Chapter 11: Political Risk

Keith HeadSauder School of Business

UBC

Take-away

• Political risk analysis is the attempt to predict tomorrow’s “hot spots” and then avoid them, insure against losses, or prepare to minimize loss through rapid exit.

• Political risk strategy follows a 4-step plan to influence host government actions.

Analysis vs Strategy

• Analysis: When the actions of host governments are beyond the influence of individual firms, like the weather.– Risk is exogenous.

• Strategy: When the MNE’s actions have an important influence on the host government’s decisions.– Risk is endogenous.

Responses to Exogenous Risk

• Forecast the “hot spots”* and avoid them.

• Invest in potential hot spots, but prepare in advance for rapid evacuation.

• Invest in potential hot spots, but insure investments against possible losses.

*Hot spot: an area of political, military, or civil unrest usually considered dangerous

Questions re “On coups and coverage”

• Where do the dangers lie? Which countries are “hot spots”?Aon 2009 Risk Map

• What events can be insured against?• Who provides the insurance?• How common are disputes?• How common are payouts on claims?• Are all risks insurable?

Insurable Risks

• expropriation• “non-repossession”• war and political violence• cancellation of operating licences• exchange transfer problems• import and export embargoes

Case studies in Political Risk

• Metalclad in Mexico• Hugo Chavez and foreign firms in

Venezuela– Orinoco oil basin (ExxonMobil)– Sidor, the steel maker– banks

• Enron in India• Bre-X in Indonesia• Lithium in Bolivia

Political Strategy: a 4-step plan

1. Understand host government’s objectives.

2. Catalogue host government’s policy options.

3. Calculate host government’s bargaining power.

4. Enhance the MNEs strategic position.

1. What do host governments want from foreign investors?

• Capital inflow• Tax revenue• Job creation

– More jobs– Better jobs (high wages)

• “Improvement” in trade balance (net export outflow)

• Technology (intellectual capital) inflow

2. How do governments get what they want from the MNE?• Jobs:

– minimum employment– restricted use of expatriates– incentives to choose backward areas

• Improved trade balance:– Export requirements– Domestic content requirements

• Technology transfer:– Forced use of local joint venture partners

3. What gives a government the bargaining power to get what it

wants?• Uniquely valuable country

characteristics– A large, protected market– A scarce natural resource

• Investment decisions by the MNE that are irreversible (or very costly to reverse)

4. How can the MNE improve its own strategic position?

• Make “friends” with powerful people• Strategic Delay

– MNE can punish host gov’t by cancelling investments that have not been done yet

– Holding back even when it is inefficient

• Make “credible threats”*– Invest in strategic alternatives– Build a reputation for toughness*credible threats: promised responses that are not bluffs,

the firm really will follow through.

Is the MNE’s threat credible?

Approve$10m subsidy*

Deny$10m subsidy

Host Gov’t

MNE

Shut plant

Keep plant

MNEpayoff

Host Gov’tpayoff-5+10=5

-5

-15

17-10=7

17

Keep plant

0

-15 0Shut plant

*subsidy not paid if firm shuts plant

MNE

Strategic alternatives make the threat credible

Approve$10m subsidy*

Deny$10m subsidy

Host Gov’t

MNE

Shut plant

Keep plant

MNEpayoff

Host Gov’tpayoff-5+10=5

-5

-15

17-10=7

17

Keep plant

0

-15 0Shut plant

*subsidy not paid if firm shuts plant

[-5=0]

[-5=-10]

[+10=-5]

[+10=-5]

MNE