The impact of political risk on foreign investment

11 August 2016 by National Bank

The unrest in Egypt* has highlighted the risks associated with foreign investments and doing business abroad. Investing abroad offers undeniable benefits, including access to key markets and clients, cost-effective production facilities and new partnerships. However, the political risk associated with such investments cannot be ignored.

What is political risk?

Political risk is measured by a country's ability to honour its obligations to foreign stakeholders. This is a special type of risk, because only Canadian companies that do business abroad are exposed to it, while those who operate exclusively in Canada are not affected.

Foreign investment can take two forms:

    • Direct investment, e.g. operating production facilities abroad

    • Financial investment, e.g. holding foreign stocks and bonds

    The possibility of the country's government intervening in the operations of the issuing company constitutes a political risk for investors. It might involve the government taking control of the company, forcing renegotiation of contract terms, dictating the number of local supervisors or imposing restrictions on the distribution of capital.

    What factors contribute to political risk?

      • The exhortation to "buy local": This is a form of protectionism that may affect sales of foreign products, thereby hurting the value of foreign stocks. During the 1980s, "Buy American" provisions were adopted in the United States to discourage purchases of foreign cars, particularly Japanese makes. President Obama's Recovery Act also included "Buy American" provisions, banning the purchase of foreign iron and steel for use in US infrastructure projects.

      • The attitude of the state: Some developing countries view foreign companies as a threat to their standard of living, creating a divide between local people and foreign employees, who are often better paid.

      • The attitude of the government: An unstable government is a serious risk for foreign investors. It could take steps to block the movement of capital and compel foreign businesses to invest locally. Another key factor is how stable the country's leadership is. While the sitting president of a country may understand the importance of honouring commitments to foreign companies, their successor may have different motivations.

      Managing political risk

      One possible solution is to take out an insurance policy. Export Development Canada (EDC) offers various insurance products that cover up to 90% of losses in the event of expropriation, currency inconvertibility, political violence and other political risks. This insurance gives investors the confidence they need to support the company's expansion plans.

      In certain markets, EDC supports direct foreign investment by offering Canadian companies accounts receivable insurance that covers the receivables of their wholly owned subsidiaries abroad.

      *This article was originally published in 2011.

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