International Investment Decision under Political Risk and Credit Risk

1. International Investment Decision under Political Risk and Credit Risk By Dr. Hsuan-Chu Lin Department of Accountancy and Graduate Institute of Finance National Cheng Kung University APEC Symposium on Enhancing SME Capacity of Managing the Risks Associated with Trade Liberalization 8/17/2011

2. What are Political Risk and Credit Risk? Macro-level: non-project specific risks Political Risk: The risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits. Weston and Sorge's (1972) definition is representative: "Political risks arise from the actions of national governments which interfere with or prevent business transactions, or change the terms of agreements, or cause the confiscation of wholly or partially foreign owned business property"

3. What are Political Risk and Credit Risk? Micro-level: project specific risks Credit Risk: Therisk due to uncertainty in a counterparty's (also called an obligor's or credit's) ability to meet its obligations. Generally speaking, from an international trading perspective, political risk should be relatively emphasized than credit risk.

4. Why do we care? The two risks bring uncertainty to the expected payoffs of investing an international project and further affect a firm’s decision on whether to take the project. They are two possible negative effects which should be carefully concerned and measured by a firm which is planning to take an international investment project.

5. Why do we care? For example, Robock (1971) suggests the following operational definition: ... political risk in international business exists (1) when discontinuities occur in the business environment, (2) when they are difficult to anticipate, and (3) when they result from political change. To constitute a 'risk' these changes in the business environment must have the potential for significantly affecting the profit or other goals of a particular enterprise.

6. How does political risk affect international business? - Some Findings A positive relationship between foreign direct investment (FDI) and intellectual property protection. (Lee and Mansfield, 1996) A negative impact of corruption on FDI flows. (Wei, 2000) Harms and Ursprung (2002), Jensen (2003), and Busse (2004) find that multinational corporations are more likely to be attracted by countries in which democracy is respected. Kobrin (1978) finds the presence of a negative relationship between political instability and FDI. The political actions and instability may make it difficult for companies to operate efficiently in these countries due to negative publicity and impact created by individuals in the top government. (Okolo, 2006)

7. Measuring the Risks (1) Political Risk Country Risk Rating: The number of country risk ratings compiled by commercial agencies such as Moody’s, Standard and Poor’s, Euromoney, Institutional Investor, Economist Intelligence Unit, International Country Risk Guide, Political Risk Services, Fitch IBCA, Business Environment Risk Intelligence S.A., S.J. Rundt & Associates, and Control Risks Group, has increased substantially since the Third World debt crisis in the early 1980s.

8. Measuring the Risks According to the International Country Risk Guide (ICRG), its risk ratings have been cited by experts at the IMF, World Bank, United Nations, and other international institutions, as a standard against which other ratings can be measured. The ICRG has been acclaimed by publications such as Barron’s and The Wall Street Journal for the strength of its analysis and rating system. The ICRG staff collects political, financial, and economic data, converting these into risk points for each individual risk component on the basis of a consistent pattern of evaluation. The following is the ICRG measurement table of political risk:

10. Measuring the Risks (2) Credit Risk: Credit Risk Rating: From rating agencies, such as Moody’s, Standard and Poor’s, Fitch, etc.. Credit risk models: Z-Score Model (Altman, 1968) O-Score Model (Ohlson, 1980) – Logistic Model BSM Model (Black-Scholes, 1973; Merton, 1974) – Option Pricing Model

11. International Investment Decision-Making under Political Risk and Credit Risk where CFi is the net cash flow brought by the project at time I II is the initial input for taking the project RADR is the risk-adjusted discount rate, the expected rate of the return integrating political risk and credit risk. N is the expected effective time period of the project Risk Adjusted NPV Method:

12. International Investment Decision-Making under Political Risk and Credit Risk Capital Budgeting: When NPV > 0  Take the project When NPV < 0  Reject the project When NPVA > NPVB > 0  If budget is limited, take Project A first. Key: RADR Different from using expected rate of return which only concerns about the operating risk as discount rate in the general NPV model, both political and credit risk should be adjusted for the discount rate used in the NPV model when making an international investment decision.

13. International Investment Decision-Making under Political Risk and Credit Risk Especially for the political risk… Since the political risk is a non-project specific risk, from the definition, it seems to be systematic and unavoidable. However, diversification is still possible… Economy A C B A

14. Conclusions and Suggestions How to manage political risk and credit risk for the modern international business becomes a challenging issue. Rating agencies and models provide helpful information and methods to measure the two risks. From the perspective of corporations (investors), the key is to remember to count the negative effects of the two risks in when making the capital budgeting decisions. Especially for the political risk, it is not unavoidable. Diversification is still possible. A challenge is how to more accurately integrate the measures of the two risks into the capital budgeting decision measurement.