Question No. 3 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 3
a)What are the different ways of managing political risk? Discuss.

The different ways in which Political Risk can be managed are as follows:

1) Avoiding Investment:

The simplest way to manage political risks is to avoid investing in a country ranked high on such risks. Where investment has already been made, plants may be wound up or transferred to some other country which is considered to be relatively safe.

This may be a poor choice as the opportunity to do business in a country will be lost.

2) Adaptation:

Another way of managing political risk is adaptation. Adaptation means incorporating risk into business strategies. MNCs incorporate risk by means of the following three strategies: local equity and debt, development assistance, and insurance.

i) Local Equity and Debt:

This involves financing subsidiaries with the help of local firms, trade unions, financial institutions, and government. As partners in local businesses, these groups ensure that political developments do not disturb operations. Localization entails modifying operations, product mix, or any such activity to suit local tastes and culture. When McDonald’s commenced franchisee operations in India, it ensured that sandwiches did not contain any beef.

ii) Developmental Assistance:

Offering development assistance allows an international business to assist the host country in improving its quality of life. Since the firm and the nation become partners, both stand to gain. In Myanmar, for instance, the US oil company Unocal and France’s Total have invested billions of dollars to develop natural gas fields and also spent $6 million on local education, medical care, and other improvements.

iii) Insurance:

This is the last means of adaptation. Companies buy insurance against the potential effects of political risk. Some policies protect companies when host governments restrict the convertibility of their currency into parent country currency. Others insure against losses created by violent events, including war and terrorism.

3) Threat:

Political risk can also be managed by trying to prove to the host country that it cannot do without the activities of the firm. This may be done by trying to control raw materials, technology, and distribution channels in the host country. The firm may threaten the host country that the supply of materials, products, or technology would be stopped if its functioning is disrupted.

4) Lobbying:

Influencing local politics through lobbying is another way of managing political risks. Lobbying is the policy of hiring people to represent a firm’s business interests as also its views on local political matters. Lobbyists meet with local public officials and try to influence their position on issues relevant to the firm. Their ultimate goal is getting favourable legislation passed and unfavourable ones rejected.

5) Terrorism Consultants:

To manage terrorism risk, MNCs hire consultants in counterterrorism to train employees to cope with the threat of terrorism.

6) Invaluable Status:

Achieving a status of indispensability is an effective strategy for firms that have exclusive access to high technology or specific products. Such companies keep research and development out of the reach of their politically vulnerable subsidiaries and, at the same time, enhance their bargaining power with host governments by emphasizing their contributions to the economy.

When Texas Instruments wanted to open an operation in Japan more than a decade ago, the company was able to resist pressures to take on a local partner because of its unique advanced technology. This situation occurred at a time when many other foreign companies were forced to accept local partners. The appearance of being irreplaceable obviously helps reduce political risk.

7) Vertical Integration:

Companies that maintain specialized plants, each dependent on the others in various countries, are expected to incur fewer political risks than firms with fully integrated and independent plants in each country. A firm practicing this form of distributed sourcing can offer economies of scale to a local operation. This strategy can become crucial for success in many industries.

If a host government were to take over such a plant, its output level would be spread over too many units, products, or components, thus, rendering the local company uncompetitive because of a cost disadvantage. Further risk can be reduced by having atleast two units engage in the same operation, thus, preventing the company itself from becoming hostage to over- specialization. Unless multiple sourcing exists, a company could be shut down almost completely if only one of its plants were affected negatively.

8) Local Borrowing:

One of the reasons why Cabot Corporation prefers local partners is that, it can then borrow locally instead of adding an additional level of risk with the investment funds being in a currency which is different from the currency of all the sales and costs of the venture. Financing local operations from indigenous banks and maintaining a high level of local accounts payable maximize the negative effect on the local economy if adverse political actions were taken.

Typically, host governments do not expropriate themselves, and they are reluctant to cause problems for their local financial institutions. Local borrowing is not always possible, however, because of restrictions placed on foreign companies, which otherwise crowd local companies out of the credit markets.

9) Minimizing Fixed Investments:

Political risk, of course, is always related to the amount of capital at risk. Given equal political risk, an alternative with comparably lower exposed capital amounts is preferable. A company can decide to lease facilities instead of buying them, or it can rely more on outside suppliers, provided they exist. In any case, companies should keep exposed assets to a minimum to limit the damage posed by political risk.

10) Political Risk Insurance:

As a final recourse, global companies can purchase insurance to cover their political risk. With the political developments in Iran and Nicaragua and the assassinations of President Park of Korea and President Sadat of Egypt all taking place between 1979 and 1981, many companies began to change their attitudes on risk insurance. Political risk insurance can offset large potential losses. For example, as a result of the UN Security Council’s worldwide embargo on Iraq until it withdrew from Kuwait, companies collected $100-$200 million from private insurers and billions from government-owned insurers.

b) What are foreign bonds and eurobonds. What are the advantages of eurobonds owner foreign bonds.

Foreign bonds: Foreign bonds are issued by foreign issuers in a foreign national market and are denominated in the currency of that market. Foreign bond issuance is regulated by the rules of the host national market. An example of a foreign bond is a bond denominated in US dollars issued by a German company in the United States. Foreign bonds bear distinct “street” names by which they are recognized as being traded in a particular country. Examples of foreign bonds are: Yankee bonds traded in the United States, Bulldog bonds traded in the United Kingdom, Samurai bonds traded in Japan, and Matador bonds traded in Spain.

A foreign bond may define as an international bond sold by a foreign borrower but denominated in the currency of the country in which it is placed. It underwrites and sells by a national underwriting syndicate in the lending country. Thus, a US company might float a bond issue in the London capital market, underwritten by a British syndicate and denominated in sterling.

The bond issue would sell to investors in the UK capital market, where it would quote and traded. Foreign bonds issued outside the USA call Yankee bonds, while foreign bonds issued in Japan are called Samurai bonds. Canadian entities are the major floaters of foreign bonds in the USA.

Euro bonds may define as an international bond underwritten by an international syndicate and sold in countries other than the country of the currency in which the issue denominates. In the Eurobond market, the investor holds a claim directly on the borrower rather than on a financial institution.

Eurobonds are generally issued by corporations and governments needing secure, long-term funds and are sold through a geographically diverse group of banks to investors around the world. Eurobonds are similar to domestic bonds in that they may issue with fixed or floating interest rates.

Advantages of Eurobonds:

The Eurobonds market possesses several advantages for borrowers and investors.

The advantages of Eurobonds to borrowers are:

• The size and depth of the market are such that it can absorb large and frequent issues.
• The Eurobond market has freedom and flexibility not found in domestic markets.
• The cost of the issue of Eurobonds, around 2.5 percent of the face value of the issue.
• Maturities in the Eurobond market are suited to long-term funding requirements.
• A key feature of the Eurobond market is the development of a sound institutional framework for underwriting, distribution, and the placing of securities.

The advantages of Eurobonds to investors are:

• Euro bonds are issued in such a form that interest can pay free of income or withholding taxes of the borrowing countries. Also, the bonds issued in bearer form and are held outside the country of the investor, enabling the investor to evade domestic income tax.
• Issuers of Eurobonds have a good reputation for creditworthiness.
• A special advantage to borrowers as well as lenders provides by convertible Eurobonds. Holders of convertible debentures give an option to exchange their bonds at a fixed price.
• The Eurobond market is active both as a primary and as a secondary market.

Bonds denominated in a particular currency that usually issues simultaneously in the capital markets of several nations. They differ from foreign bonds in that most nations do not have pre-offering registration or disclosure requirements for Eurobond issues. An Example of a Eurobond a bond issue by a Russian corporation in the European market that pays interest and principal in U.S. dollars.