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In emerging markets, the clash between politics and profits poses multiple threats.
Vincent Ryan, CFO Magazine
June 1, 2011
Even as specialty chemical products manufacturer H.B. Fuller grew sales in Europe, India, the Middle East, and Africa to 30% of its total revenue last year, it also had to deal with growth of a different kind — the groundswell of political opposition to Egyptian leader Hosni Mubarak.
That turmoil forced the $1.4 billion company to shut down a Cairo adhesive-manufacturing facility for two weeks, driving up its expenses as it sourced products for its Mideast customers from plants elsewhere. The operational disruptions were minor, but the increased costs to ship product into Egypt hurt profit margins (although Q1 growth in that region topped 13%).
While the Middle East uprisings have yet to produce infamous investment-destroying incidents like the seizure of an elevated private expressway in Bangkok (1993) or the cancellation of a privately funded power plant in India (1994), they have placed political risk on management's watch list again.
Indeed, this year the severity of political risk rose in 19 countries, according to the 2011 Aon Risk Solutions political-risk map. In a 2010 report by the Multilateral Investment Guarantee Agency (MIGA), a part of the World Bank, executives cited political risk, macroeconomic instability, and weak government institutions as the biggest challenges facing foreign direct investment (FDI) in the next three years. Breaches of contract, sudden regulatory changes, and transfer and convertibility restrictions were the three most worrisome political risks.
Despite dangers, companies aren't turning isolationist. After falling during the financial crisis, FDI in developing countries is growing again. MIGA forecasts 20% FDI growth in 2011 and 13% in 2012, by which time inflows will reach $575 billion. Much of the capital will target the growing middle-class economies in Russia, India, and China, as well as natural-resource investments in sub-Saharan Africa, North Africa, and the Middle East.
The problem is that some of the most politically risky countries offer the most enticing prospects. Russia is an example. In Transparency International's 2010 corruption-perceptions index, Russia ranked as one of the worst 20 countries for government commitment to accountability, transparency, and anticorruption. But the country's private-sector boom is hard to ignore — gross domestic product is expected to grow 4.8% this year and 4.5% in 2012.
Brightpoint, a provider of supply-chain solutions to the wireless telecom industry, exited Russia during the financial crisis because its credit insurers pulled in-country coverage and, subsequently, customers couldn't get letters of credit, says Anthony Boor, Brightpoint's former CFO. But now that insurers are starting to go back, Boor, who left the company last month, says that Brightpoint "is looking at reentering."
Political risk can be mitigated, but it's not easy. One way is to buy political-risk insurance (PRI). Policies can cover brick-and-mortar assets, net investment values (investment plus retained earnings), and sales and supply contracts.
The market for PRI has been flat over the last five to seven years, as companies either glossed over or downplayed emerging-market risks and the recession squeezed risk managers' budgets. But insurers say that is now changing. "Companies realize there is more risk than they thought there was in emerging markets," says Evan Freely, global head of political risk and trade credit at Marsh. Their co-investors and lenders also want indemnification.
Companies are demanding products that are more responsive to current threats. In some cases, they take existing policies that cover terrorism and expand them to cover other perils, such as civil war. "The baseline used to be expropriation protection — you own something, the army shows up, it's expropriated, and you have a claim," says Michael Nolan, a partner at Milbank, Tweed, Hadley & McCloy LLP. "But instead, let's say the government tells you it's going to increase taxes by 20%, pass a law requiring worker pensions, and change environmental regulations so you have to build more-expensive plants. Oh, and by the way, the only builders of those plants are local and they are politically connected," Nolan says. "Traditionally, PRI wouldn't perform on that."
"Most of our bigger clients care less about the isolated riot and more about overall impacts of regime change," Freely says. "It takes some due diligence on the client's and underwriter's part to write this risk."
Governmental agencies can also be engaged to cover private investment. The Overseas Private Investment Corp., a U.S. entity, provides financing, insurance, and guarantees for investors in foreign countries. For example, in 2009, OPIC underwrote political-risk insurance for the construction and operation of a business-class hotel in Iraq. It also provided $2 billion in financial support to push private investment in the Middle East and North Africa.
"OPIC's insurance is evolving," says Nolan. "There's a lot of interest in insurance for sovereign nonpayment of debt obligations," particularly with big governments stepping in to resolve the financial crisis. Typically, though, OPIC deals in the hottest of hot-button countries. Its largest financial exposures in 2009 were in Mexico, Jordan, Russia, Nigeria, and Turkey.
MIGA also underwrites political risk. Its stamp on a transaction or asset can actually be more effective than OPIC or private insurance. "Sometimes a local government doesn't want to default on a MIGA-insured product, because it's the World Bank," says Marsh's Freely. "So some companies use MIGA coverage for loss avoidance as well as risk mitigation."
Most companies prefer nonfinancial strategies for mitigating political risk. Executives see maintaining an open dialogue with local governments as well as joint ventures with local enterprises as the most effective tools to lower the risk of adverse government intervention, says MIGA.
As civil unrest spread across the Middle East, politics drew more attention from executives at Cooper Industries, an Ireland-based maker of electrical and circuit-protection products. Dave Barta, Cooper's U.S.-based CFO, says the company's operations in Saudi Arabia and Dubai were unscathed. And despite any continuing risks, the company's exposure doesn't warrant a huge outlay for insurance. "Insurance is nice, but it doesn't make your customers feel any better if they can't get product," Barta says. "I have to think about the bigger picture."
Cooper Industries's philosophy is to hire local workers who can provide on-the-ground intelligence about the political environment and are tied into other information resources in the region. The insight and data are collected at the executive-staff level. Barta says the company has a robust risk-management process overall, and geopolitical risk is a regular part of assessments.
In Mexico, where Cooper Industries has a large manufacturing presence, there were 15,273 drug-related murders last year. So, for that location, Cooper considers a disproportionately greater number of "what-ifs" around supply-chain risks. "What if a border crossing were to be closed because of crime, violence, or military intervention?" Barta asks. "You have to think about redundant manufacturing capabilities and other tactics that would help you get through a temporary curtailment in production."
In manufacturing, political risk will be a greater factor in expansion-plan choices, predicts Barta. Companies have been more reliant on single facilities than they were 10 years ago, but growth will force them to choose whether to enlarge current overseas plants and warehouses or diversify the manufacturing footprint to minimize geopolitical risk. "Not many businesses have been in the mode of needing that capacity over the last couple of years," says Barta.
Corn Products International, a $4.4 billion maker of sweeteners and starches, thinks being a strong local presence in overseas markets is the best antidote. The Illinois-based company produces and sells locally across a wide geographic base, which includes Europe, South America, Asia, and Africa. Its subsidiaries have their own executives and operating teams, including finance, while headquarters determines policies and performs oversight.
"Instead of having everyone in Chicago reading The Financial Times, we have them living and breathing in local capitals," says Cheryl Beebe, Corn Products International's finance chief. "It's a great way to manage political risk."
Presidents of the national subsidiaries are heavily involved in local chambers of commerce, and the subsidiaries have names that are identified with the local market, such as Productos de Maiz Uruguay.
"Take Pakistan," says Beebe. "Do you really want to be identified as a U.S. multinational?" Since Corn Products is in business-to-business markets, "there is very little value in trying to brand; it's not like McDonald's or Procter & Gamble," Beebe explains.
Corn Products's operating philosophy proved its worth in two major skirmishes earlier in this decade. In 2005, Canadian farmers led calls for a tariff on imported corn, accusing U.S. growers of "dumping" (selling below the cost of production) and the U.S. government of subsidizing the growing of grain corn. "The proposed tariff would have made our Canadian business unprofitable," says Beebe, "which wouldn't have been good for the Canadian farmers or the unemployment rate in Canada."
Corporate and local executives from Corn Products sat down with Canadian officials and went through the facts, and "that reasoned discussion carried the day," says Beebe. The company credits the fact that it had what a spokesperson describes as "smart, experienced people on the ground in Canada" for making those talks far more productive than they might otherwise have been.
The second instance occurred in Mexico in 2001, when the influential sugar lobby got politicians to pass what Beebe calls a "discriminatory" tax on beverages sweetened with corn sugar (as opposed to cane or beet sugar). The tax cost Corn Products 25% of its consolidated operating income.
The company sued the Mexican government under Chapter 11 of the North American Free Trade Agreement; it won on the legal merits and was awarded $58.4 million in damages, which it finally collected this year. "Had we just been an American company shipping into the local market, we would not have had [that] outcome," says Beebe. "If you're employing local citizens in what generally are well-paying jobs, you're not considered an interloper."
In addition, "while we were very persistent and professional about having our day in court, we did not rub the Mexican government's nose in it," Beebe says. "We wished to be viewed as a good citizen in Mexico."
Corn Products International's strategy is not the only way to go. As a service provider, for example, Brightpoint limits its physical presence in the overseas markets it enters. It usually uses a shared-services model in finance, centralizes distribution and warehouse facilities regionally, and buys and sells in the local currency. Shared services means that, in-country, the wireless company needs only a commercial marketing team and support staff. And regionalized "hub" warehouses for the wireless products it resells provide efficiencies and allow the company to invest in automation that it couldn't necessarily afford in each individual country, Boor says.
A small, local footprint also limits potential losses if the company has to pull out of a country when the political or regulatory climate gets volatile. "If [Brightpoint] finds a business model is not working, because the risk environment or the economy is different than was thought, [the company] will quickly develop a plan to exit that country," says Boor.
Brightpoint has a luxury that some other firms don't: it's growing and has enough headroom to avoid geopolitical hot spots. "Its in only 27 countries today," says Boor. "If there are 40 or 50 on the high-end risk scale, the company is not in a position where it has to enter those countries. It can get a more than adequate return by looking elsewhere."
Indeed, Brightpoint exited China in 2002 because of heavy governmental ownership and influence in the telecom sector. Despite China's huge and fast-growing wireless market, "the risk-and-reward balance doesn't yet justify [the company] going back into a country like that," Boor says. "Companies with a bigger global footprint, however, might have less leeway [to pass it by]."
And there is the dilemma. If CFOs want to profit from burgeoning economies, they must be able to stomach political discord, citizen uprisings, and sea changes in national leadership — and be prepared to deal with those hazards. Otherwise, they'd be smart to stay close to home.
Vincent Ryan is senior editor for capital markets at CFO.