3:16 pm - Tuesday January 21, 1423

Political risk arising out of political scenario – a discussion

This unit will make an attempt to bring out the salient features of political risk arising out of political scenario in financial market place.

Financial markets are the backbone of any economy, be it developed, undeveloped or underdeveloped. Financial markets are impacted by many macro factors or issues day in and day out. The main function of a financial market is facilitating capital formation and raising capital.

The prevailing political scenario is the first and foremost factor to influence such activities. It decides, discourages capital investment. Capital flows between countries are triggered by such evolving political scenario. Asset valuation techniques are very important for capital formation and investment decisions.

Having decided to invest and participate in capital formation, some important aspects arise and they need to be considered in greater detail. What is the price discovery method applicable or available and how is the price set?

In the same breadth, what is the level of prevailing interest rates and how is it going to change during the course of the investment? Hence, interest rate setting process will have to be understood.

What is the level of development of local financial marketplace by looking at arbitrage opportunities present? Factors like yield, liquidity, inflation and capital gains are parameters which enable evaluation and ascertain the future direction in the marketplace.

Size of the markets, cross border measures, quantitative easing, transparency, investor protection and regulation, and low transaction cost will impact the financial market to a greater extent.

Aspects like risk management, technology, deregulation, liberalization, consolidation and globalization are the factors greatly used and compared to choose, discard and leave by global players in the financial markets

Let us delve deeper into the prevailing political aspects.

The prevailing political scenario may lead to political risks in a country for an investor – both domestic and foreign.

Political risk is the risk faced by corporations, investors and governments due to changes in the political scenarios. It is the risk 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. It is a risk that can be understood and managed with reasoned foresight and flexible strategies.

For multinational companies, political risk refers to the risk that a host country might make political decisions which will prove to have adverse effects on the multinational’s earnings and/or profits.

Unfavorable political actions can vary from very damaging, such as widespread destruction due to revolution, to those of a more economic nature, such as the formation of laws that prevent the movement of capital.

One may recall the experience of some of the foreign investors in Indonesia in the 1980s when they wanted to close down due to economic situation and product prospects and also the experience of Indian Overseas Bank, Indian Bank and United Commercial Bank in Malaysia when they were nationalized.

Two types of political risk are common – micro risk and macro risk.

Macro risk refers to unfavorable actions that will impact all foreign firms, such as expropriation or insurrection, whereas micro risk refers to the adverse conditions affecting only a specific industrial sector or a particular business, such as corruption charges or prejudicial actions against foreign companies.

All in all, regardless of the kind of political risk that a multinational faces, if companies are not adequately prepared they end up losing a lot of money.

Sometimes, political risk concerns among savers among emerging market countries have in the past led to enormous outflows of dollars from these countries, often to the US branches and subsidiaries of banks in the Cayman Islands and the Bahamas, where there are very stringent bank secrecy rules.

Because of the secrecy rules in some foreign countries and the possibility that these rules may result in money laundering and the financing of terrorist activities, the US government enacted the US Patriot Act in 2001.

The Act prohibits the US banks from providing banking services to foreign banks that have no physical presence in any country (so called shell banks). The bill also added foreign corruption offences to the list of crimes that can trigger a US money laundering prosecution.

Before we venture into any country let us analyse the prevailing political scenario and its prospects.

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