Unsw Fins3616 - Political Risk Paper

Chapter 14 – Country and Political Risk (for written component)

Recent political issues:

• Israel Gaza border clashes
• U.S pulling out of Iran deal
• U.S embassy being placed into Jerusalem
• Russia election corrption and Cremea
• Russia world cup ?
• Russia expelling diplomats from various countries following the poisoning scandal.

Israel Allie – America

Russia Allie – Syria, Lebanon (involved in indirect war with Israel) .. Israel recently bombed Iranian military sites in Syria (or lebanon?).

Could be a strong business relationship due to sophisticated weapons production and the greater tech industry .

Political risks:

Israel is backed by the U.S which has a tumultuous relationship with Russia.

As part of the task above, you have also been asked to submit a 1-2 page (A4 paper, double-spaced, 10-12 point font) report answering each of the following questions.   These write-ups must be completed individually by each group member and submitted via Blackboard using Turnitin:

1. How would you compare Israel’s and Russia’s corruption perception index?  What might be driving these differences?  What issues could this create?

Transparency International CPI results

1. In general how would you rate the overall political risk of both countries?  Are there any recent examples of political risk?  How could the current political relations between the countries and their allies spillover into your investment?  What are some possible methods, as well as potential drawbacks, to hedge against such risk?

Political risk–risk that the government will do something bad like expropriate funds or refuse to pay foreign debt

Political risk - the risk that a government action will negatively affect a company’s cash flows.

Risk Factors:

Expropriation – The possibility that the host country takes over MNC’s subsidiary, with or without compensation. See eastern European countries following WWII

Contract Repudiation – Revoke or repudiate contracts with companies without compensation for their investment or services

Taxes and Regulation changes - unexpected increases in taxes, restrictions on hiring and firing local workers, and sudden stricter environmental standards

Exchange controls - Governments have been known to prevent the conversion of their local currencies to foreign currencies. In general, doing busi- ness in countries with inconvertible currencies puts an MNC at considerable risk.

Corruption and Legal Inefficiency - Highly inefficient governments with large bureaucracies can increase a company’s costs of do- ing business. Governments may also be corrupt and demand bribes. Transparency International (TI) produces an annual “Corruption Perceptions Index” for more than 170 countries. Russia ranked 154/178 for this. TI also compiles information on which companies have the highest propensity to pay bribes and therefore undermine efforts of governments to improve governance. Multination- als from Russia, China, Mexico, and India were the worst offenders in 2008

Ethnic Violence, Political unrest and terrorism - Significant MNC losses can occur due to internal civil strife or wars. In war-torn regions across the world, companies often hire their own private armies in order to try to function normally.

Home country restrictions - The politics of a company’s home country can affect its cash flows from foreign operations. For example, after the Iranian Revolution in 1979, a U.S. embargo on Iran forced Coca-Cola to shut down its operations there.

Adjusting Expected Cashflows due to political risk (Incorporating political risk into capital budgeting)

Positive covariation between the cash flows from the project and the world market return increases the required global discount rate. Consequently, unless political risk, which adversely affects the MNC’s invest- ment returns, is systematically high when the world market return is low, political risk should not enter the calculation of the discount rate. Instead, the company’s cash flows should be adjusted for the presence of political risk.

It is, indeed, possible to purchase political risk insurance, and in some countries, such insurance is even subsidized by the government.

Mehtod one is to factor in political risk as a probability in future cash flows.

Alternative method is adjusting the discount rate due to political risk and keep expected cash flows in the “perfect situation”.

Political Risk analysis:

Analysts have noted that ethnic conflicts in a country tend to adversely affect foreign investors, including MNCs. They have also noted that a good predictor of future ethnic conflict is the presence of ethnic fractionalization. → Israel

Similarly, left-wing governments may be associated with actions that harm foreign investors, such as stricter labor regulations or outright nation- alization. → Israel currently right wing and Russia is also Right?

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Indicators of Political Risk [pic 1]

[pic 2]

Lecture Notes:

Financial and Economic Risk Factors:

• Ratio of external to internal debt
• Ratio of debt service payments to GDP
• Ratio of country’s imports to international reserves
• Terms of trade (export and import prices)
• Currnet account deficit

Political Risk Factors:

• Expropriation / nationalization
• Contract repudiation
• Taxes and regulation (eg: hiring, firing, environmental standards, repartriation of funds)
• Exchange controls (limitation of conversion from domestic to foreign)
• Corruption and legal inefficiency
• Developing countries – bribery
• Poor investor and property rights protection
• Ethnic violence, political unrest and terrorism
• Home country restrictions eg: US embargo on companies doing business with Iran

Political Risk Services Group

ICRG (International country risk guide) information:

(nb: higher scores are good)

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