POLITICAL RISK ANALYSIS

PREFACE—

 Political Risk

 Sovereign Risk

 Country Risk

 Human Development Index

 Corruption Index

 Ratings
POLITICAL RISK
 Political risk is a type of risk faced by investors, corporations, and governments. The
risk that an investment's returns could suffer as a result of political changes or
instability in a country. Political risk is also known as "geopolitical risk". Also referred
as any political change that alters the expected outcome and value of a given
economic action by changing the probability of achieving business objectives.
Political risk faced by firms can be defined as “the risk of a strategic, financial, or
personnel loss for a firm because of such nonmarket factors as macroeconomic and
social policies (fiscal, monetary, trade, investment, industrial, income, labour, and
developmental), or events related to political instability (terrorism, riots, coups, civil
war, and insurrection)

There are both macro- and micro-level political risks-

MACRO POLITICAL RISK

These affect MNCs at the project and corporate level and originate at the country
level. They include:

1) Transfer risk, which arise from uncertainty about cross-border flows of capital
payments and know-how, unexpected imposition of capital controls inbound or
outbound, blocked funds, withholding taxes on dividend and interest payments, etc.

2) Operational risks, these are associated with uncertainty about the host country’s
policies affecting the local operations of MNCs, some overlap with firm specific risk,
e.g. unexpected changes in environmental policies, sourcing local content
requirements, etc.

3) Cultural & institutional risks, related to ownership structure, human resource

norms, minimum wage laws, religious heritage, nepotism and corruption, intellectual
property rights, and protectionism.

MICRO POLITICAL RISK

These affect the MNC at the project/corporation level. They include:

1) Interest rate and Foreign exchange risks, these arise from fluctuation in host
country’s interest rate or currency vis-à-vis home currency.
2) Business risks arise from factors affecting cash flows and hence profitability of the
firm, such as change in taxation for foreign firms, or local disputes with trade unions
or suppliers, etc.
3) Governance & Control risks arise from uncertainty about the host country’s policy
regarding ownership, and control of local operation, restriction on access to local
credit facilities, goal conflict between a MNC and the host government.
OTHER POLITICAL RISK

GLOBAL SPECIFIC RISK-

These too affect the MNCs at the project or corporate level but originate at the
global level.

 Examples:

• Terrorism

• Anti-globalization movements

• Environmental concerns

• Poverty

• Cyber attacks

SOVEREIGN RISK
 The potential for loss that arises as a Government either cannot meet its Sovereign
obligations, imposes restrictions on convertibility of its currency, devalues its
currency, changes regulation to restrict funds transfer etc

 The risk that a foreign central bank will alter its foreign-exchange regulations thereby
significantly reducing or completely diminishing the value of foreign-exchange
contracts. This is one of the many risks that an investor faces when holding foreign
exchange contracts

SOVEREIGN RISK FACTORS-

 Debt Service Ratio
o DSR = Debt Payments / Exports
o Debt Payments and Exports in Hard Currencies
 Currencies likely to appreciate (Soft currency likely to depreciate)
 Hard currencies usually those of developed nations
o Higher ratio
 Greater chance the LDC (Less Developed Countries) will have trouble
repaying.

 Import Ratio
 o IR = Imports / FX Reserves
o In times of financial distress a country may need to use it’s FX reserves to pay
for imports already bought
o Fewer Reserves relative to the level of Imports, the greater the risk of
financial distress.

 Investment Ratio (INVR)

o INVR = Real Investment / GNP (Gross National Product, measures of
national income and output)
 Large Investment
 LDC increases it’s income producing potential
 Less chance that it will experience financial problems
 Sovereign nation will instead buy-back foreign debt.
 Lower sovereign risk
 Conversely
 Less need for external financing in the future
o The LDC may be more inclined to default on today’s
debt

 LIBOR
(London Interbank Offered Rate, a daily reference rate based on the interest
rates at which banks borrow unsecured funds from other banks in the London
wholesale money market or interbank market)
o Banks charge a spread over LIBOR
o As LIBOR increases, so do rates on new loans (and floating rates on existing
loans)
o As LIBOR increases, the probability of financial distress increases

COUNTRY RISK
Country risk refers to the risk of investing in a country, dependent on changes in the
business environment that may adversely affect operating profits or the value of assets in a
specific country.

For example, financial factors such as currency controls, devaluation or regulatory changes,
or stability factors such as mass riots, civil war and other potential events contribute to
companies' operational risks.

“Potential Investors don't want flexibility; they want fixed rules of the game”
 -John Gavin, U.S. Ambassador to Mexico

Assessment of potential rewards and risk associated with doing business in a country.
Several non-economic (political/national) factors affect country risk.

Factors affecting Country risk:

• Well functioning legal system

• Absence of corruption

• Ratio of government deficit to GDP

• Price controls, labor laws

• Propensity to increase money supply

• Controlled exchange rate system

Country risk analysis can be used:

• to monitor countries where the MNC is currently doing business

• as a screening device to avoid conducting business in countries with excessive risk

• to revise its investment or financing decisions in light of recent events

HUMAN DEVELOPMENT INDEX

 The Human development index is a composite statistic used as index to rank
countries by level of human development & separate developed, developing, and
under developed

 A process of enlarging people’s choices and enhancing human capabilities to enable

them live a long and healthy life, to access knowledge and standard of living

 The Human Development Index ranks the countries of the world in terms of its
human development.
 The Human Development Index implies whether a country is developed, developing
or underdeveloped.

 The Human Development Index sets a standard means of measuring human

development and sets levels of options of person for personal achievement.
  The Human Development Index is published by the United Nations Development
Programme and is the centrepiece of the UN’s Human Development Report.

 The Human Development Index was created as an alternative to the common

practice to rank human development solely on a country’s gross domestic product.
 First published in 1990 under Pakistani economist Mahbub ul Haq and Indian Nobel
Laureate Amartya Sen, the goal of the Human Development Report and the Human
Development Index was to accurately measure whether people are better off in
terms of health, freedom, education and other aspects of life not measured by gross
GDP. The originators stated: “People are the real wealth of a nation. The basic
objective of development is to create an enabling environment for people to enjoy
long, healthy and creative lives. This may appear to be a simple truth. But it is often
forgotten in the immediate concern with the accumulation of commodities and
financial wealth.”

 The Formula
In order to rank whether a certain country is developed, developing, or
underdeveloped, the Human Development Index looks at a number of different
factors. The Index measures life expectancy, literacy, education, and GDP for
countries worldwide. These variables are then put into a mathematical algorithm
which measures the potential and real development of any given nation.

 Essential Components of HDI

Equity: People must enjoy equitable access to opportunities

Sustainability: The next generation must enjoy the same well being that we enjoy

Productivity: Requires investment in people and enabling micro-environment for them

Empowerment: It means people are in a position to exercise choices of their own free.

CORRUPTION PERCEPTION INDEX

The Corruption Perceptions Index (CPI) measures the perceived level of public-sector
corruption in 180 countries and territories around the world. The CPI is a "survey of
surveys", based on 13 different expert and business surveys.

As the world economy begins to register a tentative recovery and some nations continue to
wrestle with ongoing conflict and insecurity, it is clear that no region of the world is immune
to the perils of corruption. The vast majority of the 180 countries included in the 2009
Corruption Perceptions Index (CPI) score below five on a scale from 0 (perceived to be highly
corrupt) to 10 (perceived to have low levels of corruption).

 It is a composite index drawing on corruption-related data in expert surveys carried

out by a variety of reputable institutions
 It reflects the views of businesspeople and analysts from around the world including
experts who are resident in the countries evaluated.

OBJECTIVES OF CORRUPTION PERCEPTION INDEX (CPI)-

• Measure the level of corruption in public sector by experienced observers,
researchers (business people, academic persons, risk analysts).

• To enhance comparative understanding of levels of corruption.

• To offer a snapshot of the views of experts who influence trade and investment.

• To stimulate scientific research and complementary diagnostic analysis on causes

and consequences of corruption, both at international and national level.

• To create public awareness of corruption

– and create a climate for change.

CHALLENGES (CPI)-
• Composite methodology can result in misinterpretation-

- Only the countries with sufficient information are analysed

- Endeavours of the countries to fight corruption is not measured

- Inclusion of information of 2-3 years instead of one

• Political sensitivity of CPI-

- Accusation that finger is pointed at developing countries.

- Ignores the actions taken in the countries to fight corruption

WHY CPI-
• Promote public debates

• Provide an incentive to conduct complementary local diagnostics

• Create worldwide media coverage (raise awareness and draw attention)

• Drive demand for change, as a powerful advocacy tool

 • Brand-awareness globally

RATINGS

 A rating is the evaluation or assessment of something, in terms of quality (as with a

critic rating a novel), quantity (as with an athlete being rated by his or her statistics),
or some combination of both

 A credit rating estimates the credit worthiness of an individual, corporation, or even

a country. It is an evaluation made by credit bureaus of a borrower’s overall credit
history. A credit rating is also known as an evaluation of a potential borrower's
ability to repay debt

HIMANSHU SISODIA
AMITY INTERNATIONAL BUSINESS SCHOOL