Chapter 1 Introduction Of Business Environment

Global Political Environment

Course InstructorJunu HadaOpening CaseChina: Legal Growing pains in a land of opportunityDuring its thirty years of communist rule, China prohibited foreign investment and restricted foreign trade. Then, China enacted the Law on Joint Ventures using Chinese and Foreign Investment in 1978. Chinas subsequent transformation has been fueled by a landslide of foreign investment made in response to the countrys market potential, market performance, improved infrastructure, enormous resource and strategic position. Frustrating this process, however have been the politics of Chinas elaborate bureaucracy, as well as its ill-defined legal system and pervasive corruption Historically china has relied upon the rule of man and the belief that legal rights are derived from the power of the individual. It has also endured a long running legal battle between the central and local Chinese authorities. Upon joining the WTO in 2002 China agreed to continue to reform its business environment and move toward transparent rule- based, enforcement oriented standards. Coming full circle, todays full owned Chinese enterprises are themselves becoming global investors, both by acquiring foreign firms and investing in foreign lands. IntroductionFor a multinational enterprise to succeed in countries with different political and legal environments, its management must carefully analyze the fit between its corporate policies and the political and legal conditions of each particular nation in which it operates.Political EnvironmentA political system is the complete set of institutions, political organizations and interest groups, the relationships among those institutions and the political norms and rules that govern their activities.

It integrates the various parts of a society into a viable functioning entity.

It influences the extent to which government intervenes in business and the way in which business is conducted both domestically and internationally.Political IdeologyA political ideology is the body of goals, theories and aims that constitute a sociopolitical program ( eg liberalism or conservatism).Pluralism indicates the co existence of a variety of ideologies within a particular society.Although shared ideologies create bonds within and between countries, differing ideologies tend to split societies apart.The two extremes on the political spectrum are democracy and totalitarian.

Political IdeologyDemocracyA democracy represent a political system in which citizens participates in the decision making and governance process, either directly or through elected representatives.

Contemporary democracies share the following characteristics- Freedom of opinion, expression, press, religion, association and access to information: freedom to organize, free election, independent and fair court system citizen assess to decision making process.Political IdeologyTotalitarianismTotalitarianism represents a political system in which citizens seldom, if ever participate in the decision making and governance process: power is monopolized by a single agent and opposition is neither recognized nor tolerated.

In theocratic totalitarianism, religious leader are also the political leaders.

In secular totalitarianism, the government maintains power through the authority of the state.Trends in Political SystemsSeveral factors have led the worlds towards democratization of the world.First many totalitarian regime failed to improve the economic lives of their citizens who eventually challenged the right of the state to govern.Second vastly improved communications technology weakened the ability of regimes to control peoples access to information.Third , many people who champion democracy truly believe that greater political freedom leads to economic freedom higher standards of living.Country (Political Risk) ?Political risk is the exposure to potential loss or adverse effects on company operations and profitability caused by developments in a countrys political or legal environment.

It is the risk that political decisions or events in a country negatively affect the profitability or sustainability of an investment

It is the risk caused by government action to deny or restrict the right of an investor or owner to use or benefit from his/ her assets or which reduce the value of a firm.

Country (Political Risk) ?Political risk includes:- War, revolutions, government seizure of property and action to restrict the movement of profits of other revenue from with in country.

As every is characterized by diverse political and legal systems that pose significant challenges for company strategy and performance so managers must adhere to business laws and regulations of the host country and closely monitor the changing political and legal environment

Country (Political Risk) ?Political risk may take different forms. Policies may change after elections. A new leadership with a different ideology may emerge within the same political party and reverse earlier policies. More extreme events are civil strife and war. Even issues such as kidnapping, sudden tax hikes, hyper inflation and currency crises come under the broad category of political risk.

At a macro level, political risk arises due to external factors such as fractionalisation of the political system, societal divisions on the lines of language, caste, ethnic groups and religion, dependence on a major political power, and political instability in the neighbouring region. At a micro level, risks may result from change in policies in areas such as taxation and import duties, controls on repatriation of dividends, convertibility of currency, etc. Classification of Political Risk Firm Specific RiskFirm Specific risk also known as micro risks are those political risks that affect the MNE at the project or corporate level. Governance risk, due to goal conflict between an MNE and its host government is the main political firm-specific risks.

Classification of Political Risk Country Specific RiskCountry specific risk also known as macro risks are those risks that also affect the MNE at the project or corporate level but originate at the country level. Two main political risk categories at the country level are transfer risk and cultural and institutional risks. Transfer risk concerns mainly the problem of blocked funds but also sovereign credit risk.Cultural and institutional risks spring from ownership structure, human resource norms, religious heritage, nepotism and corruption, intellectual property rights ands protectionismClassification of Political Risk Global RiskGlobal-specific risks are those political risks that affect the MNE at the project or corporate level but originate at the global level.Examples are terrorism, the anti globalization movement, environmental concerns, poverty and cyber attacks.Classification of Political Risk

Types of Political RiskConfiscation : Taking of the private property by government without any offer of compensation, on the ground that foreign firm are exploiting the country and relation between the government and foreign country are to much strained.

Expropriation of Property: Seizure of the private property owned by a foreign company with compensation being offered, aimed at specific company.Forced divestment of equity ownership of a foreign direct investor (Minor 1994)Was Mostly in Africa till 1980, then Latin America

Types of Political RiskCurrency Convertibility: Restrict the right of foreign firms to repatriate ( send home) profits to their home country. Because of passage of new laws or bureaucracy of a foreign country slows the process to convert the currency and it become financial burden to foreign owned companies.

Embargo: To prohibit or forbid the movement of certain or all goods to a certain country or countries.

Nationalization: Action of government to transfer private property to the government. The compensation offered with no guarantees that it will be sufficient to pay for loss of value and future profit of the nationalized firm.

Types of Political RiskCatastrophic political RiskCatastrophic political risk includes unanticipated political changes that largely affect all business operations in the country, but can be especially dangerous for local operations of the foreign country. That includes military conflicts, racial and ethnic clashes, civil war, terrorism.

Discriminatory taxation: Charging higher tax rates to the foreign companies than for domestic companies.Political Risk Assessment ( Host Country)The macro approachAt the macro level, firms attempt to assess a host countrys political stability and attitude toward foreign investors.At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulationsAggregation of subjective assessments by a panel of experts on various economic, social, and political factors Global Research CenterPolitical Risk Yearbook (Political Risk Services of East Syracuse, New York) International Country Guide The Economist Intelligence Unit Provides quarterly ratings and individual report on each country

Political Risk Assessment (micro approach)Micro approach: industry-specific and business specific factors Political risk depends directly on the characteristic of foreign investment Who owns it?What technology does it use?What is its economic sector?

20Extractive industries are always vulnerable because their core assets are not portable. Political Risk Assessment (take away)It can be diversified awayHigh risk (variance) is usually associated with high (mean) returns. Most of the variance in returns to investment is driven by local and global economic conditions. Global economic conditions account for the portion of risk you cannot diversify away (the covariant portion of your cash flows from investments in various parts of the world). Political risk is local and residual (not correlated with global economic conditions). Therefore, you ought to be able to diversify it away. 21Formulating and Implementing Responses to Political RiskThree related corporate political strategiesRelative bargaining power analysisThe MNC works to maintain a bargaining power position stronger than that of the host countryIntegrative, protective, and defensive techniquesIntegrative techniques help the overseas operation become a part of the host countrys infrastructureDeveloping good relations with the host government and other local political groupsProducing as much of the product locally as possible with the use of in-country suppliers and subcontractorsCreating joint ventures and hiring local people to manage and run the operation22Formulating and Implementing Responses to Political RiskDoing as much local research and development as possibleDeveloping effective labormanagement relationsProtective and defensive techniques discourage the host government from interfering in operationsDoing as little local manufacturing as possible and conducting all research and development outside the countryLimiting the responsibility of local personnel and hiring only those who are vital to the operationRaising capital from local banks and the host government as well as outside sourcesDiversifying production of the product among a number of countries23Formulating and Implementing Responses to Political RiskProactive political strategiesLobbying, campaign financing, advocacy and other political interventions designed to shape and influence the political decisions prior to their impact on the firmFormal lobbyingCampaign financingSeeking advocacy through the embassy and consulates of the home countryFormal public relations and public affairs activities such as grassroots campaigning and advertising24Assessing Political RiskPredicting firm-specific risk (micro risk):Assessing the political stability of a country is only a first stepThe real objective is to anticipate the effect of political changes on activities of a specific firmClearly, different foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regulationsAssessing Political RiskPredicting country-specific risk (macro risk):Political risk studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activitiesAnalysis of trends in these metrics leads many to speculate that the future will resemble the past, which is often not the caseDespite this difficulty, the MNE must conduct adequate analysis in preparation for the unknownAssessing Political RiskPredicting global-specific risk:Global-specific risk is clearly quite difficult to predict (i.e. September 11th)There are many groups interested in disrupting MNEs operations for the cause of religion, anti-globalization, environmental protection, and even anarchyWe can expect to see a number of new indices, similar to country-specific indices, but devoted to ranking different types of terrorist threats, their locations, and potential targetsFirm-Specific RisksThe firm-specific risks that confront MNEs include:Business riskForeign exchange riskGovernance risksGovernance risk is the ability to exercise effective control over an MNEs operations within a countrys legal and political environmentFor an MNE, it must be addressed for the individual business unit as well as for the MNE as a wholeFirm-Specific RisksCorporate governance principles include:Accountability (transparent ownership, appropriate board size, defined board accountability, and ownership neutrality)Disclosure and transparency (broad, timely and accurate disclosure, use of proper accounting standards)Independence (dispersed ownership, independent audits and oversight, independent directors)Shareholder equity (one share, one vote)Firm-Specific RisksNegotiating investment agreements:An investment agreement spells out specific rights and responsibilities of both the foreign firm and host governmentThe presence of MNEs is as often sought by development-seeking host governments as a particular foreign location is sought by an MNEAn investment agreement should spell out policies on many areas including (among others):The basis of fund flows (fees, royalties, dividends)The basis for setting transfer pricesThe right to export to third-country marketsMethods of taxationFirm-Specific RisksInvestment insurance and guarantees: OPICMNEs can sometimes transfer political risk to a home-country public agency through an investment insurance and guarantee programThe US investment insurance and guarantee program is managed by the government-owned Overseas Private Investment Corporation (OPIC)OPIC offers insurance for four separate types of political risk:InconvertibilityExpropriationWar, revolution, insurrection, and civil strifeBusiness income (resulting from political violence)Firm-Specific RisksOperating strategies after the FDI decision:Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changesMost MNEs, in their own self-interest, follow a policy of adapting to changing host-country priorities whenever possibleThe essence of such adaptation is anticipating host-country priorities and making the activities of the firm of continued value to the host countryFirm-Specific RisksHost countries may look for control of:Local sourcing of raw materials and componentsFacility locationTransportationTechnologyMarkets Brand names and trademarksExhibit 16.4 Management Strategies for Country-Specific Risks Preinvestment strategy to anticipate blocked funds Fronting loans Creating unrelated exports Obtaining special dispensation Forced reinvestmentBlocked FundsOwnership StructureIntellectual Property Joint venture Legal action in host country courtsHuman Resource Norms Understand and respect host country religious heritage Local management & staffingReligious HeritageNepotism and Corruption Disclose bribery policy to both employees and clients Retain a local legal advisor Support worldwide treaty to protect intellectual property rightsProtectionism Support government actions to create regional marketsTransfer RiskCultural andInstitutional RiskCountry-Specific Risks: Transfer RiskMNEs can react to the potential for blocked funds at three stages:Prior to making an investment, a firm can analyze the effect of blocked funds on return on investment, the desired local financial structure etc.During operations a firm can attempt to move funds through a variety of repositioning techniquesFunds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciationCountry-Specific Risks: Cultural and Institutional RisksWhen investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences:Differences in allowable ownership structuresDifferences in human resource normsDifferences in religious heritageNepotism and corruption in the host countryProtection of intellectual property rightsProtectionismCountry-Specific Risks: Cultural and Institutional RisksOwnership structure:Many countries have required that MNEs share ownership of their foreign subsidiaries with local firms or citizensThis requirement has been eased in most countries in recent yearsHuman resource norms:MNEs are often required by host countries to employ a certain proportion of host country citizens rather than staffing mainly with foreign expatriatesIt is often very difficult to fire local employees due to host country labor laws and union contractsCountry-Specific Risks: Cultural and Institutional RisksReligious heritage:Despite religious differences, MNEs have operated successfully in emerging markets, especially in extractive and natural resource industries such as oil, natural gas, minerals and forest productsNepotism and corruption:There is clearly endemic nepotism and corruption in many important foreign investment locationsBribery is not limited to emerging markets, as it is also a problem in industrialized nations such as the US and JapanCountry-Specific Risks: Cultural and Institutional RisksIntellectual property rights:Intellectual property rights grant the exclusive use of patented technology and copyrighted creative materialsCourts in some countries have historically not done a fair job of protecting these rightsProtectionism:Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competitionIndustries that are usually protected are defense, agriculture, and infant (emerging) industriesProtectionism occurs through the use of tariff and non-tariff barriersGlobal-Specific RisksGlobal-specific risks faced by MNEs have come to the forefront in recent years:Terrorism and warPovertyAnti-globalizationCyber attacksEnvironmental concernsManagement Strategies for Global-Specific Risks Support government efforts to flight terrorism and war Crisis planningTerrorism & WarPovertyAnti-Globalization Support government efforts to reduce trade barriers Recognize that MNEs are the targets Provide stable, relatively well-paying jobsCyber Attacks No effective strategy except internet security efforts Support government anti-cyber attack effortsEnvironmental Concerns Show sensitivity to environmental concerns Support government efforts to maintain a level playing field for pollution controls Establish the strictest of occupational safety standardsMNE movement towards multiple primary objectives:Profitability, Sustainable Development, Corporate Social Responsibility