Although emerging economies have the potential to give investors much higher returns on investment than developed markets, they often carry with them the risk of less established political and economic systems which are more prone to sudden changes. Jaco Maritz discovers that these threats, although often exaggerated, can be managed by taking the right precautionary measures and knowing where to turn should things go wrong.
Investopedia defines political risk as "the risk that an investment's returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control. Political risk . . . becomes more of a factor as the time horizon of an investment gets longer."
"When one has dealings overseas, whether you are importing or exporting goods and services; involved in a building or engineering project; financing or investing, you encounter special problems," says Tony George, London-based partner of Ince & Co law firm. "You become involved in another country’s customs and practices, and rules and regulations which may be very different from your own. They may change during the life of your contractual relationship with your counterparty."
"Leaving aside . . . commercial risks, there may be a great deal more 'political' risk than you are used to: an exposure to political environments which may adversely affect your assets and trading relationships now [that] you are operating outside your home territory. Traditionally, at one end of the spectrum political risks involve the risks of war and civil war, terrorism – political violence generally. At the other end, they might involve . . . currency fluctuations, now in the news again. Political risks also have a habit of returning and evolving into new forms. Over the past decade we have encountered the return of ‘resource nationalism’, now being balanced by the risk of sovereign default as states’ anticipated income fails to meet their spending plans. We now also hear of a risk of increased state protectionism," he explains.
Political risks should however not be a reason to give up on the lucrative returns offered by emerging economies, given that it can be managed effectively. Yukiko Omura former Executive Vice President of the Multilateral Investment Guarantee Agency (MIGA) writes in FDI Magazine: "Increasingly, managing political – along with commercial – risks is becoming a normal part of the corporate decision-making process for companies that invest abroad. With a good understanding of the investment environment and appropriate risk management, there are clearly tremendous opportunities for investors to make both profitable and productive investments that also benefit people in the developing world. Indeed, through managing the risks relating to political uncertainties effectively, a good investment can go ahead in even the riskiest of environments."
Political Risk Insurance
One of the ways of managing political risk is through political risk insurance (PRI). The Political Risk Insurance Centre defines PRI as "a tool for businesses to mitigate and manage risks arising from the adverse actions - or inactions - of governments. As a risk mitigation tool, PRI helps provide a more stable environment for investments into developing countries, and to unlock better access to finance."
PRI is available from both public and private organisations. Public organisations covering political risk include multilateral agencies and export credit agencies (ECAs). MIGA, a member of the World Bank Group, for example will insure everything from currency transfer restrictions, expropriation, war and civil disturbance, to breach of contract.
Projects supported by MIGA have ranged from the rehabilitation of sugar plantations to the establishment of broadband wireless service. They vary in size — from US$115 million in guarantee coverage for a hydropower project in Uganda to a $600,000 hotel privatisation project in Guinea-Bissau. MIGA projects in Africa include the OrPower 4, Inc., a geothermal power plant in Kenya; a PVC pipe manufacturing plant in the Democratic Republic of Congo; the Bujagali Hydropower Project in Uganda; the Sasol gas pipeline project in Mozambique, and many more.
In turn, ECAs are private or semi-governmental institutions that act as intermediaries between national governments and exporters to issue export financing. The financing can take the form of financial support or credit insurance and guarantees or both.
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"Through managing the risks relating to political uncertainties effectively, a good investment can go ahead in even the riskiest of environments." |
One the private front, investors will find many companies covering political risk. Well known insurers with political risk departments include Lloyds, American International Group (AIG), Zurich and AEGIS.
Public insurers generally have stricter conditions for what they will insure. MIGA, for example, requires that investments must be new and stretch over at least three years. Projects eligible for guarantees must also support the host country’s development goals, comply with MIGA’s guidelines for the environment, labour conditions, and corruption, and also be financially viable.
Private insurers are generally more flexible. "The barriers are coming down, but the main difference between the private and state insurers is that private insurance does not have a nationality requirement other than that the insured is not a citizen of the host country," says George.
"A private insurer may insure existing as well as new investments whilst government insurance entities will usually only insure new projects or the expansion of an existing project. This is because the underlying rationale of the government organisations is the promotion of foreign investments," he explains.
Although insurance offered by the private sector is usually more expensive, there is a perception that the private market is more versatile and open to negotiate the provisions of the policy.
But does PRI actually work? Figures about successful claims are hard to come by but a few years ago AIG, a major player in the market, published figures that between 1978 and 2006 the company paid out US$1.2 billion from about 300 claims.
George says that the PRI market has been around for over 35 years and has weathered claims from various significant political crises over the years. He sees the fact that the PRI market still exists as a sign that it must be doing something right.
Contracts and the Law
Using the law is also a powerful way in which to handle disputes. "The law can help minimise or avoid problems and recover compensation for losses suffered," says George.
One of the most important aspects is to familiarise oneself with the regulatory situation in the country into which you invest. "Whenever you are contemplating a deal overseas, it is important to understand the regulatory background in the foreign country," says George. "It is also worth thinking the unthinkable – not just about claims and dispute resolution, but what happens if the counterparty goes bust?"
He goes on to highlight the importance of drawing up proper contracts which spell out who has to do what, by when, how and what is to happen if a party does not do what it is supposed to do in the way it should in the time required.
Bilateral Investment Treaties
Another avenue where investors can turn should some aspect of their investment go wrong is bilateral investment treaties (BITs). A BIT is basically an agreement between two governments to encourage, promote and protect investments in each country by companies based in the other nation.
Carol Searle, also from Ince & Co, says: "The exceptional feature is that BITs characteristically provide for investors to have direct recourse to arbitration against a host state or other means of dispute settlement where it is alleged that the terms of the bilateral investment treaty have not been observed."
"Even where an investor has a contractual right to arbitrate with the state, the right to treaty arbitration is valuable as an alternative or supplemental avenue of redress. Treaty arbitration may [also] allow an investor to assert claims beyond those that would be available in the dispute resolution mechanism under the contract, including claims of expropriation."
Even though these treaties might seem more like a general sign of goodwill between two governments, rather than a practical agreement, there are many examples of where they actually have been enforced. The International Centre for Settlement of Investment Disputes (ICSID), which operates under the auspices of the World Bank and is considered to be the leading international arbitration institution devoted to investor-state dispute settlement, lists numerous cases on its website where it has effectively settled disputes.
As can be seen, there are various ways to manage political risks. In the end, however, a risk remains a risk but following the right procedures and knowing what to do when things go sour, might just make investors – and their financiers – sleep a little bit sounder.
