Giving managers 'the creeps': in emerging markets, political risks are the source of creeping expropriation, as citizens who own local firms are often charged with regulating the companies as well

Risk & Insurance, Feb, 2005 by Paula L. Green

Multinational corporations may no longer have to worry about capricious Latin dictators ordering a sweeping takeover of the oil industry or the banking system in order to satisfy the anti-foreign fervor of its irate citizens. But instead of facing the outright nationalization of an entire industry or a company's operations, today's global risk manager is dealing with more subtle yet equally devastating risks that can render their foreign assets worthless overnight.

This so-called "creeping expropriation" is emanating from a variety of more subtle political risks that are occurring in emerging markets from South America to Southeast Asia.

Edicts rendered by biased legal systems that favor local companies to taxes slapped on products manufactured by a foreign firm to more powerful, and arbitrary, provincial governments can give any risk manger with an overseas operation some sleepless nights.

"In several emerging markets, new governments are often more likely to renege on an agreement rather than confiscate assets," says Andrew van den Born, director political, project & credit risks in the global risks division of Arthur J. Gallagher Ltd. in London. "In countries where local authorities are both owners of key corporations and the regulators of market competition, the potential of creeping expropriation through punitive regulatory measures is therefore a very real concern."

And oddly enough, any of these events can take place in a country where a national government and its citizens are openly welcoming foreign investment and the accompanying boost to the local economy. Analysts say the restrictive measures are an inevitable part of the economic and political cycles that many developing countries experience after opening their doors to foreign investment over the past decade.

"Everything works in cycles ... you have a couple of steps forward and a few steps backward," says one insurance industry expert. "What we're seeing now is a recalibration of the benefits of investment to the host country and to the investor."

Michel Leonard, chief economist and head of political risk consulting at Aon Trade Credit in New York, agrees that this paradox is an inevitable part of the investment cycle as governments and foreign investors work out mutually satisfying boundaries.

"There is no such thing as a golden goose," says Leonard. "Governments need to be more restrained in their demands and companies need to understand that they can't get everything they want."

So whether it is a new South African law that roils the mining industry in general or a Mexican government tax slapped on a sugar substitute used in the manufacture of soft drinks that hurts one U.S. company doing business in that nation, risk managers have become more alert for the subtle risks that can torpedo an overseas investment.

"When you go into uncharted waters, a risk cost-benefit analysis is important. You have to invest slowly," says Lance Ewing, vice president of risk management at Caesars Entertainment Inc. in Las Vegas. "Insurance is not the first resort, it's the last resort. What's appropriate is loss prevention, due diligence and having adequate safeguards in place."

Ewing, the past president of the Risk and Insurance Management Society Inc., adds that the gaming industry has an advantage since it is a heavily regulated sector that usually generates large returns for the host country. So discriminatory regulations that could hamper the returns of a foreign-owned casino are unlikely to be put through by the host country's government officials.

And it's not only multinational giants that are reassessing their political risks. After exporting to foreign markets for years, many midsize companies are heading overseas for the first time.

"With the improving conditions in emerging markets, many midsize companies are going abroad ... setting up distribution plants or warehouses or even manufacturing overseas," says Dan Riordan, executive vice president and managing director of Zurich's unit providing solutions for emerging markets risks. The unit is part of Zurich, North America. "I expect that to continue in 2005."

Brokers agree that whether a company is generating $50 million in revenue or $50 billion, today's global business environment demands a thorough political risk audit. The first step: identifying the risks.

"Each company is unique. The industry, the company's profile, its operations and the country where it has operations will all affect its political risk exposure," says Leonard. "If you are a high-profile company like an IBM or a Citigroup, obviously your risks are going to be different."

Quantifying the financial costs of any political risk is the next important step for a company. The risk manager needs to determine how any loss will affect its financial position--from receivables to revenues.

"You want a clear financial assessment of the risk," says Leonard. "If there is a war in a country where you are doing business and you can't produce your product for two weeks, you have to know how that will affect your bottom line."