11.5 Foreign direct investment and country risk
Although the term country risk is sometimes used interchangeably with political risk and sovereign risk, they do not mean exactly the same thing.Country risk is broader than political risk and sovereign risk, encompassing both of them.
Country risk arises because of the possibility of losses due to country-specific economic,political and social events.Sovereign risk, on the other hand, involves the possibility of losses on claims on foreign governments and government agencies.The risk mostly pertains to bonds issued by and loans granted to these bodies, whereby losses will be incurred when they default.Hence, this kind of risk is not relevant to FDI.Political risk refers to the possibility of incurring losses due to changes in the rules and regulations governing FDI and also to adverse political developments.
Country risk is normally measured by giving each country a score calculated as a weighted average of the values of some indicators.The country risk rating of Euro-money magazine, for example, is based on three sets of indicators.The first is the analytical indicators that include: (i)economic indicators, which measure the country’s ability to service its debt (including the size of debt, the balance of payments position and the debt service ratio); (ii)economic risk; and (iii)political risk.The second set is the credit indicators, which measure the country’s ability to reschedule payments and its performance in servicing its debt in the past.The third set is market indicators, which measure the risk premiums that financial markets place on bonds and securities issued by parties belonging to the underlying country.
Political risk is of special importance for FDI.This category first includes the possibility of confiscation, whereby the host government assumes ownership of assets belonging to a multinational firm without proper compensation.If compensation is granted, then what we have is the risk of expropriation.Political risk also involves the possibility of losses resulting from changes in the rules governing currency convertibility and remittance restrictions that affect the value of cash flows received by the parent firm.Finally, it includes the possibility of losses resulting from such events as riots, civil unrest and military coups.
How can multinational firms reduce political risk? The first method is to keep control over some crucial elements of the firm’s operations.If the operations cannot be run properly without these elements, then a would-be confiscator would think twice before trying something.Another way to reduce the possibility of confiscation is by promising divestment,turning over ownership to local parties in the future.An alternative is to share ownership with foreign parties right from the beginning, by forming joint ventures.The multinational firm can also protect itself by borrowing in the country where the investment takes place.In the event of confiscation, the firm can react by defaulting on the loans it has been granted.