International financing and structuring - Country risk and p...

Learning Outcomes

After reading this article, you will be able to identify the major forms of country risk and political risk that affect international corporate financing and structuring decisions. You will also be able to assess methods for measuring these risks, explain approaches to mitigate and manage them, and apply these concepts to multinational investment scenarios. The content is focused on key areas relevant for the ACCA Advanced Financial Management (AFM) exam.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand how country risk and political risk influence international financing and structuring. Focus your revision on the following areas:

• Identification of political and country risk factors in international financial management
• Assessment of political and economic risks facing multinational investments
• Measurement techniques for country and political risk, including rating systems and qualitative indicators
• Evaluation of risk mitigation and management strategies, including structuring, insurance, and local adaptation
• Application of risk management to project appraisal, funding decisions, and the design of group structures

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is most likely to reduce a multinational's exposure to political risk?
   1. Retaining all profits within the host country
   2. Sourcing local finance and entering joint ventures
   3. Relying exclusively on expatriate management
   4. Avoiding compliance with host country laws

2. What distinguishes country risk from political risk in international investment decisions?

3. True or false? A double tax treaty eliminates the need to consider blocked remittances when appraising a foreign project.

4. List two methods a company might use to transfer funds abroad when faced with foreign exchange controls.

Introduction

International financing exposes companies to risks not normally present in purely domestic operations. Country risk and political risk are two key concerns for financial managers planning foreign investments or structuring multinational operations. These risks arise from factors such as government actions, macroeconomic instability, regulatory changes, and local social conditions, all of which can threaten the financial returns or even the survival of an overseas venture. A systematic approach to identifying, measuring, and mitigating these risks is essential for sound international financial management.

Key Term: country risk
The total risk that arises from investing or conducting business in a particular country, including political, economic, legal, and social risks that may affect a project's returns.

Key Term: political risk
The risk of financial loss arising from actions or events attributable to government or political actors in a given country, such as expropriation, currency controls, or regulatory changes.

TYPES AND SOURCES OF RISK

Country risk analysis considers a wide range of factors that can disrupt international projects. These include political risk, economic instability, regulatory constraints, legal environment, corruption, and even cultural issues.

Political Risk

Political risk is a component of country risk and can result from acts by governments (such as nationalisation or expropriation), regulatory changes, imposition of capital controls, or civil disturbance. Both macro-level (affecting all foreign firms) and micro-level (affecting specific sectors or companies) risks must be considered.

Key Term: expropriation
The compulsory seizure of private assets by a government, typically with compensation that may be below market value.

Key Term: blocked funds
Profits or capital that cannot be remitted out of a country due to government-imposed exchange controls or restrictions.

Key Term: remittance restriction
A government policy limiting the amount of funds (such as dividends, royalties, or capital repayments) that can be transferred abroad by foreign investors.

Economic and Regulatory Risk

Economic risk, sometimes called financial risk, arises from changes in a country's economic environment—such as inflation, devaluation, or recession—which may reduce the value of future cash flows. Regulatory risk includes changes to laws, taxes, or rules affecting business operations.

IDENTIFYING AND MEASURING COUNTRY AND POLITICAL RISK

Before investing or financing internationally, a company must evaluate both the probability and potential impact of country and political risks.

Qualitative Methods

These involve expert opinion, management judgement, and analysis of qualitative indicators:

• Expert reports and country risk assessments
• Political and economic stability ratings
• Industry benchmarking and local knowledge

Rating agencies, such as Moody's and S&P, provide sovereign ratings that reflect overall default and transfer risks but may not capture all political risk aspects.

Quantitative Methods

Scoring models aggregate various risk indicators such as:

• Economic growth and inflation rates
• Political stability indexes
• Rule of law and corruption metrics
  Each factor is weighted and scored to provide a composite country risk rating. These models aid comparison but must be interpreted with caution.

Worked Example 1.1

A UK engineering company is considering investing in a factory in Country A. Country A has a recent history of abrupt government changes, high inflation, and strict limits on profit repatriation. Management wants to systematically assess the risks.

Question: How might the company assess and summarise the country and political risks in this scenario?

Answer:
The company should identify risk factors such as regime instability (high likelihood of sudden policy change), persistent high inflation (impacting real value of returns), and remittance restrictions (affecting cashflows). It can use a scoring model to evaluate and compare risk factors with those in other potential host countries, supplementing this with specialist reports for a deeper qualitative understanding.

MANAGING AND MITIGATING COUNTRY AND POLITICAL RISK

Managing these risks begins with project and finance structuring decisions and extends to operational responses.

Structuring Investments to Minimise Risk

• Choose joint ventures with local partners to align interests with influential stakeholders.
• Source local finance to signal long-term engagement and reduce exposure to expropriation.
• Retain some critical inputs (technology, intellectual property) outside the host country to reduce vulnerability.
• Use international arbitration clauses in contracts for dispute resolution.

Financial Strategies

• Arrange loans through multilateral agencies (e.g., World Bank, regional development banks), which may deter hostile government action.
• Hedge currency risk where feasible.
• Structure intercompany funding to allow flexibility in profit extraction (e.g., through management fees, royalties, or transfer pricing—subject to local rules).

Key Term: transfer pricing
The setting of prices for transactions between entities of the same multinational group, often used to allocate profits across jurisdictions.

Dealing with Exchange Controls and Remittance Restrictions

If direct remittance of profits is blocked or restricted, companies may:

• Increase charges for intra-group services or intellectual property (within the law).
• Lend surplus funds to the parent (intercompany loans).
• Use parallel or back-to-back loans with other multinationals.
• Invest blocked funds locally to generate returns until remittance becomes possible.

Key Term: parallel loan
An arrangement where two companies in different countries lend equivalent sums to each other's subsidiaries, allowing each to obtain local currency without cross-border transfers.

Insurance and Support

Specialist insurance policies, such as those offered by export credit agencies or multilateral organisations, can protect against political risks like expropriation and currency inconvertibility.

Adaptive Operational Practices

• Engage in local sourcing and employment to build goodwill.
• Maintain close relations with government and local communities.
• Monitor local developments and be ready to adjust operational plans quickly.

Worked Example 1.2

A multinational receives only 50% of its profits from its Latin American subsidiary due to strict exchange controls. It is searching for alternative profit extraction mechanisms.

Question: Suggest legal ways the group might reduce the amount of profits trapped in the host country.

Answer:
The company might charge the subsidiary for head office management services or for use of patents and trademarks, provided these fees are commercially justified and permitted under local tax laws. It could also arrange for part of the initial investment to be in the form of a loan, so repayments (interest and principal) can flow to the parent, subject to local regulations.

Political Risk Insurance Example

Credit agencies may cover against:

• Expropriation
• War or civil disturbance
• Currency inconvertibility

The policy will compensate if a direct government action causes specified losses.

IMPACT ON PROJECT APPRAISAL AND GROUP STRUCTURES

A thorough country and political risk assessment affects project appraisal calculations:

• Discount rates may be increased to reflect additional risk.
• Cash flow forecasts must consider remittance limitations and probability of adverse events.
• Sensitivity analysis should test the impact of adverse scenarios (e.g. expropriation after year 3).

Careful group structuring (including intermediate holding companies in stable jurisdictions) can also reduce exposure.

Exam Warning

Country and political risk must not be ignored in NPV calculations for international investments. The mere presence of a double tax treaty does not remove the risk of blocked profits, transfer pricing adjustments, or expropriation. Always address these factors in exam scenarios.

Summary

Managing country and political risk is a core responsibility for financial managers in international operations. ACCA candidates must be able to identify, measure, and propose strategies to reduce risk exposure. A mix of structural, financial, legal, and operational responses is often needed, supported by robust risk analysis and contingency planning.

Key Point Checklist

This article has covered the following key knowledge points:

• Understanding the nature and sources of country risk and political risk
• Main techniques for evaluating and rating political and country risks
• Structural and financial strategies to reduce multinational exposure
• Use of local partnerships, local financing, and political risk insurance
• Methods for dealing with blocked remittance and exchange controls
• Impact of risk assessment on project appraisal and group structuring

Key Terms and Concepts

• country risk
• political risk
• expropriation
• blocked funds
• remittance restriction
• transfer pricing
• parallel loan