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8/12/2019 11. Country Risk
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Country Risk
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Types of Risk Facing Businesses
Price risk Credit risk Pure risk
Output price risk Input price risk
Commodity price risk
Exchange rate risk
Interest rate risk
Damage to assets
Legal liability
Worker injury
Employee benefits
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Enterprise Risk Management
The holistic approach to assessing, measuring
and managing the different types of risk to
which an organisation is exposed.
Operational Risk
Credit Risk
Business Risk Market Risk
Country risk
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Risk Management
For any type of risk, the risk managementprocess involves a number of key steps
1. Identify all significant risks
2. Evaluate potential frequency and severity of losses3. Develop and select methods for managing risk
4. Implement risk management methods chosen
5. Monitor performance and suitability of risk management
methods and strategies on an ongoing basis
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Risk Management Methods
Three main methods of managing risk
Loss control
Loss financing
Internal risk reduction
Loss control and internal risk reduction usually
involve decisions to invest (or forego investing)
resources to reduce expected losses
Loss financing decisions relate to how to pay for
losses if they do occur
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Factors Affecting Country Risk
Macroeconomic Factors
The first of these factors is the size and structure of thecountrys external debt in relation to its economy.
More specifically: The current level of short-term debt and the potential
effect that a liquidity crisis would have on the ability ofotherwise creditworthy borrowers in the country tocontinue servicing their obligations.
To the extent the external debt is owed by the publicsector, the ability of the government to generate sufficientrevenues, from taxes and other sources, to service itsobligations.
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The condition and vulnerability of the countrys current
account is also an important consideration, including: The level of international reserves held by Central Bank
The importance of commodity exports as a source of
revenue, the existence of any price stabilization
mechanisms, and the countrys vulnerability to a downturnin either its export markets or the price of an exported
commodity.
The potential for sharp movements in exchange rates and
the effect on the relative price of the countrys imports andexports. (Iceland)
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The role of foreign sources of capital in meeting the
countrys financing needs is another important
consideration for country risk, including:
The countrys access to international financial markets and thepotential effects of a loss of market liquidity. (Greece)
The countrys relationships with private sector creditors, includingthe existence of loan commitments and the attitude among bankers
toward further lending to borrowers in the country. The countrys current standing with multilateral and official creditors,
including the ability of the country to qualify for and sustain anInternational Monetary Fund (IMF) or other suitable economicadjustment program.
The trend in foreign investments and the countrys ability to attractforeign investment in the future.
The opportunities for privatization of government-owned entities.
i h hi hli h d h i
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Past experience has highlighted the importance
of a number of other important
macroeconomic considerations, including:
The degree to which the economy of the country may beadversely affected through the contagion of problems inother countries.
The size and condition of the countrys banking system,
including the adequacy of the countrys system for banksupervision and any potential burden of contingentliabilities that a weak banking system might place on thegovernment.
The extent to which state-directed lending or othergovernment intervention may have adversely affected thesoundness of the countrys banking system, or the structureand competitiveness of the favoured industries orcompanies.
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Social, Political, and Legal Climate
The analysis of country risk should also take intoconsideration the countrys social, political, and legalclimate including:
The countrys natural and human resource potential.
The willingness and ability of the government torecognize economic or budgetary problems andimplement appropriate remedial action.
The degree to which political or regional factionalism
or armed conflicts are adversely affecting governmentof the country.
Any trends toward government-imposed price, interestrate, or exchange controls
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Social, Political, and Legal Climate
The degree to which the countrys legal system can be relied
upon to fairly protect the interests of foreign creditors and
investors.
The accounting standards in the country and the reliability and
transparency of financial information.
The extent to which the countrys laws and government policies
protect parties in electronic transactions and promote the
development of technology in a safe and sound manner.
The extent to which government policies promote the effective
management of the institutions exposures.
The level of adherence to international legal and business
practice standards
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Institution-Specific Factors
Finally, an institutions analysis of country risk should take intoconsideration factors relating to the nature of its actual (or approved)exposures in the country including, for example:
The institutions business strategy and its exposure management plans forthe country.
The mix of exposures and commitments, including the types ofinvestments and borrowers, the distribution of maturities, the types andquality of collateral, the existence of guarantees, whether exposures areheld for trading or investment, and any other distinguishing characteristicsof the portfolio.
The economic outlook for any specifically targeted industries within thecountry.
The degree to which political or economic developments in a country arelikely to affect the institutions chosen lines of business in the country.
For instance, the unemployment rate or changes in local bankruptcy lawsmay affect certain activities more than others.
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Institution-Specific Factors For an institution involved in capital markets, its susceptibility to
changes in value based on market movements. As the market value ofclaims against a foreign counterparty rise, the counterparty maybecome less financially sound, thus increasing the risk of nonpayment.This is especially true with regard to over-the-counter derivativeinstruments.
The degree to which political or economic developments are likely toaffect the credit risk of individual counterparties in the country. For example, foreign counterparties with healthy export markets or
whose business is tied closely to supplying manufacturing entities indeveloped countries may have significantly less exposure to the localcountrys economic disruptions than do other counterparties in thecountry.
The institutions ability to effectively manage its exposures in a countrythrough in-country or regional representation, or by some otherarrangement that ensures the timely reporting of, and response to,any problems.
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Foreign Direct Investment Theory
and Political Risk
Ch 18
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18-15
Sustaining and Transferring
Competitive Advantage In deciding whether to invest abroad, management must first determine
whether the firm has a sustainable competitive advantage that enables itto compete effectively in the home market.
The competitive advantage must be firm-specific, transferable, andpowerful enough to compensate the firm for the potential disadvantages
of operating abroad (foreign exchange risks, political risks, and increasedagency costs).
There are several competitive advantages enjoyed by MNEs.
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18-16
Sustaining and Transferring
Competitive Advantage Economies of scale and scope:
Can be developed in production, marketing, finance, research anddevelopment, transportation, and purchasing
Large size is a major contributing factor (due to international and/or domesticoperations)
Managerial and marketing expertise:
Includes skill in managing large industrial organizations (human capital andtechnology)
Also encompasses knowledge of modern analytical techniques and theirapplication in functional areas of business
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18-17
Sustaining and Transferring
Competitive Advantage
Advanced technology:
Includes both scientific and engineering skills
Financial strength: Demonstrated financial strength by achieving and
maintaining a global cost and availability of capital
This is a critical competitive cost variable thatenables them to fund FDI and other foreign
activities
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18-18
Sustaining and Transferring
Competitive Advantage Differentiated products:
Firms create their own firm-specific advantages by producing andmarketing differentiated products
Such products originate from research-based innovations or heavy
marketing expenditures to gain brand identification Competitiveness of the home market:
A strongly competitive home market can sharpen a firms competitiveadvantage relative to firms located in less competitive ones
This phenomenon is known as the diamond of national advantage and
has four components
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18-19
Where to Invest?
The decision about where to invest abroad is influenced by behavioral factors.
The decision about where to invest abroad for the first time is not the sameas the decision about where to reinvest abroad.
In theory, a firm should identify its competitive advantages, and then search
worldwide for market imperfections and comparative advantage until it findsa country where it expects to enjoy a competitive advantage large enough togenerate a risk-adjusted return above the firms hurdle rate.
In practice, firms have been observed to follow a sequential search pattern asdescribed in the behavioral theory of the firm.
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18-20
Where to Invest?
The decision to invest abroad is influenced by behavioral factors.
The decision about where to invest abroad for the first time is not thesame as the decision about where to reinvest abroad.
In theory, a firm should identify its competitive advantages. Then it should
search worldwide for market imperfections and comparative advantageuntil it finds a country where it expects to enjoy a competitive advantagelarge enough to generate a risk-adjusted return above the firms hurdlerate.
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18-21
Exhibit 18.3 The FDI Sequence: Foreign Presence and
Foreign Investment
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18-22
How to Invest Abroad:
Modes of Foreign Investment
Exporting versus production abroad:
There are several advantages to limiting a firms activities to
exports as it has none of the unique risks facing FDI, Joint Ventures,
strategic alliances and licensing with minimal political risks
The amount of front-end investment is typically lower than other
modes of foreign involvement
Some disadvantages include the risks of losing markets to imitators
and global competitors
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18-23
How to Invest Abroad:
Modes of Foreign Investment
Licensing and management contracts versus control of assets
abroad:
Licensingis a popular method for domestic firms to profit from foreign
markets without the need to commit sizeable funds
However, there are disadvantages which include:
License fees are lower than FDI profits
Possible loss of quality control
Establishment of a potential competitor in third-country markets
Risk that technology will be stolen
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18-24
How to Invest Abroad:
Modes of Foreign Investment
Management contracts are similar to licensing,
insofar as they provide for some cash flow from a
foreign source without significant foreign
investment or exposure Management contracts probably lessen political
risk because the repatriation of managers is easy
International consulting and engineering firmstraditionally conduct their foreign business on the
basis of a management contract
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18-25
How to Invest Abroad:
Modes of Foreign Investment
Joint venture versus wholly owned subsidiary:
Ajoint ventureis here defined as shared ownership in a foreignbusiness
Some advantages of a MNE working with a local joint venture partner
are: Better understanding of local customs, mores and
institutions of government
Providing for capable mid-level management
Some countries do not allow 100% foreign ownership
Local partners have their own contacts and reputationwhich aids in business
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18-26
How to Invest Abroad:
Modes of Foreign Investment However, joint ventures are not as common as 100%-owned foreign
subsidiaries as a result of potential conflicts or difficulties including:
Increased political risk if the wrong partner is chosen
Divergent views about the need for cash dividends, or
the best source of funds for growth (new financingversus internally generated funds)
Transfer pricing issues
Difficulties in the ability to rationalize production on a
worldwide basis
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18-27
How to Invest Abroad:
Modes of Foreign Investment
Greenfield investment versus acquisition:
A greenfield investmentis defined as establishing aproduction or service facility starting from the groundup
Compared to a greenfield investment, a cross-borderacquisition is clearly much quicker and can also be acost effective way to obtain technology and/or brandnames
Cross-border acquisitions are however, not withoutpitfalls, as firms often pay too high a price or utilizeexpensive financing to complete a transaction
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18-28
How to Invest Abroad:
Modes of Foreign Investment
The term strategic allianceconveys different meanings to different
observers.
In one form of cross-border strategic alliance, two firms exchange a share
of ownership with one another.
A more comprehensive strategic alliance, partners exchange a share ofownership in addition to creating a separate joint venture to develop and
manufacture a product or service
Another level of cooperation might include joint marketing and servicing
agreements in which each partner represents the other in certain markets.
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18-29
Foreign Direct Investment Originating in
Developing Countries
In recent years, developing countries with
large home markets and some entrepreneurial
talent have spawned a large number of rapidly
growing and profitable MNEs
These MNEs have not only captured large
shares of their home markets, but also have
tapped global markets where they are
increasingly competitive
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18-30
Foreign Direct Investment Originating in
Developing Countries
The Boston Consulting Group has identified sixmajor corporate strategies employed by theseemerging market MNEs
Taking brands global
Engineering to innovation
Leverage natural resources
Export business model
Acquire offshore assets
Target a niche
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18-31
Defining Political Risk
In order for an MNE to identify, measure, and
manage its political risks, it needs to define
and classify these risks which include
Firm-specific risks
Country-specific risks
Global-specific risks
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18-32
Assessing Political Risk
At the macro level, prior to under-taking
foreign direct investment, firms attempt to
assess a host countrys political stability and
attitude toward foreign investors
At the micro level, firms analyze whether their
firm-specific activities are likely to conflict
with host-country goals as evidenced by
existing regulations
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18-33
Predicting Risks
Predicting firm-specific risk
Different foreign firms operating within the samecountry may have very different degrees of
vulnerability to changes in host-country policy orregulations
Predicting country-specific risk
Political risk analysis is still an emerging field,though firms need to attempt to conduct thisanalysis
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18-34
Firm-Specific Risks
Governance risks
Governance riskis the ability to exercise effective control over anMNEs operations within a host countrys legal and politicalenvironment
Historically, conflicts of interest between objectives of MNEs and host
governments have arisen over such issues as the firms impact oneconomic development, the environment, control over exportmarkets, balance of payments (to name a few)
The best approach to conflict management is to anticipate problemsand negotiate understanding ahead of time
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Firm-Specific Risks
Negotiating Investment Agreements
An investment agreement spells out specific rights
and responsibilities of both the foreign firm and
the host government
The presence of the MNE is as often sought by
development-seeking host governments
An investment agreement should define policies
on a wide range of financial and managerial issues
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Operating Strategies after the FDI Decision
Although an investment agreement creates obligations on thepart of both foreign investor and host government, conditionschange and agreements are often revised in the light of suchchanges
The firm that sticks rigidly to the legal interpretation of itsoriginal agreement may well find that the host governmentfirst applies pressure in areas not covered by the agreementand then possibly reinterprets the agreement to conform tothe political reality of that country
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Operating Strategies after the FDI Decision
Some key areas of consideration include:
Local sourcing
Facility location
Control of transportation
Control of technology
Control of markets
Brand name and trademark control
Thin equity base
Multiple-source borrowing
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18-38
Country-Specific Risk: Transfer Risk
Country-specific risks affect all firms, domestic
and foreign, that are resident in a host country
The main country-specific political risks aretransfer riskand cultural and institutional risks
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18-39
Country-Specific Risk: Transfer Risk
Transfer riskis defined as limitations on the MNEs ability to
transfer funds into and out of a host country without
restrictions
When a government runs short of foreign exchange and
cannot obtain additional funds through borrowing or
attracting new foreign investment, it usually limits transfers of
foreign exchange out of the country, a restriction known as
blocked funds
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18-40
Exhibit 18.6 Management Strategies for Country-
Specific Risks
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18-41
Country-Specific Risk: Cultural and Institutional
Risks
When investing in some of the emerging markets, MNEs thatare resident in the most industrialized countries face seriousrisks because of cultural and institutional differencesincluding:
Differences in allowable ownership structures
Differences in human resource norms
Differences in religious heritage
Nepotism and corruption in the host country
Protection of intellectual property rights
Protectionism
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Global-Specific Risks
Global specific risks faced by MNEs have come to theforefront in recent years
The most visible recent risk was, of course, the attack byterrorists on the twin towers of the World Trade Center inNew York on September 11, 2001.
In addition to terrorism, other global-specific risks include theantiglobalization movement, environmental concerns, povertyin emerging markets and cyber attacks on computerinformation systems