Political Risk and Financial Risk

Political risk and financial risk

In addition to the foreign exchange risks, this UK company also needs to take political risks into consideration. Greene (1974) states that political risks in international finance context stem from unanticipated political change. Due to its unpredictability, it has the potential to have a significant impact on the company's profit as well as other objectives (Root, 1968). Therefore, it is essential for the UK company to identify and analyse its potential political risks (firm-specific risk, country-specific risk and global-specific risk), then take proactive measures to reduce these risks.

Firstly, firm-specific risks are mainly concerned about the foreign exchange risk and governance risk. Since foreign exchange risk has been analysed in details in the above section, this section focuses on the governance risk only. The goal of MNE is to increase the profit and enhance the shareholders' wealth. It might conflict with the government objective which is to improve the welfare of the local community. For instance, though the MNE prefers to purchase the cheaper raw material abroad, it may under the constraint of government to local source the input contracts, because the government want to reduce the unemployment rate. Operating in the host country, MNEs are under the potential threat of local government intervention and expropriation. As a result, it is crucial for MNEs to take effective measures in advance such as negotiating investment agreement, purchasing investment insurance and adopting various operating strategies. For example, like Overseas Private Investment Corporation (OPIC) in the USA, Export Credits Guarantee Department (ECGD) in UK offers insurance to protect the UK MNEs against hostility of host country government (Demirag and Goddard, 1994).

Secondly, country-specific risk can be classified into two categories: transfer risk as a result of blocked funds and cultural and institutional risk because of the different cultural and social context (Eiteman, Stonehill and Moffett, 2010). MNE's primary objective of opening a subsidiary in foreign country is to make a profit; however, the local government will impose strict control of the amount of earning that the subsidiary can remit to the parent or even totally block the transfer either because the remittance may harm the domestic balance of payment or the transfer might lead to the consequence of 'illegal' profit (Demirag and Goddard, 1994). To deal with fund blockage, one possible strategy the UK company can implement is fronting loan which is a parent to subsidiary loan in nature, but through the intermediary of international bank. The reason behind this strategy is that preventing the subsidiary paying the international bank will have a detrimental effect on the host country's credit rating (Eiteman, Stonehill and Moffett, 2010). Additionally, this UK