Political Risk in International Business

Keywords: international business and politics

International businesses often do encounter political and country risks in markets in which they operate. Investigate examples of political risk in international business and show how these risks can be managed.

Introduction:

Political and country risks:

Financial institutions and business organizations operate its business activities abroad in order to diversify and expand their sources of revenue and profitability. Organizations that make investment in a foreign market either in the form of equity or assets are exposed to risks that may arise either from an act of the host government or from other external political events taking place in that country, these risks include social, political and economic conditions and events that imposes negative impact on the financial performance and profitability of foreign organizations.

Types of political and country risks:

The following are the main types of political and country risks that may affect the business performance of an international organization operating in foreign countries.

Nationalization or deprivation:

Nationalization is a process whereby a government takeover privately owned industries, corporations and resources with or without compensation.

Nationalization is a political risk which makes it very difficult or impossible for international organizations to invest in a country where businesses are exposed to such risk.

In past governments have nationalized highly profitable industries on the ground that it does not want foreign ownership of its valuable resources for instance in 2006 the Bolivian government nationalized the country’s oil and natural gas industries. Similarly in January 2007 the Government of Venezuela announced to nationalize firms in two major sectors of the country’s economy i.e. telecommunications and electricity.In November 2009 the president of Venezuela announced that he will nationalize banks in the country.

Forced divestiture:

forced divestiture another type of country risk in which an international firm is forced to divest its business operation, an example of forced divestiture is the Indonesian subsidiary of French retail giant Carrefour which has been ordered to sell the 75% stake it acquired in smaller rival Alfa Retailindo in January 2008.

Gradual expropriation:

Expropriation means a quick action of government to seize the assets of foreign entity, but in gradual expropriation a single international company is targeted by the host government. Gradual or creeping expropriation involves slow and gradual removal of property rights by way of tax increase on profits to make a foreign business less profitable, increase in property tax, instituting increasing barriers, changing the proportion of ownership which must be held locally.In gradual expropriation the ownership title of business remains in the name of foreign investor but the right to use the business is diminished as a result of the government interference.

An example of gradual expropriation is when China announced a policy restricting the property rights of domestic and foreign automakers to transfer their ownership or enter into strategic alliance in China, by banning the sale or transfer of manufacturing licenses by bankrupt or failing automakers.

Similarly in Tecinicas Medioambientales Tecmed S.A. V. The United Mexican States it was declared that the Mexican government has committed expropriation because of non-renewal of a license necessary to operate the landfill.

Currency inconvertibility and exchange:

Currency inconvertibility means a situation where one currency can not be converted or exchanged into foreign currency. This is another political risk for an organization operating its business activities abroad. In such case a foreign government may restrict the right of foreign firms to repatriate profits to their home country and all profits remain in the foreign country. Inconvertibility of currency may arise due to passing new legislation or administrative delays. In administrative delays the bureaucracy in a foreign country takes more time in currency conversion and creates a financial burden upon foreign companies.

Some countries issues inconvertible currency for instance Cuban peso in order to protect its citizens from perceived capitalist infiltration, similarly domestic regulators may consider foreign currency inconvertible in order to protect local investors from bad investment decision i.e. hyperinflation of currency.

Termination of fuel supply agreements:

Termination of fuel supply agreement is another political risk for an international organization functioning in a foreign country. A foreign company whose business activities are solely dependent upon fuel supply under an agreement with the host government, or with the host company and when such agreement is terminated than in such circumstances the company will face major problem in continuing its business in such foreign country.

Confiscation:

Confiscation of international business is a severe form of political risks where host government seizes the assets of a foreign company without compensation. The U.S. 1996 Helms-Burton Law entitles the U.S. companies to sue companies from other countries that use property confiscated from U.S. companies following Cuba’s communist revolution in 1959. But the U.S. government waived this law repeatedly in order to maintain good relations with other countries.

Terrorism and kidnapping:

Kidnapping and other terrorist activities are means of making political statements. Small groups unhappy about the current political or social situation can resort to terrorist tactics to fulfill their demands. 9/11 tragedy is a prominent example. These groups may target the executives of large international companies for kidnapping and taking of hostages in order to fund their terrorist activities.

The current political instability, terrorist activities and internal conflicts in Pakistan is a good example, where an international firm is exposed to a verity of threats arising from such activities and makes it impossible for such firm to operate business effectively and increase its profitability.

Policy changes:

Furthermore good relationship between the host government and international companies is of vital importance for operating a successful and profitable business and any political change that modify the anticipated effect and worth of a given economic action by changing the likelihood of achieving business objectives than it affects international businesses to a greater extent and the government’s hard and fast new policies can create huge problems for international companies.

Contractual frustration:

Frustration of contract means legal termination of contract between the parties because of unforeseen circumstances which makes the performance of such contract practically impossible. These circumstances include, accident, change in law, sickness of one of the parties and interference from third party etc.

In international business perspective companies that enter into trade agreements for export or import of goods or services either with government or private entities in foreign countries are often exposed to underlying political risks. Such contract may be frustrated at any time for a number of political reasons that are beyond the control of the parties.

Transfer:

Transfer risks take place when host government policies imposes limitation on the transfer of capital, payments, production, people and technology in and out of country i.e. imposing tariffs or restrictions on import and export, repatriation of capital or remittance of dividend etc.

Trade disruptions:

Devaluation:

Screening for political risks:

In order to operate successful business activities overseas it is very important for international companies to identify, analyze, measure and manage those political and country risks that are encountered by such company.

Analysis of political risks:

In order to analyze political risks, these are categorizes in two levels according to their nature, severity and intensity i.e. Macro political risk analysis and micro political risk analysis.

Macro political risk analysis:

This is an analysis that observes major political decisions likely to affect all businesses in a country. Macro risk factors include freezing the movement of assets out of the host country, limiting the remittance of profits or capital, currency devaluation, refusing to perform contractual obligations previously signed with the MNC’s, industrial piracy (counterfeiters), political disorder and government corruption.

Micro political risk analysis:

This is an analysis that is directed towards government policies and decisions that influence selected sectors of the economy or specific foreign businesses in the country. The examples are selective discrimination, industry regulation, imposition of taxes on specific types of activity, restrictive local laws and host government policies that promote exports and discourage import.

Management of political risks:

Political risks can be managed through applying different strategies i.e. avoidance, reduction or shifting of risk and post commitment practices.

Avoidance:

If any enterprise realizes that making investment in a country will expose such enterprise to political risks the most simple strategy to keep away from such political risks is not to invest in such country and to go somewhere else, this is pre-commitment strategy that can be used before the commencement and making any final commitment.

Reduction or shifting of risk:

Another way of managing political risk is that a foreign company can implement a financial structure that shifts risks to local creditors and shareholders.

Similarly contracts can be designed whereby a force majeure clause is included to revise and free contractual parties from their contractual obligations in case of any violence, coup, insurrection and long-term trade disruption etc.

Post-commitment practices:

Post-commitment practices mean adoption of strategies after making investment and commencement of business activities in overseas market. This kind of strategy takes various forms i.e. modification of employment or the ownership of the business, minority interest, designing operational structure, diversification and taking insurance policy.

Modification of employment or the ownership of the business:

If a foreign firm’s top management is controlled by local nationals or their ownership is significant or establishing of a joint venture of 50-50 ownership with a local firm than the host government would have less incentive to nationalize such business.

Minority interest:

Another useful strategy of managing political risks is to adopt minority interest in the business.

Designing operational structure:

Designing the operational structure of business in a way that attracts the inflow of foreign exchange in the host country and establishing good relations and close cooperation of management with the host government will also safeguard such firm from any threat from the host government.

Diversification:

If any political risk is encountered by a foreign firm while operating business activities overseas the best way is to diversify and expand its business operation into other countries that are not exposed to such type of risks.

Taking insurance policy:

Moreover to avoid any kind of loss that can be inflicted due to any political or country risk the company can go for insurance policy but it is very expensive and can minimize the profitability of such firm.