Political Risk and Government Policy Changes.

Presented By: Alysa Shcherbakova

Political Risk

Potential for the value of an investment to change due to changes in government policy.

Definition

Host Country Policy

Severe

Expropriation Nationalization

Mild

Tax Increases Additional Government Regulation

Continuum

Home Country Policy

Continuum

Severe

Required Divestment Sanctions

Mild

Licensing Requirements Tax changes affecting treatment of foreign income

Types of Policy Changes

Not directed at foreign owners Examples:

Tax increase Change in government regulation

General

Selective

Directed primarily at foreign owners Usually single out specific industries Examples:

Scrutiny of transfer prices Equity dilution

Benefit-Cost Analysis

Benefit-Cost Analysis Continued

Considers the benefits and costs of government action

Government policy changes occur when the present value of the benefits from intervention exceeds the present value of the costs of intervention

Definition

Benefit-Cost Analysis Continued

Expropriation – country receives firm’s assets and future cash flows

Increased Price/Currency Controls – macroeconomic controls

Equity Dilution – higher employment, improved job training and access to technology

Stricter Regulation – microeconomic control over affected industries

Increased Taxes – additional revenues

Benefits of Policy Change for the Host Country

Benefit-Cost Analysis Continued

Long Term Consequences of Policy Change

Expropriation – less investment in the future and some disinvestment resulting in a decline of economic base, higher unemployment, reduced transfer of technology

Increased Price/Currency Controls – unemployment and general stagnation of the economy

Equity Dilution – less investment and less technology transfer

Increased Taxes – firms will locate profits abroad

Benefit-Cost Analysis Continued

Estimating benefits and costs of government intervention is difficult

Government has no motivation do to a general analysis but rather prefers specific analysis approach

In Summary

Bargaining Power Analysis

Bargaining Power Analysis Continued

Occurrence and severity of incidents depends on one party’s bargaining power vis-à-vis the other party involved.

Definition

Host Country

The Firm

Bargaining Power Analysis Continued

Size of the market it offers

Wealth of the market

Abundance of skilled labour or raw materials

Uniqueness of the product and sophistication of technology required to product it

Size of the Multinational

Ongoing investments in the host country

Example: Intel’s Site Selection in Latin America

Brazil vs. Costa Rica

Brazil has high bargaining power relative to Intel because of FDI in the country – Intel needs Brazil’s opportunities more than Brazil needs Intel

Cost Rica has low bargaining power relative to Intel and was willing to negotiate and make concessions as it needs Intel’s Investment

Intel Chose Costa Rica as its manufacturing location because it had a relatively high BP compared to the BP of Costa Rica.

Bargaining Power Analysis Continued

Bargaining Power Leverage over Time Initial Investment – firm BP > country BP otherwise investment will not occur.

Country is interested in obtaining something from the firm - technology, product, etc.

As time progresses, BP shifts to host country.

Size and wealth of the market increase and nationals eventually acquire skills necessary to operate the project Similarly, the longer a firm operates in a country the more highly specific assets it acquires, decreasing its BP However, if the firm’s operations grow or exports increase the firm may sustain its BP

With time, Firm BP = Country BP

Bargaining Power Analysis Continued

Factors Influencing Bargaining Power Two Main Factors:

Best alternative to no agreementStatus Quo

The farther one is between its current state and the status quo, the less BP it is likely to have

Other Factors:

Drastic changes in economic environment can shift the bargaining powerDifferent countries have different levels of bargaining power and acquire additional bargaining power at different rates.

Bargaining Power Analysis Continued

In Summary

BP Analysis is useful in predicting incidents within a particular country

Is not very good at predicting incidents across countries

Example:

Brazil vs. Bolivia – while risk analysis suggests that Bolivia is riskier than Brazil because of high uncertainty, BP analysis would suggest that Brazil is a riskier investment because it’s BP is high and growing rapidly

Questions?