Identify the main types of political risk encountered by multinational corporations and discuss how these risks can be minimized.
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 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).
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).
Classification Of Risks For An International Investor :
- Sovereign Risk
- Transfer Risk
- Political Risk
- Transfer Risk
- Duration Risk
- Counterparty Risk
- Industry Risk
- 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 ,
- Transfer Risk, is the risk for the investors in transfer of capitals across the border .(Eun & Resnick 2007,p.411).
- 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).
- 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:
(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 :
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)
Key Political Risks to watch And Their Impact on International Investor In China:
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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