects the cash flow of the investor in that country.


  • Corruption, it badly affects the investor's budget and its cost of running projects in a country as it has to bribe the government to officials to get a contract or make some funding to political parties.


  • (Jeff Madura & Roland Fox,p.549-552)

    Due to all the the above factors and risks in a country there arises some more problems for MNC's to invest such as Exchange Rate Risk, due to which company suffers heavy losses if there is a change of exchange rate from the currency of host country to their own country. Interest Risk, If there are some changes made in the government policies and the interest rate goes high, then it results in the demand and supply of foreign currencies which inturn affects the exchange risk. (Jeff Madura & Roland Fox,p.128,321)

    Attitude towards International Investor:

    1. In India:

    According to Coface analysis by Sylvia Greismen and Pierre Paganelli (2004-05), after independence the government of India attained the policy of "self-sufficiency" , but from 1991 Indian Govt. is trying to attract international investors by adopting the sectors which are listed negatively, so that the Foreign Direct Investment (FDI) can be approved easily. But still there exists a lot of hurdles , such as regulation of shareholding by international companies in many sectors , restriction of investment by foreign MNCs in retail sector and if a foreign investor based in India in a partnership with some Indian company cannot open a subsidiary without the permission of its Indian partner. Also there exists regulations with respect to taxation as foreign companies have to pay 41 percent tax where as indian comapnies just pay 35 percent.

    There are a lot of barriers but still government schemes continues to make a passage for the foreign investment by introducing more transparent ways for the approval of international investor's application, covertion the foreign currency to rupee for business transactions and many more.(The Handbook Of Country Risk 2004-2005, p.218)


    2. In China:

    According to Coface analysis by Sylvia Greismen and Pierre Paganelli (2004-05), after the entry of China in World Trade Organization (WTO), the Foreign Direct Investment (FDI)is ver well handled by the government .

    The Chinese government has categorized FDI in 4 ways i.e. "encouraged, tolerated, restricted and prohibited- by sector". But still ther are sectors in which FDI is prohibited like post services , control of traffics of airlines and media while sectors like telecom, real estate and sectors like gas, water and central heating supply are open for foreign investors. There are a lot of undertakings for international investors in the chinese market , like they have access to the retail markets without any restrictions from 2005. For any foreign investment it requires a approval from the government but the level of issuing body depends upon the amount of investment made. In China the local authorities are given more powers because it is more effective in enforcing legalisation nationally but stiil the central government kept the rights of carefully examining the locally approved projects. For incentives in taxation generally a international investor invests through a foreign investment company. The principle of "public owmnership of land" exists due to which foreign investors can only acquire a lease maximum for 50 years for an industry. And also the foreign investors are required to give job preference to the local chinese people and foreign people in very rare cases. The working hours for the people is around 40 hours a week and workers can have leave from 5-15 working days per year.(The Handbook Of Country Risk 2004-2005, p.218)


    Key Political Risks to watch And Their Impact on International Investor In India :

  • ECONOMIC REFORM , After the disappointment of the previous year's budget the government is prepared to produce some good reforms, so the investors are accepting some better policies regarding FDI and foreign banks. Even they are excepting some change in taxation policies which would result in a postive manner towards the market.(REUTERS 2009,dt. 03 nov)

  • TRADE AND PROTECTIONISM, in the doha round at WTO India is playing a crucial role in reaching the terms of agreement of provinding easier trade. Accordingly the investors must be keeping a watch that India must be realxing the restrictions on trade and next meetings at last of this month will prove the flexibility of the country. (REUTERS 2009,dt. 03 nov)

  • EXTERNAL SECURITY, between India and Pakistan , there have been several times peace talks taking across both sides and this time India want some strict decisions regarding the Mumbai terrorist attacks and want Pakistan to deal strictly with the accused behind these attacks. Talks between India and Pakistan are almost taken in a positive manner by the investors.

    As per the relations between India and China , there is always issues going on betewen both of them regarding long disputes on the border of Arunachal pradesh and china's support on projects going on in Pakistan occupied kashmir . Even China opposes the visit of Dalai lama in India this month as it seems to be a political movement for china on Tibet.

    There are meetings going on between both the countries on disputed border of Arunachal Pradesh this month so that there would be a open passage for the trades between both the countries.(REUTERS 2009,dt. 03 nov)

  • INTERNAL SECURITY, There are high risks of attacks by militants in due India to which countries like Israel and Australia are giving warnings to their citizens who wish to travel to India and after the recent attacks in India the relations between India and Pakistan are almost in a tense state which would not result good for the Indian market as it doesnt sounds to be safe to invest in India for the foreign investors. Even the government of India are taking strict measures against the maoist attacks in some parts of the country to open the passage for investment in those parts also.(REUTERS 2009,dt. 03 nov)

  • MONETARY POLICY DISAGREEMENTS, there is a conflict arising between the central bank and the government of India on the implementation of the monetary policy in the market , so the international investors at this time should keep a watch on the arguements between the officials of central bank and the ministry of India that they would rather compromise or show signs of disagreemet on monetary policy.(REUTERS 2009,dt. 03 nov)

  • Key Political Risks to watch And Their Impact on International Investor In China:

  • GOVERNMENT STABILITY, From a long period of time chinese government had maintained a control over its infrastructure but a matter of concern is that if the recent economic boom cannot be maintained it would result in major loss for international investors. Even there are some protest for democracy which does not proved successful as the China government is very strict in controolin these kind of movements and do not let them spread nationwide and just finish off them at a local level.(REUTERS 2009,dt. 03 nov)

  • TRADE AND CURRENCY DISPUTES, There have been disputes between China and USA over the issues rearding the trade barriers. Political analysts had suggested that Beijing and Washington have a lot of assests to loose if there conflicts goes on. Still China have indicate the world market that they dont want the global financial markets to be dependant on the American dollar. But both of the countries doesnt want some serious economic disputes as it would cause damage to the markets.(REUTERS 2009,dt. 03 nov)

  • SECURING STARTEGIC SUPPLIES, China is just looking all over the world for resources to fees its own economy. The chinese government are intersted in investing in the countries producing raw materials which are useful in their development, which is a major concern for countries all over the world beacause chinese are overatking the comapnies worldwide. But some examples like U.S. government blocking the deal of China National Offshore Oil Corporation(CNOOC) overtaking Union Oil Company Of California(Unocal)due to national security issue, so the world market would be waiting to watch China's reaction if major deals of the government of China is blocked.(REUTERS 2009,dt. 03 nov)

  • THE ENVIRONMENT, Finacial progress must be given preference but developed countries should take measures in reducing global emissions, as the China government says. Beijing has undertaken to cut the carbon intensity till 2020 and citizens of China are now very aware of their health and reducing pollution. Foreign markets will be inspecting that whether China can follow its emission policy upto the mark without any major fail in its growth, investors would be also attracted if the government provides a clean environment with renewable sources of energy. But its not that easy for the government because they have to impose restrictions on the construction of new industrial plants and it could also lead to the closure of the plants running not according to the standards.(REUTERS 2009,dt. 03 nov)

  • CORRUPTION, ACCOUNTABILITY AND COMPANY BEHAVIOUR,
    Corruption is a major concern for the foreign investors as well as the Chinese governmnet to maintain its stability. The investors would be watching the rise and fall in corruption perception rankings of China.(REUTERS 2009,dt. 03 nov)
  • Source: Essay UK - http://www.essay.uk.com/free-essays/finance/various-types-of-political-risks.php


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