Download - Political Risk: An Analysis of the Oil Industry Investment Environment by Denis Parfenov [2002]
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Political Risk: an Analysis of the Oil Industry
Investment Environment
by Denis Parfenov
A dissertation prepared in partial fulfilment of the requirements for the
Degree of Masters of Business Studies (in International Business)
The Michael Smurfit Graduate School of Business,
Faculty of Commerce,
University College Dublin,
Ireland
Research Advisor: Dr. John F. Cassidy
July 2002
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To my Grandmother
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Abstract
Companies diversify geographically and gain entry to traditionally
inaccessible regions. Direct foreign investments allow them to exploit unique
assets and to generate larger profits. Investments in any country entail political
risk. This paper aims to examine the concept of political risk as perceived by
three major oil companies (Exxon Mobile, Royal Dutch Shell, British
Petroleum) with activities diversified around the world. In order to compare
companies strategies, the chosen research sample includes the companies
with interests on Sakhalin island, Russia.
The objective of this dissertation is to analyse the current threats of the
international business environment and the strategies companies employ to
deal with them. The sample of three oil companies is taken, presuming that
the exploration business is a typical example, of where political risk is usually
involved.
When the findings of the secondary research are analysed with regard to the
literature available on the research topic many correlations are found. Most
notable is the finding that in order to achieve long term goals, oil companies
have to undertake tasks with risk and uncertainty. Second, the threat of losing
ownership rights is relatively low at present. Host countries are highly
dependent on foreign investments, technology and managerial expertise. On
the other hand, the risks imposed by forces, which are beyond governments
control, and changes in the international relationship are high. The topic of
dealing with risks caused by forces beyond governments control is under
explored in academic literature. Finally, in spite of high bureaucratic barriers,
the Russian Federation is becoming an investor attractive region. The leading
Western oil companies are actively investing in Russia. The multinationals
practices of dealing with risks in Russia do not differ from their practices in
other countries or to each other.
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Acknowledgments
Following a great time at the Michael Smurfit Graduate School of Business, I
would like to thank the following for their help and support throughout the
year:
Dr. John F. Cassidy, thank you for your continued guidance and
advice.
Dr. Anne Bourke, thank you for keeping me focused
My family
My friends
J. ORourke, for a great time.
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Table of Contents
Page
Chapter 1: Introduction 1
Chapter 2: Literature Review 5
Section 1: Theory of Internationalisation 5
1.1 FDI 6
1.2 Joint Ventures 8
1.3 FDI in Oil Industry 9
Section 2: Uncertainty and Risk 10
Section 3: Political Risk 11
3.1 Macro Political Risks 14
3.2 Micro Political Risk 16
3.3. Managing/ Minimizing Political Risks 18
Step1: Risk Recognition/Evaluation 18
1.1 Sources of Information (Internal and External) 19
1.2 Technique to Assess Political Risks 21
1.3 Industry Associated / Project Associated Risks 23
1.4 Country Associated Risk 26
Step 2: Developing Pre-investing Planning/
Crisis Planning 30
Step 3: Post-investment Policies/
Crisis Management 32
Section 4: Risk/ Return Trade-off 33
Conclusion 34
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Chapter 3: Research Methodology
Section 1: Introduction in the Case Study Approach 35
Section 2: The Case Study Approach as a Research Strategy 36
Section 3: Sources of Data for This Study and Their Limitations 38
Section 4: The Selection of Cases 39
Section 5: Generalisation 40
Section 6: Boundaries to Case Studies 40
Section 7: Limitations of the Case Studies Approach 41
Section 8: Research Objectives 42
Conclusion 42
Chapter 4: Background- Global Oil & Russia
Section 1: Oil Industry Profile 43
1.1 Uses of Cruel Oil 46
Section 2: Exxon Mobiles Profile 46
Section 3: Royal Dutch Shells Profile 47
Section 4: British Petroleums Profile 47
Section 5: Russian Oil and Gas Sector 48
Section 6: Product Sharing Agreements 51
Section 7: Sakhalin Projects 52
Conclusion 54
Chapter 5: Case Studies 55
Case One: Exxon Mobile
1.1 Exxons Business 55
1.2 Exxon, Chad and Indonesia 56
1.3 Exxon and Sakhalin 1 58
Case Two: Royal Dutch Shell Group
2.1 Shell in Nigeria 61
2.2 Shell and Sakhalin 2 63
Case Three: British Petroleum PLC 65
3.1 BP and Colombian Oil 66
3.2 BP and Sakhalin 4-5 69
Conclusion 70
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Chapter 6: Findings
Section 1: Political Risk and Oil Companies 71
Section 2: Risk Recognition/ Evaluation in the Oil Industry 73
Section 3: Risk Management 74
Section 4: Investing in Russia 77
Chapter 7: Conclusions 79
Future Research Direction 84
List of References a-f
List of Websites g
Appendix I: OLI variables according to Dunning A
Appendix II: Histories of Companies C
Appendix III: World Energy Fuel Shares 1998 2020 F
Appendix IV: Map of Sakhalin Island
G
Appendix V: Sakhalin Projects
H
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List of Tables
Page
Table 3.1 Comparing a case with others of its type 40
Table 4.1 Which countries have the worlds largest
proven oil reserves. 43
Table 4.2 Which countries produce the most oil 44
List of Figures
Page
Figure 2.1 Patterns of Political Intervention 13
Figure 2.2 Four types of risk 14
Figure 4.1 Rate of oil reserve renewal, 1990-1999 by country 45
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Glossary of Terms & List of Abbreviations
Barrel - Crude oil is measured in barrels. One barrel equals 42 US gallons,
or 159 litres.
Crude Oil is a naturally-occurring substance found trapped in certain rocks
below the earth's crust. It is a dark, sticky liquid, which, is classed in science
as a hydrocarbon. This means, it is a compound containing only hydrogen
and carbon. Crude oil is highly flammable and can be burned to create
energy. Along with its sister hydrocarbon, natural gas, crude oil makes an
excellent fuel.
Developed Countries are considered for the purpose of this study to be
OECD member countries. Those countries are primarily are the US, Japan,
European countries.
Developing Countries are considered for he purpose of this study to be the
all countries that are not a member of OECD or former centrally planned
economies. Most developing countries are located in Africa, Latin and South
America and Eastern Europe
FDI- Foreign direct investment
FSU- The Former Soviet Union
MNE- Multinational enterprise
NGO- Non-government organisation
OECD- Organisation of Economic Co-operation and Development
OPEC- Organisation of Petroleum Exporting Countries, which was
formed 14th of September, 1960 in Baghdad, Iraq. The current members are:
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Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia,
the United Arab Emirates (UAE) and Venezuela.
Political Risk- Changes in operating conditions of foreign enterprises that
arise out of political process, either directly through war, insurrection, or
political violence or through changes in government policies that affect the
ownership and behaviour of the firm. or affect in any way the future
profitability of given investment (Jodice, 1980)
PSA- Product Sharing Agreement
UNCTAD- United Nations Conference on Trade and Development
WEC- World Energy Council
World Oil Reserves are estimated at more than one trillion barrels (OPEC,
2002). The 11 OPEC Member Countries hold about 75 per cent and produce
40 per cent of the world total output, which stands at about 75 million barrels
per day.
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Chapter I: Introduction
Chapter 1: Introduction
As global competition drives corporations into distant, unfamiliar markets,
managers are searching for ways to minimise the uncertainty they have to cope
with. In order to analyse the types of risk most common at present, how foreign
investors manage political risk and how political risk affects their work, the
author takes the case of the three largest oil companies in the world (Exxon
Mobile, Royal Dutch Shell and British Petroleum) which have diversified
interests around the world and at the same time which conduct business in
Russia. This chapter gives the reader the authors reasons for choosing this
topic and states research questions.
Why Political Risk? First, firms operating internationally often have to deal
with dramatic changes in the political, economic and business environments of
host countries. Governments can intervene in the operations of foreign-owned
firms by restricting ownership and control, regulating financial flows and the
employment of foreign management. More radical measures would be
nationalisation, expropriation, or confiscation of assets. Furthermore, civil
disorders, rebellions and revolutions can seriously offset the benefits of
internationalisation. Thus evaluation of political risk and minimising its
exposure can be an important issue for firms operating abroad (De Mortanges
& Allers, 1996). Moreover, besides being subject to political risk, it is also
quite possible that companies miss opportunities because they perceive more
political risk than actually exists.
Second, political risk exists in different forms in all countries and every
investor estimates its presence/degree. However the level is higher in
developing countries than in those which are developed.
Third, international relations more and more influence international business.
Nowadays, trade, political or military sanctions of one government against
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Chapter I: Introduction
another one can affect the investors decisions and companies growth
strategies.
There are two recent examples of how political risk and relations among
nations affect MNEs business. After September 11, 2001 the U.S. worked hard
to get Pakistan into its anti-terrorist alliance. British Petroleum (BP), which
extracts 60,000 barrels of oil a day in Pakistan, has withdrawn all its overseas
executives from this country. At the same time, Britains Premier Oil, a small
exploration company, announced it was expanding its modest presence in
Pakistan through a US$ 105 million joint venture with a Kuwaiti partner
(Tomlinson, 2001a).
Another example is French oil giant TotalFinaElf. Since 1995, Total has
pursued an aggressive strategy of expanding in the Middle East (mainly in
Libya and Iran), where almost a quarter of the company's oil and gas
production is located. Their exploration and production division accounted for
about seventy per cent of the group's operating income in the year 2000.
Considering that, Total got into an extremely sensitive position following the
attacks against America on September 11 and the vow by the U.S. and its allies
to target nations that harbour or sponsor terrorists. (Tomlinson, 2001b)
To conduct quality research on Political Risk, it is necessary to focus on the
specific sector. According to Shapiro (1981) susceptibility to political risk
depends on the industry, where companies work, size of company, composition
of ownership, level of technology and degree of vertical integration with other
affiliates. Taking into account that, the sample of private oil companies is
chosen.
Why oil? The world lives on oil. It is probably the most important commodity
in the world. Oil is the foundation for the plastics and petrochemical industries.
Oil is fundamental to the welfare of the industrialised world and it is a major
component of the farming industry.
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Chapter I: Introduction
In the last twenty years most of the discoveries of oil and gas reserves were
made in third world countries, so it has to be explored there. The majority of
these countries are unfortunately extremely uncertain places. Finally, the
exploration of oil and gas is a business which needs huge investments, so the
losses can be very high. Thus risk assertion and management must be very
thorough.
Why companies with interests in Russia? Russia is still an emerging market
and political risk is still quite high in the Russian business environment. This
fact badly impacts the level of needed FDI there.
Moreover, Russia is a unique example due to its history. Beginning in the
nineteenth century the fortunes of Russian oil had a significant impact, when
the development of an oil industry in Azerbaijan (part of Russian Empire)
around Baku broke the Rockfellers Standard Oil monopoly. Furthermore,
Russia is the place where oil companies experienced the first political
interruption caused by the revolution of 1905. Later, the Bolsheviks export
campaign in the 1920s brought about the global price war that led to the
meeting at Achnacarry Castle in Scotland in 1928 and the As-Is agreement.
In the late 1950s the Soviets drive for market share stimulated price-cutting,
and gave a birth to OPEC on September 14th, 1960 (Yergin, 1991).
The Russian Federation possesses abundant deposits of natural resources
including large stocks of fuel minerals. Historically, the country has been one
of the major producers of oil and gas, providing a significant share of the
supply to the worlds markets. The Former Soviet Union (FSU) used to be the
worlds largest oil and gas producer, with output in 1989 more than double that
of Saudi Arabia, and it was the second largest exporter after Saudi Arabia
(Yergin, 1991). Russia is about to do it again.
The Russian oil and gas industry desperately needs foreign investment,
experience and technology to develop its oil reserves, especially offshore ones.
In spite of the increases in output achieved in the last 3-5 years, without FDI,
making further progress seems to be unachievable goal.
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Chapter I: Introduction
The Russian budget is heavily dependent on export revenues. Oil/gas and
metals have 54 per cent and 17 per cent respectively in the Russian export
profile (Gostomstat, 2002). Thus, the raw material exploration industry is a key
sector in the Russian economy.
Risks differ from one country to another, so the strategy of a company
operating in Chad would be somewhat different to a company doing business
in Colombia. In order to compare how companies handle identical types of
risk, it is necessary to look at their operations in the same environments. Exxon
Mobile, Royal Dutch Shell and BP are all involved in business in Russia.
Moreover, all of them have interests in the same region of Russia, on Sakhalin
Island. This suggests that Russia is a good case study for examining the
behaviour of multinationals.
The research questions of this dissertation are as follows:
1. What kinds of political risk are most common at present?
2. How do firms deal with political risk?
3. Why do firms enter a region with high risk and uncertainty?
4. Do companies investment strategies in Russia differ to other countries
and each others?
In order to eliminate the general by focusing on the particular, a case study
approach will be implemented, since the author does not have the choice of a
great deal of suitable cases to include in the investigation. The following
strategy will be followed: chapter two will examine the academic literature
related to political risk matters. Chapter three will introduce the reasons for
choosing the case study approach as a research strategy and its limitations.
Chapter four will give background information on the worlds oil industry,
companies profiles, the oil sector of Russian economy and issues related to it.
Chapter five will deal with case studies. Chapters six and seven will be
dedicated to findings and conclusions with future research direction.
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Chapter 2: Literature Review
Chapter 2: Literature Review
The following chapter outlines the concept of political risk as a part of
internationalisation. The literature included in this section contributed to the
authors understanding of the research issues.
Due the vast range of academic literature regarding the chosen topic, the author
found it appropriate to concentrate on the following strands as the most
important and relevant in regard to dealing with political risk in the context of
the internationalisation process: (Section 1) Theory of Internationalisation,
which examines (1.1) FDI, (1.2) Joint Ventures and (1.3) FDI in Oil Industry;
(Section 2) Uncertainty and Risk; (Section 3) Political Risks looks into (3.1)
Macro Political Risks, (3.2.) Micro Political Risks and strategies of (3.3)
Managing/Minimising Political Risks. The final section (4) is dedicated to
Risk/Return Trade-off.
Section 1: Theory of Internationalisation
The pioneers of the international trade theory are Adam Smith with a theory of
absolute advantage (1776) and Ricardo with a theory of comparative advantage
(1817). These theories state that countries gain, if each devotes resources and
capabilities to the production of goods and services in which it has an
advantage.
However, since these works were written, the world has changed dramatically.
Now international business is not only about trade, but also more and more
about acquiring and placing value creating capabilities and diversifying risks
around the world. The increase in international business activity is mainly due
to: (1) an increase and expansion of technology, (2) a liberalisation of
government policies on cross- border trade, (3) the creation of institutions to
facilitate international trade and (4) the increase in global competition.
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Chapter 2: Literature Review
The International Business channels are: (1) Export & Import; (2) tourism,
transportation, services (consulting, banking etc.); (3) licensing, franchising;
(4) turnkey operations; (5) management contracts; (6) MNE / TNC; (7)
Collaborative agreements; (8) Indirect Foreign Investments (Portfolio
Investment) and (9) Foreign Direct Investment (FDI).
Truitt (1974) points out the difference between indirect foreign investments and
direct foreign investment. Indirect (portfolio) foreign investment is the
purchase and ownership of foreign stock and bonds for the purpose of dividend
as interest payment on return of investment. But in reality, relations among
parent companies and host government can become more involved in business
than in just getting bonuses and thus it is less easily differentiated from direct
foreign investment.
Section 1.1 FDI
Investment implies the acquisition of rights to future income. Alternatively,
transactions that procure such rights may be regarded as forms of investment
(Oman, 1984). Foreign direct investment (Truitt, 1974) can in general be
defined as the acquisition of specific productive capacities abroad, with
entrepreneurial, managerial and technical skills applied to these foreign assets.
The assets may be wholly owned or a part of a joint venture relationship.
According to commonly accepted definitions, any investment worth more than
10 per cent of the total equity of the host organisation counts as direct
investment (Dyker, 2001).
The major part of the literature on FDI relates to the idea of transaction costs.
Simply, this notes that companies involved in so-called oligopolistic
industries which are characterised by technological and financial advantages
produce abroad rather than export or license their technologies. Vernon (1966)
highlighted the importance of location in the theory of FDI in his analysis of
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Chapter 2: Literature Review
the product life cycle and the potential for the firm to exploit a foreign market.
These ideas were summarised by Dunning (2000) (see Appendix I). In
accordance with Dunning (2000) firms invest abroad because they possess
ownership advantages, location factors and internalisation factors (O-L-I),
which may be described as follows:
(O) Ownership advantages: economies of scale, other technological
advantages, or management skills. These ensure or enable the firm to
recover the costs of investing in different assets abroad.
(L) Location factors: these contribute to the decision to employ
ownership advantages to produce abroad (e.g. risks or barriers in export
markets or availability of low cost labour or natural resources)
(I) Internalisation factors: foreign production occurs within the firm
an internal market is created between parent and affiliates to control key
sources of competitiveness or to reduce the risk that the firm might lose
control of knowledge or technology (which would happen through
licensing).
Dunning (1977) proposed three potential advantages of FDI over export-import
strategies. First, MNE should have an advantage derived from ownership of
intangible assets such as brand management, trade secrets, technology, or tacit
management capability, which confers a market or cost advantage. Second,
FDI should give the advantage of being located in the host country resulting in
tariff avoidance, transport cost reduction, low factor prices, or proximity to
customers. Third, the MNE should benefit from internationalising and more
fully controlling its foreign business through FDI; from more fully controlling
its foreign business through FDI to more fully appropriating the profits or rents
generated by its unique assets or capabilities.
Dunning (2000) also insists that OLI theory is applicable to home country and
host country FDI. The country-specific determinant of ownership and
internalisation advantages, and the country specific determinants of location
advantages of the host country, explain that FDI has roots in one country
(because the home country possesses ownership and internalisation
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Chapter 2: Literature Review
advantages), and locates in another (host) country, as the host country
possesses location advantages. The importance of FDI lies in both MNEs and
the foreign host country.
Vernon (1966), in his product life cycle theory, examined the trend for the
production of goods to be concentrated in the developed countries early in the
life of the product, but to move to other developing economies later on. Welch
and Luostarinen (1988) state that there is evidence, that as companies increase
their level of international involvement, there is a tendency for them to change
the method/s by which they serve the foreign markets. There are additional
changes to the shape of companies and the way they conduct business.
1) Operational methods (How?) grow with the increasing commitment of the
investor to FDI (no exporting exporting via agent sales subsidiary
production subsidiary). The future international success of companies will
depend on their ability to master and apply a range of methods of foreign
operations.
2) Sales objects (What?) also progress as companies increase its involvement
in international operations. There is a tendency to offer foreign markets a
mean to deepen and diversify (e.g. expansion within an existing product
line or into new line, or a change to the whole product concept.). The
offering to foreign markets usually begins from the simplest form: goods
and mature further- services systems know-how.
3) Target markets (where?). Companies expanding more distant operations
typically over time in political, economic and physical terms.
Welch and Luostarinen (1988) also noticed the changes in companies
personnel policies, organisational structure and finances with increasing
commitment to internationalisation.
Section 1.2 Joint Ventures
A joint venture (JV) normally applies the sharing of assets, risks/profits and
participation in the ownership (i.e. equity) of a particular enterprise or
investment project by more than one firm or economic group (private
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Chapter 2: Literature Review
corporation, public corporation or even states). The distribution of equity
shares in a joint venture may be determined according to each partners
financial contribution, or it may be based on other forms of capital
contribution, such as technology, management, access to the world markets,
licenses etc.
Daniels & Radebaugh (2001) review the combination of partners, which may
exist in a joint venture:
Two companies from the same country join together in a foreign market
(e.g. Exxon and Mobile in Russia).
A foreign company joining with a local company.
Companies from two or more companies establishing a joint venture in
a third country.
A private company and a local government forming a joint venture
(sometimes called a mixed venture) (e.g. Philips (Dutch) with the
Indonesian Government).
A private company joining a government owned company e.g. BP
Amoco (private UK-US) and Eni (Italian government owned) in Egypt.
Czinkota et alli (2000) argue that: The key to joint venture is the sharing of a
common business objective, which makes the arrangement more than
customer-vendor relationship, but less than outright acquisition. Madura
(2000) states that most joint ventures allow business partners to apply their
respective competitive advantages in a given project. The benefits of the joint
venture as a form of FDI are (Czinkota et alii 2000):
JVs are valuable when pooling of resources results in a better outcome
for each partner than if eachone conducts activities individually.
JVs often permit a better relationship with local government and other
organisations such as labour unions.
JVs allow minimising the risk of exposing long-term investment
capital, while at the same time maximising the leverage on the capital
invested.
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Chapter 2: Literature Review
Typical problems with JVs are as follows: (1) difficulty with selecting a partner
in a host country (Liu & Bjornson, 1998); (2) Different objectives of foreign
partners, which cause disagreements among partners about business decisions
e.g. strategy, accounting and control, marketing policies, management style,
etc. Liu & Bjornson (1998) state that in principle, MNEs seek to maximise
their firm value, consistent with economic efficiency, while local partners may
seek to maximise short-term profit, sometimes at the expense of product
quality or reputation. Other flaws of JVs are:(3) leakage of know-how from
one partner to another and (4) lack of control for investor over joint venture
Section 1.3 FDI in Oil Industry
In the context of a complex and dynamic world, specific companies or groups
of companies in specific countries or regions develop specific capabilities
(Dyker, 2001). Dyker (2001) states that specific FDI decisions are based on the
perception and scope for internalisation, not only of firm-specific advantages,
but also of location-specific advantages. It is not enough for the investing firm
to have something special to offer, but also the host country has to have
something special as well. Since in the context of FDI the investing firm by
definition provides the capital, with attention focusing on the other two main
factors of production, labour and land (including natural resources), FDI in the
developing countries is mainly cheap-labour-seeking and/or land/natural-
resource-seeking.
Furthermore, as products and their marketing become more complicated,
companies need to combine resources that are located in more than one
country. This fact makes business more complex and the companies need a
tight relationship to ensure that production and marketing continue to flow.
One way to help ensure this flow is to gain a voice in the management of one
or more of the foreign operations by investing in it. Vertical integration is a
companys control of the value chain in making its product from raw materials
through production to its final destination. Daniels & Radebaugh (2001) state
that most of the worlds direct investments in the oil industry may be explained
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Chapter 2: Literature Review
by the concept of international vertical integration, as much of the petroleum
supply is located in countries other than those with a heavy demand.
In order to exploit potential sources of competitive advantage gained from FDI,
firms must be able to identify and manage risk in individual foreign markets
(Kashlak, 1998). To examine possible threats the author turns next to
uncertainty and risks.
Section 2: Uncertainty and Risk
The difference between uncertainty and risk is difficult to recognise.
Haendel (1975) argues that some authors have defined risk as uncertainty
concerning possible outcome, so the distinction between risk and uncertainty
would have become a distinction between objective and subjective risk. Risk is
an objective doubt concerning the outcome in a given situation (Haendel,
1975). Uncertainty can be defined as subjective doubt concerning the outcome
during a given period.
More broadly, uncertainty is measured by degree of belief while, risk is a
combination of hazards and is measured by probability. Uncertainty is a state
of mind; risk is a state of the world. Uncertainty imposes cost on society and its
removal constitutes a potential source of gain. Risk is usually associated with
degree of loss (Haendel, 1975).
Country risks can be divided into economic risk, commercial risk, and political
risk.
Economic risk is risk related to the macroeconomic development of the
country, such as the development in interest and exchange rates that
may influence the profitability of an investment.
Commercial risk is risk related to the specific investment, such as the
risk related to the fulfilment of contracts with private companies and
local partners.
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Chapter 2: Literature Review
The third category, political risk, may in many countries be the most
important one. A country is a political entity, with country-specific rules
and regulations applying to the investment.
The next subsection is dedicated to political risk. For perspective within the
overall context of political risk, various definitions of political risk and
summary of empirical efforts to predict political risk will be given. Ways of
managing different types of risks in terms of reducing its exposure will be
examined.
Section 3: Political Risk
There seems to be considerable confusion among authors concerning what
constitutes a political risk event, which has changed over time and still there
is no consensus over this matter. Each author has avoided in some measure the
difficult task of defining precisely what is meant by and what trends are
covered by the term political risk. One of the pioneers in the risk analysis,
Root (1968) focuses on the sources of the international managers judgements
about future political conditions and events in a host country: Political
uncertainty for an international manager refers to the possible occurrence of
political events of any kind (such as war, revolution, expropriation, taxation,
devaluation, exchange control, and import restrictions) at home or abroad, that
would cause a loss or profit potential and/or assets in international business
operations... When the international manager makes a probability judgement of
an uncertainty into political risk (Root, 1968).
Jodice (1980) defined political risk as: Changes in operating conditions of
foreign enterprises that arise out of political process, either directly through
war, insurrection, or political violence or through changes in government
policies that affect the ownership and behaviour of the firm. Political risk can
be conceptualised as events, or a series of events, in the national and
international environments that can affect the physical assets, personnel and
operation of foreign firms.
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Chapter 2: Literature Review
De la Torre & Nectar (1986) define political risk as the probability distribution
that a real potential loss will occur due to the exposure of foreign affiliates to a
set of contingencies that range from the total seizure of corporation assets
without compensation to the unprovoked interference of external agents, with
or without governmental sanction, with the normal operations and performance
expected from affiliates.
Gilligan (1987) maintains, political risk could be defined as the likelihood that
political forces can cause drastic changes in a countrys business environment
in turn affecting the profit and other goals of a business enterprise. It can be
seen to stem from a countrys economic, political and social environments, all
of which are capable of changing dramatically in a short time, particularly in
the traditionally volatile parts of the world.
Czinkota et alli (2000) give a shorter definition: Political risk- the risk of loss
assets, earning power or managing control as a result of political actions by the
host country. The working definition of this dissertation is The political risk
faced by foreign investors is defined as the risk or probability of occurrence of
some event(s) that will change the prospects for profitability of a given
investment in a home or host country.
Politics and the laws of a host country affect international business operations
in a variety of ways. The political risks can be distinguished between (De la
Torre & Nectar, 1986) 1) the real contingences faced by the firm operating in
the foreign country and 2) the sources of the risk.
There are two different contingencies of losses:
1) Macro risk- (the more dramatic one) the involuntarily loss of control
(generally meaning property rights) over specific assets location in
the foreign country, typically without adequate compensation (e.g.,
expropriation, domestication, civil war, terrorism).
2) Micro risk- (the more prevalent one) the loss in the expected value of
a foreign-controlled affiliate due to discriminatory actions taken
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Chapter 2: Literature Review
against it, either because of its foreign nature or as a general
tightening on free market rights often imposed by government in
times of domestic crisis.
The political risks can also be classified as Indirect Intervention (micro risk)
and Direct Intervention (macro risk).
Figure 2.1 Patterns of Political Intervention
Indirect Intervention Direct Intervention
I--------------------------------------------I-----------------------------------------------I
Price controls Domestication Expropriation of
Tax controls assets
Import controls
Labour restrictions
Exchange controls
Market controls
Source: Gilligan, 1987
Another measurement of the exposure to political risks concerns the proximate
cause. It can be differentiated:
a) The actions undertaken by legitimate governments in the exercise of their
national prerogatives, and
b) Those which are the result of actions outside the direct control of the local
government
The source of trouble could be also internal (e.g. political repression) or
external (e.g., dramatic fall in commodity export prices). These forces may
when activated, have very direct impacts depending, greatly, on the maturity
and capacity of national institutions.
The types of most common types of risk facing by foreign investors are
summarised in the Figure 2.2
Figure 2.2 Four types of risk
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Chapter 2: Literature Review
Loss contingencies:
An inventory loss of
control over specific
a s s e t s w i t h o u t
adequate
compensation
Type A:
Massive expropriations
Type B:
Selective
nationalisations
Value contingencies:
R e d u c t i o n i n t h e
expected value of the
benefits to be derived
f r o m t h e f o r e i g n
affiliate
Type C:
General deterioration of
the investment climate
Type D:
Restrictions targeted to
key sectors
Macro risks:
S u d d e n c o n v u l s i v e
chances that threaten most
of the population of
foreign direct investors
within the country.
Micro risks:
Interventions generally
motivated by specific
consideration closely
related to the economic
a n d t h e s o c i a l
conditions prevailing at
t h e t i m e , a n d t o
specific industry and
firm characteristic
Source: De la Torre & Nectar (1986)
Section 3.1 Macro Political Risks
Situations such as revolutions in Cuba and Iran produce what is known as
macro risk. In such situations, impacts on a firm are totally determined by
events in the external political environments, and organisational characteristics
such as industrial sector and technology become largely irrelevant. Macro
political risk is the chance that political events in a host country will affect all
foreign firms in a country, without regard to what they do or what industry they
are in. These effects occur simply because they are foreign. Under these
conditions, political events affect all firms in much the same way, and it is
reasonable to talk about the investment environment in a given country
(Kobrin, 1981). Root (1974) defines this type of risk as an ownership control
risk, which is linked to events influencing the owners' ability to control and
manage the investment.
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Chapter 2: Literature Review
The term of expropriation has been used loosely by practising international
businessmen, business journals, and the commercial press to cover a variety of
host government actions ranging from the sudden enforcement of previously
unenforced foreign controls to outright confiscation and physical take-over
(Truitt 1974).
According to Gilligan (1987), the expropriation of assets is the official seizure
of foreign property by a host country whose intention is to use the seized
property for public interest. It is typically seen as a far harsher and less fair
coarse of action, since in many cases the multinationals at best received only
partial compensation.
The concept of expropriation is generally narrower in scope than
nationalisation, but the two do not differ in their legal nature. While an
expropriation usually refers to a singular case of a state taking property, a
nationalisation usually entails a number of individual expropriations.
Expropriation, Truitt (1971) argues, is aimed at a particular company or
companies that are taken over by the host government, while nationalisation is
directed toward a general type of industry or a sector of economy.
Neither expropriation nor nationalisation (Truitt, 1974) is to be confused with
confiscation, which may: (1) Be the pejorative term for any expropriation; (2)
Describe the taking of property without prompt, adequate, and effective
compensation, or no compensation at all (De Mortanges & Allers, 1996); (3)
Describe government seizure of the property of war criminals, illegally
transported goods (such as narcotics or pornography), or property deteimental
to the national security.
Domestication is characterised by the gradual take-over of control and is
achieved most frequently by foreign government imposing certain conditions
on the multinationals and their methods of operation. Gilligan (1987) argues
that most the typical of these include:
The gradual transfer of ownership.
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Chapter 2: Literature Review
The insistence on an increasing number of goods being manufactured
locally rather than simply being imported for local assembly.
Nationals being given priority for promotions.
Nationals being given greater decision- making and veto powers.
Domestication is a less extreme and far more gradual strategy than outright
expropriation or nationalisation. According to Kobrin (1987), while these harsh
macro risks tend to attract considerable managerial attention; their number is
relatively limited.
Section 3.2 Micro Political Risks
Micro-political risk is the chance that political events in a host country will
affect only a specific firm or firms in a specific industry. Examples might be
constraints on petroleum firms that do not apply to foreign firms in other
industries, or constraints on a specific firm because it also does business in a
country unfriendly to the host country. Examples of the latter would be
constraints by Islamic countries against firms doing business in Israel.
Although whilst the macropolitical risk is more dramatic and obvious, micro-
political risks are manifested more frequently in a less obvious way, sustaining
over the long term is such as increased controls and restrictions upon operating
methods. Micro risks generally result from situations that do not involve
political conflict or even a change in regime, but rather a change in policy
(Kobrin, 1981) They represent attempts by host country governments to exert
control over their economies in order to attain national objectives.
Kobrin (1979) points out that, political environments can affect both the
security of assets and the viability of operations; possible contingencies may
include non-discriminatory measures.
Madura (2000) summarises the most common forms of micro political risks
which include:
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Chapter 2: Literature Review
Attitude of the consumers in the host country- a tendency of residents to
purchase only homemade goods (Gilligan, 1987).
Attitude of the host government- various actions of host government
which affect the cash flow. E.g., new pollution control standards, tax increases,
price controls, fund transfer restrictions; partial divestment of ownership, limits
on expatriate employment (Kobrin 1979, Gilligan, 1987).
Blockage of fund transfer- a blockage by host government of fund
transfers from subsidiaries of MNE to the headquarters, which could force
subsidiaries to undertake projects that are not optimal (Kobrin, 1979).
Currency inconvertibility- the home currency cannot be freely
exchanged into other currencies, thus, the earning generated by a subsidiary in
the host country cannot be remitted to the parent through currency conversion
(Gilligan, 1987).
Bureaucracy- this type of political risk can seriously complicate
MNEs business. E.g., Eastern Europe in the early nineties.
Corruption- can adversely affect an MNEs business in a host country,
because it can increase the cost of conducting business or reduce revenues.
Root (1972) lists examples of political risk situations, i.e. examples of events
affecting real investments. Root (1972) distinguishes three types of political
risk: transfer risk, operational risk and ownership control risk.
(1) Transfer risk, which is risk related to the transfer of products and services
across national borders, or the transfer of funds such as payments of
dividends.
(2) Operational risk is risk related to the operation and profitability of an
investment in the host country, such as the operation of an assembly plant.
Examples of operational risk are price controls and possible requirements
that the producer should use sub-standard or expensive local suppliers.
(3) Ownership Control Risk is a risk of losing control over asset and
investments in a foreign country.
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Chapter 2: Literature Review
Section 3.3 Managing/Minimising Political Risks
A direct consequence of the uncertain political environments in many parts of
the world is that there is now a greater need than ever for companies to
recognise that the political environment should no longer been seen as a totally
uncontrollable variable, but rather as a factor upon which effective strategic
management can impact (Gilligan, 1987). The MNEs cannot control political
risk much, but can instead manage its exposure through the structure and type
of investment.
The basic approach to the management of the extreme form of political risk,
such as expropriation, in accordance with Shapiro (1981), involves three steps:
1. Recognition of the existence of political risk and its likely consequences;
2. Developing policies in advance to cope with the possibility of political risk;
3. In the event of expropriation, developing measures to maximise
compensation.
Step1: Risk Recognition/Evaluation
Daniels & Radebaugh (2001) state: As managers evaluate countries as a
potential place to do business and as they struggle to succeed once they have
committed resources, they need to be aware of political risk. However, what
concern the international investor is not political events and processes per se,
but the management contingencies they may generate and the impact that any
externally induced shock may have value on its assets (Kobrin, 1981., De la
Torre & Nectar., 1986).
Kobrin (1981) stated, that compared to most types of economic or business
forecasting, political forecasting remains a very underdeveloped art. However
along with Gilligan (1987), If firms are to avoid or at least minimise the
consequences of risk, it is essential that truly effective techniques of political
risk assessment (PRA) and strategies of risk management be developed.
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Chapter 2: Literature Review
The term country risk analysis describes the activity of predicting future
conditions for the investment in a host country. Robock (1971) and Haendel
(1975) identify four steps in political risk analysis:
1) An understanding of the type of government presently in power, its patterns
of political behaviour and its norms of stability.
2) An analysis of the multinational enterprises own product or operations to
identify the kind of political risk likely to be involved in particular areas.
3) A determination of source of political risk.
4) To project into the future the possibility of political risk in term of
probability and time horizons.
Robock (1971) cited one international company that forecasts political risk via
two projections. One projection is the chance that a particular political group
will be in power during a specific forecast period. The second is of the type of
government interference that each political group can be expected to generate.
Step 1.1 Sources of Information (Internal and External)
A number of studies have concluded that firms rely primarily on internal
sources for information about external environments. The most important
sources of information are (Gilligan, 1987):
a) Managers of overseas subsidiaries are the most important resource of
information available to the international firms (as located around the
world, many of whom are host country nationals).
b) A subsidiarys managers are members of the local elite, and although
that often provides the advantage of direct access to top-level officials
of the current government, it may constrain contact with other
important groups, such as student leaders, labour unions and the
political opposition.
c) Regional managers
d) Managers in HQs with international responsibilities
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Chapter 2: Literature Review
The main flaw of using the internal sources for information is that subsidiary
and regional managers are strongly motivated and therefore tend to
underestimate the potential dangers of the country in which they work.
There are at least three external sources of information that the predictions may
be based on (1) written reports; (2) information deduced from financial
markets; and (3) summary measures like risk indices and ratings. Because it is
often difficult to quantify country risk, all three sources of information used
together are likely to provide the investment analyst with the best estimates.
Written reports usually contain descriptions of possible future developments in
a country. Such reports may be issued by private companies or international
organisations like OECD or the World Bank, the International Monetary Fund,
International Financial Statistics UN; U.S. Commerce Department. Figures
from national accounts may be presented in these reports, but in many cases the
analysis is primarily qualitative and in textual form. Written reports are useful
in providing background information, but may often be too general and give
little guidance to the numerical evaluation. The second source of information is
analyses of prices of assets traded in financial markets.
Moreover many consulting companies and investment banks provide country
and political risk advisory services enabling international investors to identify
and evaluate broad political macro and micro risks in a chosen region from
changes in government legislation and selective discrimination to the impact of
war and terrorism. For example, Deloitte & Touche assesses the likelihood of
more than 40 risks, including:
Currency inconvertibility and capital controls.
Political violence and civil disorder.
Industrial action.
Shareholder action.
Confiscation, expropriation and creeping expropriation.
Adverse tax changes.
Selective discrimination.
Contract frustration or repudiation.
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Chapter 2: Literature Review
Negative investment or trading environment.
Devaluation risk.
According to Mortanges & Allers (1996), while external environments rapidly
change, the data of governmental agencies and international organisations can
create a time lag, which can be crucial. The same can be said in regard to
consulting companies' reports as they are often based on the primary data
which is taken from the governments' resources.
Step 1.2 Techniques to Assess Political Risks
There are various techniques available for implementing country risk
assessment. Some of the most popular are:
Checklist Method - consists of several variables, related to international
cash flows (GNP Growth, GNP/Population, Inflation, Reserves/Imports etc.) or
the balance of payments approach- that are weighted according to their impact
on debt servicing ability, with the weight ranging from 0 to 100. Each variable
in the model is weighted or multiplied by a fixed weight, or coefficient, and the
results are aggregated from the index or composite score. The shortcomings of
this method are the somewhat discriminatory selection of the variables, and
often discriminatory assignment of weight to the variables.
Delphi Method - based on pulling a panel of experts for their estimates of
environmental risks and then aggregating and weighing their responses.
International managers often look to futurists for help in forecasting changes in
their internal and external organisational environments. Futurists use
techniques such as the Delphi method and scenario development to identify
possible futures, often consisting of events and trends, occurring both globally
and within a specific geographical region. The Business Environmental Risk
Index (BERI) and the Business International Index of Environmental Risk (BI)
are based on the Delphi method. Both the BI and BERI indices stress a
description of existing conditions in the host country and are strongly oriented
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Chapter 2: Literature Review
toward short term projections of less than a year, which make then hardly
useful for investors.
Scenarios. As Mortanges & Allers (1996) state, this approach consists of the
formulation of certain possible scenarios for a given country. E.g. the arrival in
power or maintenance in power of a leading political group, defined according
to their attitude towards foreign investment. The next step is to assess
probability of the given scenario coming into being.
Quantitative Analysis. Rather then rely on soft opinion measures (such as
the Delphi method) quantitative measures are based on hard data...
(Haendel, 1975). Quantitative methods are developed to reduce the bias of the
subjectivity of qualitative methods (Mortanges & Allers, 1996). Quantitative
analysis helps a risk analyst to identify characteristics that influence the level
of country risk after the financial and political variables have been measured
for a period of time.
Discriminate analysis is a statistical tool used for this purpose. The general idea
of this analysis is to identify the factors; to help to distinguish between
tolerable risk and intolerable risk countries by examining political and financial
factors of these countries.
Another type of quantitative model was developed by Schollhammer (1978),
uses measures of certain casual factors to forecast political change. He
suggested two types of casual factors: 1) political factors (quantitative
estimates of national riots, armed attacks, death from domestic violence,
government sanctions, defence expenditures and fractionalisation among
parties). 2) The economic factors (e.g. average expenditures, and available food
supply measured in terms of calories per capita) (De Mortanges & Allers,
1996).
The main limitation of these analyses is that they are based on historical data,
which are not always an accurate indicator of the future (Haendel, 1975). The
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Chapter 2: Literature Review
time lag effect of the governmental agencies and international bodies data
can also exist while using the quantitative model for assessing political risks.
Inspection Visits ("grand tours") - involve travelling to a country and
meeting with government officials, firms executives, and/or consumers. Such
meetings help clarify any uncertain opinions the firm has about the country.
The results of this kind of investigation can be very limited, containing only
selective information which does not take into account factors possibly
disastrous for the company (De Mortanges & Allers, 1996). However, when
properly organised, a team of executives can be very useful. Moreover, some
experience with the political environment is better than none. Mortanges &
Allers (1996) suggest supplementing this method with other less subjective
ones.
Company-specific Methods. Shell Oil Company developed the ASPRO-
SPAIR system (De Mortanges & Allers, 1996). ASPRO is short for
Assessment of Probabilities and SPAIR is short for Subjective Probabilities
Assigned to Investment Risk. This approach contains a model of the potential
impact of the political environment on a specific project. Expert analysts are
recruited from a variety of backgrounds to review a set of factors like civil
disorder, sudden expropriation, taxation restrictions, restriction on remittances,
and oil export restrictions. A major disadvantage of this method is that it is very
expensive and appropriate only for large MNEs.
Combination of Techniques. Since each technique has its own pros and
cons, its most appropriate to implement two or more of the techniques
described above (Madura, 2001). An integration of qualitative and quantitative
methods may be a more accurate way to forecast political risks.
There is no consensus as to how country risk can best be assessed. Madura
(2000) suggests dividing the risk evaluation into two steps: 1) the risk
assessment of a country as related to the MNEs type of business
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Chapter 2: Literature Review
(microassessment) and 2) an overall risk assessment of the country
(macroassesment).
Step 1.3 Industry Associated Risk/ Project Associated Risk
Not all events will have similar consequences for different projects. Truitt
(1974) points out that some types of investment are more politically exposed
and sensitive to the threat of expropriation than others. De Mortanges & Allers
(1996) state "the vulnerability and likelihood of an adverse political event
increase when moving from firms producing final goods to those using up
natural resources (e.g. oil) in the host country". The latter are subject to
nationalistic feelings.
Shapiro (1981) and De la Torre & Nectar (1986) declare that companies vary in
their defencelessness in the face of political risks, depending on:
1) Industry Factors (Shapiro, 1981., De la Torre & Nectar, 1986)- different
economic sectors experience different propensity to expropriation and
government intervention in general. Level of risk varies enormously from
one industry to another.
a) Activity/ Economic Sector - as stated by Truitt (1974) and backed up by
Kobrin (1981), De la Torre & Nectar (1986) the areas of highest risk are
perhaps the extractive industries and utilities, with developing countries
demonstrating a strong desire to increase their level of control over
natural resources and infrastructure.
b) Technology (De la Torre & Nectar, 1986) and particularly its level
(Shapiro 1981) - the higher the R&D intensity of the technological
complexity of the business, the less likely it is to be expropriated and
the higher the bargaining power of the foreign investor.
c) Product Differentiation (De la Torre & Nectar, 1986)-highly
differentiated goods require specialised inputs for their sale or service
which often cannot be provided by local firms. Differentiated goods
will be less subject to government intervention as they are more capable
of exercising their bargaining power.
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Chapter 2: Literature Review
d) Competition (De la Torre & Nectar, 1986) - the higher the level of
competition (and consequently, alternative sources of capital and
technology) the higher the probability of government intervention.
2) Corporate factors
a) Size (Shapiro, 1981) - with the smaller firm, the asset gain fails to out
weight the loss of confidence and hostile reaction amongst the worlds
financial community:
b) Nationality (De la Torre & Nectar, 1986)- the nationality of a foreign
investor is relevant to the risk factor, because it is subject to the quality
of the relations which the host country has or has had with the
investors home country.
c) Scope of Activities ( De la Torre & Nectar, 1986) and the Degree of
Vertical Integration with Other Affiliates (Shapiro, 1981) - the nature of
the companys activities and the geographic locations of its affiliates
may have a material influence on the level of risk (e.g. US firm does
business in Israel and Arabic countries)
d) Corporate Image (De la Torre & Nectar, 1986., Daniels & Radebaugh,
2001) - bribery scandals or a history of involvement in the financing of
political subversion can leave the company with a damaged reputation
for a long time.
e) Previous Losses (De la Torre & Nectar, 1986) - the relative bargaining
strength of the company can be assessed from those examples where it
avoided losses while most other firms did not.
3) Structural Factors
a) Contribution to the Local Economy (De la Torre & Nectar, 1986)- to
calculate the perceptible benefits to the local economy resulting from
the foreign firms involvement; the higher the benefits, the lower the
likelihood of government intervention.
b) Intra - corporate Transfers (De la Torre & Nectar, 1986)- the more
closely the affiliate or project is tied to the global network of the parent
company, the lower risk of an expropriation or interference.
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Chapter 2: Literature Review
c) Local Ownership (De la Torre & Nectar, 1986) or Composition of
Ownership (Shapiro, 1981) - the degree of the local ownership in the
foreign subsidiary is both the result of a bargaining process and a major
influence on the risk
d) Environmental Dissonance (De la Torre & Nectar, 1986) - the actual
location of the affiliate can have influence on the risk factor as it affects
the noticeable contribution to national development goals and it
exposes the firm to varying levels of population, ethnic, environmental,
unionisation or guerrilla risks.
4) Management Factors
a) Local Management (Shapiro, 1981., De la Torre & Nectar, 1986.,
Gilligan, 1987)- the use of local management to the largest extent
possible can help to reduce the risk exposure.
b) Corporate culture and Management Philosophy (De la Torre & Nectar,
1986) - the more complex and diversified the operations of the parent
company, the more likely it is that it will have to rely on the judgement
and skills of a managers with international experience, which helps to
reduce political risk explosure.
c) Political Responsiveness (De la Torre & Nectar, 1986). An activist
political role on the part of local management reduces risk. If an MNE
plays an active role in the host country is political life, it can lead to a
better relationship over the long term.
d) Financial Policies (Shapiro, 1981., De la Torre & Nectar, 1986) - the
excessive use of local sources of finance may greatly reduce the risks of
a host government is intervention.
As stated by Truitt (1974), Kobrin (1981) and backed up by De la Torre &
Nectar (1986) the areas of highest risk, traditionally the areas of foreign
investment, which are most vulnerable to expropriation, are natural resource
investments and public utilities. The developing countries demonstrated a
strong desire to increase their level of control over them. Investments in
extractive, export oriented industries and public utilities combine a peculiar set
of characteristics that make them vulnerable:
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Chapter 2: Literature Review
1) remote location, lack of general social responsibility on the part of the
developer, the instability of export prices (that is fluctuating foreign
exchange receipts for the host;
2) a large investment in exploration;
3) the exploitation of irreplaceable natural resources, which has political
significance and general visibility. Some of the largest and most spectacular
expropriations- Mexican Oil, Iranian Oil, and South American power and
communications- have involved natural resources and public utilities.
Step 1.4 Country Associated Risk
There are political risks in every country, however the level and ranges differ
broadly from one nation to another. De la Torre & Nectar (1986) identifies a
total of 22 variables or composite factors that must be monitored on an ongoing
basis, estimates of possible events, their probability of occurrence and the
expected timetable in order to succeed in assessing the countrys associated
risk:
Economic Factors- Internal
a) Population and Income - historical trends in the size of the countrys
population, its economic growth and per capita income provide an
approximation of the national welfare. When viewed against the recent
past, public proclamation about expected growth rates indicate the
potential disparity between the countrys aspirations and its capacity to
provide for its future
b) Workforce and Employment- the size and composition of the countrys
workforce, its sectoral and geographic distribution, its productivity.
Social instability and political risks, especially in developing countries
can result from the polarisation of the population into urban and rural
camps with different problems and priorities.
c) Sectoral Analysis- strengths and diversity of the agricultural sector,
importance of the industrial sector; who controls strategically important
sectors.
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Chapter 2: Literature Review
d) Economic Geography (natural resources)- the more dependent the
economy is on a single source of wealth, the less stable it is.
e) Governmental and Social Services- Are the basic needs (e.g., health
services, education, economic infrastructure, defence, etc.) adequately
covered? If revenues are highly volatile while expenditures consist of
inflexible social programs, any disorder to the revenue stream could
have rigorous political consequences.
f) General Indicators (e.g., price indices, wage rates, interest rates levels,
money supply, etc.)- the objective is not economic analysis per se, but a
search for indicators of trouble.
2) Economic Factors - External
The following set of questions serves to determine to what extent external
limits will determine domestic economic policy. A high degree of dependency
and instability, together with external debt servicing problems, will boost the
risk of host-government-interference with foreign investors in the country, both
in term of expropriation (macro risks) and convertibility (micro risks).
a) Foreign Trade - countrys current account balance and its
composition; price volatility of imports and exports; competitive
conditions; trade in services etc.
b) Foreign Investments - the size and importance of the foreign
sector, its distributions by sectors of industry, its spread by
country of origin.
c) External Debt and Servicing - the level of outstanding foreign debt
relative to GNP and export earnings; its maturity profile; the level
of debt service relative to national income and exports.
d) Overall Balance of Payments- the capital account, level and
changes in a countrys reserves; its liquidity situation.
e) General Indicators- the official and unofficial exchange rates,
their movements over time; the spread and terms which national
borrowers can obtain in international capital markets.
3) Socio-political Factors - Internal
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Chapter 2: Literature Review
a) Composition of Population - ethnolinguistic groups, religious
persuasion, or tribal and class components, their political activism and
the distribution of wealth and power among them.
b) Culture- an analysis of the underlying cultural values and beliefs of the
host society might hold the essential to insight, not so much of potential
instability, but of the probability that foreign influences (e.g., the local
affiliates of MNE) will be the first to suffer the consequences of any
potential disruption to the established regime.
c) Government and Institutions - comprehension of how the host country
system of government and its socio-political institutions work, or are
meant to work, is a key point in the analysis. To establish the principal
features of the constitutional order, the relative functions of the head of
the state, the government (prime minister, cabinet officers, agency
directors and other appointment officers), the legislative bodies and the
legal system, and the nature and structure of bodies, such as the law
enforcement agencies, the armed forces and the political parties and
similar organisations.
d) Power - who are the key decision-makers; their background and
education; their attitudes to critical issues and their relationship to each
other. What is the role of the internal security apparatus? What is the
influence of pressure groups such as trade organisations, labour unions,
army and mafia?
e) Opposition - the problem with assessing the strength of opposition
groups, their sources of support and effectiveness is the access reliable
and balanced information.
f) General Indicators - the level and frequency of strikes, riots or terrorist
acts, the number and treatment of political prisoners, and the extent of
corruption among local authorities.
4) Socio-political Factors - External
a) Alignments - to establish the countrys international position, its
principal political allies, its public position on global issues (e.g., global
terrorism, the Middle East, etc.) and its mutual dependencies. In this
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Chapter 2: Literature Review
context the examination of the United Nations and World Bank Data
may be useful.
b) Financial Support - this includes direct sources of economic support,
such as provision of financial aid, food and military assistance, in
addition to cases of de facto support by important economic and trade
connections.
c) Regional Ties - Border disputes, external military threats, the possibility
of the spill- over effect of nearby rebellious actions, etc. Can have a
profound impact on the domestic composure of government priorities.
d) Attitude Towards Foreign Capital and Investment - many of the rating
services (e.g., the United Nations and World Bank) maintain up-to-date
records of foreign investment flaws and decisions by local authorities,
courts and local chambers of commerce. They also conduct, on a
regular basis, polls on local attitudes toward foreign investors. This
information can be valuable in assessing trends when examining the
country.
e) General Indicators - human rights records as published by international
organisations such as Amnesty International, the existence of formal
and active opposition groups in exile, signs of diplomatic stress
between home and host country, and terrorists acts committed in third
countries etc.
For international firms, however the bottom line is not a comparison of
countries, but rather of investments; of risk and return. In pursuit of high
investment returns, MNEs assume political risk that cannot be accurately
measured but which can be managed (Liu & Bjornson, 1998).
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Chapter 2: Literature Review
Step 2: Developing Pre-investing Planning/ Crisis Planning
Shapiro (1981) points out that, given the recognition of political risk, an MNE
has at least four separate, though not necessarily mutually exclusive, policies
that it can follow:
1) Avoidance (Root, 1968., Haendel, 1975., Shapiro, 1981)- the easiest way
to manage political risks. However because all governments make decisions
which influence the profitability of business, all investments face some
degree of political risk. Therefore risk avoidance is impossible.
2) Insurance (Haendel, 1975., Shapiro, 1981., Madura, 2000) -is an
alternative to risk avoidance. Some governments provide their investors with
insurance programmes or investment guarantee programm, which cover the
risk of inconvertibility of assets, expropriation and war, revolution or
insurrection. For instance, the US government provides insurance through the
Overseas Private Investment Corporation (OPIC), which covers the risk of
expropriation. The US government insurance premiums paid by a firm
depend on the degree of insurance coverage and risk associated with the firm.
Another example is the Japanese government through the offices of the
Ministry of International Trade and Industry (MITI) which insures investing
companies against losses associated with commercial and political risks.
The World Bank has an affiliate called the Multilateral Investment Guarantee
Agency (MIGA) to provide the insurance against political risk for MNEs with
FDIs in less developed countries. MIGAs insurance covers expropriation,
breach of contract, currency inconvertibility, war, and civil disturbances.
Some host governments in order to encourage more FDIs provide their own
insurance programmes. Russia in 1993 established an insurance fund to
protect MNEs against various forms of country risks (Madura, 2000).
3) Negotiating the environment- defining the rights and responsibilities of
both parties, an investor and a host government prior to undertaking
investment. However, when the host government, changes then concession
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Chapter 2: Literature Review
agreements can become resented or unpopular, and may sometimes even
increase political risk (Liu & Bjornson, 1998).
4) Structuring the investment- structuring the investment is a more active
policy of political risk management than previous three. The firm can try to
minimise its exposure to political risk by adjusting (a) its operating policies in
the areas of production, logistics, export, and technology transfer and (2) its
financial policies by borrowing local funds (Madura, 2000)
The key element of the structuring investments strategy is to keep an
affiliate dependent on sister companies for markets and suppliers, one such
strategy is vertical integration (Shapiro, 1981., De la Torre & Nectar, 1986.,
Liu & Bjornson, 1998). Another element is to concentrate R&D facilities and
proprietary technology, or important components thereof, in the home country.
Furthermore, it is possible to establish a global trademark that cannot be legally
duplicated by a host government. Moreover, control of transportation
(shipping, pipelines and railroads) and sourcing production in multiple plants
reduces the governments ability to hurt the MNEs single plant and thereby
changes the balance of power between government and MNE. Finally,
developing external financial stakeholders by raising capital for a venture from
the host and other governments, international institutions and customers can
reduce risks dramatically.
After recognising the possibility of a change in government policy, the firm
must assess its consequences in the context of its investment. Political risks can
be incorporated in several ways, including:
a) Shortening payback period (Shapiro, 1981)- The MNE can maximise cash
generation for the short term.
b) Rising the Discount Rate (Shapiro, 1981., Madura, 2000)- If the perceived
risk is high in the host country, the investor can charge the high discount rate to
adjust project cash flaws. However there is no precise formula for adjusting the
discount rite to corporate country risk.
c) Adjustment of Estimated Cash Flows (Shapiro, 1981., Madura, 2000)- The
idea is to estimate how cash flows would be affected by each form of risk. E.g.
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Chapter 2: Literature Review
if there is a 20 per cent probability that the host government will temporary
block funds from the subsidiary to the parent, the MNE should estimate the
projects present value under these circumstances, realising that there is 20 pre
cent chance that this will occur.
Step 3: Post-investment Policies/ Crisis Management
Shapiro (1981) states that once the multinational has invested in a project, its
ability to influence its susceptibility to political risks is greatly diminished but
not ended. He points out five different policies that the MNE can pursue.
1) Planned Divestiture (Shapiro, 1981)- MNE can phase out their ownership
over a fixed time period by selling all or a majority of their equity interest to
local investors. The disadvantages of this policy are: a) a difficulty to satisfying
all parties involved: an investor and a host government; b) if the buy out price
had been set out in advance and the investments were unprofitable, the host
government would probably not honour the purchase the commitment; c)
legislation in certain countries requires local ownership.
2) Short Term Profit Maximisation (Root, 1968., Robock, 1971., Shapiro,
1981)- is an attempt to make maximum profit from the local operation in a
short run by deferring maintenance expenditures, cutting investment to the
minimum necessary to sustain the desired level of production, limiting
marketing expenditures, producing lower quality merchandise. A disadvantage
of this strategy is that it can create a negative attitude in the present and the
future government towards an investor with all its resultant circumstances. An
alternative form of divestiture is to pursue a passive strategy, to do nothing and
believe that the local regime has chosen not to expropriate in case of losing
necessary foreign investments.
3) Adaptation (Root, 1971., Shapiro, 1981) is more a radical approach to
political risk management. This policy entails adapting to potential
expropriation inevitability and trying to earn profits on the firms resources by
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Chapter 2: Literature Review
entering into licensing and management agreements. From the economic
perspective, legal ownership of property is essentially irrelevant, but what
really matters is the ability to generate cash flows from that property. Through
contractual arrangements, continuing value can be received from a confiscated
enterprise in at least three ways (Shapiro, 1981): a) handling exports as in the
past but under commission arrangements; b) providing technical and
management skills under a management contract; c) selling raw materials and
components to the foreign state.
These first three approaches relate less to managing the exposure to FDI for the
long term. The forth and fifth approaches relate to how the MNE makes its
investment and generates benefit streams for the host country.
4) Change the Benefit/ Cost Ratio (Shapiro, 1981) is a more active political
risk management strategy. The general idea of this policy is to increase the
benefits to government of not nationalising a firm affiliate and to increase the
costs if it does. In other words, to raising the cost of expropriation by
increasing the negative sanctions would involve control over export markets,
transportation, technology, trademarks and brand names, and components
manufactured in other countries.
5) Developing Local Stakeholders/ Joint Ventures (Root, 1971., Shapiro,
1981) is the strategy of developing local individuals and groups who have a
stake in the business while it continues existence as a unit of the parent
multinational. Potential stakeholders include consumers, suppliers, the
subsidiaries local employees, local bankers, and joint venture partners. This
strategy can substantially increase bargaining power over the government (De
la Torre & Nectar, 1986).
Section 4: Risk/Return Trade-off
Ironically, it is the case that many multinationals recognise that some of the
areas offering the greatest opportunities for growth and development, are also
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Chapter 2: Literature Review
those areas in which the level of political risks are likely to be the highest
(Gilligan, 1987).
It is known that the expected returns from the emerging markets can be
impressive and these markets can be a highly risky and volatile (Harvey,
1994a). The return axis may be measured by potential return on assets or return
on equity. The risk may be measured by potential fluctuations in the returns
generated by each project (Madura, 2000). The term efficient project refers
to a minimum risk for a given return.
MNE can achieve more desirable risk- return characteristics form their project
portfolios if they sufficiently diversify among products and markets. For
instance by combining project A with several other projects, the MNE may
decrease its expected return. On the other hand, risks could be also reduced
greatly. Project portfolios outperform the individual projects because of
diversification of risks.
Conclusion
This chapter has had an objective to introduce the reader to the Political risk
related literature. Section one has been dedicated to the Theory of
Internationalisation. Foreign Direct Investments, as one of the alternative ways of
expansion into distant markets, has been reviewed. The benefits and flaws of Joint
Ventures have been discussed. The uniqueness of FDIs in the Oil Industry has been
stated.
Section two has debated the difference in terms between uncertainty and risk.
Section three has dealt with Political Risks. The types of political risk have been
introduced. Ways of minimising political risk exposure (risk recognition /
evaluation, development pre-investment and post-investment policies) have been
analysed. The final section of the chapter has given a brief overview of trade-off
between risk and return.
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Chapter 2: Literature Review
From the analysis of International Trade theories, FDI theories and Joint
Ventures as a form of FDI, it is possible to conclude that there are many
reasons and advantages for companies in internationalisation. However, the
risks can seriously offset these benefits. International managers need to identify
and assess the risk they face on the way to internationalisation. Compared to
most types of economic or business forecasting, political forecasting remains a
very underdeveloped art; In spite of that fact there is a possibility to develop
and implement strategies, which allow the company to reduce the likelihood of
losses or at least lessen its amounts. Investors with projects positioned around
the world have to be concerned with the risk - return characteristics of the
project (Madura, 2000).
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Chapter 3: Research Methodology
Chapter 3: Research Methodology
This chapter will outline the research methodology adopted for the purpose of
carrying out the dissertation. It is the authors intention to make it clear to the
reader how the data was collected and analysed. The research approach taken
was that of multiple case studies. These case studies are related to three
companies: Exxon Mobile (Exxon), Royal Dutch Shell (Shell) and British
Petroleum (BP). The objective of this chapter is to detail the research
methodology employed in this study and to give its limitations.
Section 1: Introduction in the Case Study Approach
With the purpose of this study, to attempt to understand the nature of political
risks in international investment environment and how firms deal with different
forms external threats, it was necessary to examine contemporary events and to
collect qualitative information. The research questions involve specific
objectives in examining complex issues of the relationship between foreign
company and business environments in a host county, and also in exploring the
perceptions and attitudes of managers to evaluating and minimising the
political risk exposure to their companies. In this instance a case study
approach was considered appropriate in providing a greater degree of
flexibility than that offered by other research methods in reply to the research
questions.
Furthermore, the subjective interpretation of relationship would not be suitable
for normative, numerically based data gathering and interpretation. Descriptive
and exploratory research was deemed more appropriate because the author is
interested in gaining insights into the general nature of the topic such as
dealing with different kinds of political risks. So, the nature of the topic should
involve the collection of rich qualitative data.
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Chapter 3: Research Methodology
Moreover, as it has been stated in the Introduction chapter, there is a rationale
in focusing on one industry. The oil industry is chosen. There are only a few
big private players in the extractive industry with interests diversified around
the globe and who at the same time conduct businesses in the same country. In
order to provide a multidimensional picture of a situation with political risk,
its assessment and management; it was decided to base the research on a
small-scale research (three cases).
Section 2: The Case Study Approach as a Research Strategy
The case study approach is one of the several research strategies which can be