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					                     OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURG
                     Faculty of Economics & Management

                     DONETSK NATIONAL TECHNICAL UNIVERSITY
                     Faculty of Management
                     Department of International Business Activity




Methods of Political Risk Measurement in FDI Inflow
into Ukrainian Economy




Kseniia Berezhna
195 Kuibysheva 61
83012 Donetsk
Ukraine
International Economics
specialisation "European Studies"
Semester: 3


E-Mail: Ksenia.Berezhna@gmail.com
Date of submission: 17.10.2010
Table of content


Abbreviations............................................................................................... 3
Abstract ........................................................................................................ 4
1. Introduction ............................................................................................. 5
2. Political Risks Measurement in Investing Process
  2.1 General Influence of Global Economic Crisis on FDI .................... 7
   2.2 Nature of Political Risk ..................................................................... 8
   2.3 Methods of Political Risk MeasurementError!                                      Bookmark              not
   defined.10
   2.4 Political Risk Measuring in Ukraine.............................................. 12
3. Conclusion .............................................................................................. 16
References .................................................................................................. 17




                                                        2
Abbreviations


Avg.    Average
BERI    Business Environment Risk Index
EIU     Economist Intelligence Unit

EU      European Union
FDI     Foreign Direct Investment
Fdm.    Freedom
IMF     International Monetary Fund
MIGA    Multilateral Investment Guarantee Agency
WTO     World Trade Organisation




                               3
Abstract
Readers of this paper will deal with evaluation of political risk in Ukraine. Foreign

direct investment of capital into the country is vitally essential for the period of

worldwide economic recession, but investors do not feel comfortable placing capital

blindly so they do estimations of possible risks. Survey proves that political risk has

become a key factor in investment-decision making process lately.



Keywords: political risk, foreign direct investment




                                          4
1. Introduction

Globalization has led to dramatic results in the world: each and every economic depends
on the economic of other countries. Globalization processes have increased international
cooperation in many different spheres, especially in economics. There is an integrating
tendency among countries, which came evolutionary to conclusion that cooperation
gives more positive results, than negative and it helps to expend their own economical
growth using and sharing resources and markets.


Among the negative sides of globalization there can be mentioned investment addiction
of many countries to foreign capital. Foreign direct investment (FDI) brings needed
capital into the countries suffering from the economical recession and reduces the
negative implement of crisis on country‘s economy. Nowadays countries are fighting
for the ability to get investors and due to the openness of many countries‘ economies
investors can choose where to make money.


Investing process is always connected with risks. Usually risks which investors face
inside of their own country aren‘t taken to account as there is nothing can be done about
it. National risks are more well-known, better-estimated and easy-predicted, but when it
comes to other countries investors prefer to deal with less-risked economies or at least
to be prepared to face them being ensured.


There are three main types of risks, taken to account while making investment decision:
economic, financial and political. It is very important to estimate each of them. Usually
this job is done by independent rating agencies all over the world and it can also be
done by special orders of investors to bureaus dealing with such problems and making
paid estimations and models. Investors can either delegate this task to their own staff,
which is in charge of risk investigation. This paper is devoted to political risks and it‘s
estimation for the Ukraine.


Political risk usually means an unpredicted behavior of FDI-recipient country
government and consists of four main problems, taken into account while the process of
investment decision-making:
      nationalization;
                                             5
       expropriation;
       intervention into business;
       changes in taxation.


Nationalization is the risk of government‘s decision to turn assets owned by foreign
investors to the governmental property. Usually government pays back to owners for
nationalization, but the conditions are unfavorable and investor faces losses as the price
paid for assets is lower than the market one. If the price is fair then nationalization does
not have negative effect and the risk is minimal. Expropriation means the same losing of
property as in case of nationalization, but there is no compensation paid.


Intervention into business is the set of unfavorable actions from the side of government.
It can be explicit and implicit as well. Explicit one consists of license regulation or price
control. Implicit intervention is the way of hidden pressure on foreign companies by
bureaucracy, unfair inspections and lawsuits for unreasonable cases. The purpose for
such behavior is a will to promote native companies and to protect them from foreign
invaders.


Changes in taxation policy of a country may provoke uncertainty about the returns of
investment which is also unfavorable fact in the moment of taking investment decision.
It decreases profits and attraction of a project.




                                              6
2. Political Risks Measurement in the Investing Process
into Ukraine's Economy


2.1 General Influence of Global Economic Crisis on FDI


According to the MIGA Global Report, the global financial and economic crisis
decreased flows of private capital into developing countries. The nature of foreign direct
investment (FDI) provides its resilience compared to other forms of private capital
inflows and it is expected to be the main source of private capital into developing
countries. It is also expected, that after the world economy recovery, the volumes of
foreign direct investment will increase1.


                              2001    2002      2003      2004    2005    2006    2007     2008
    Net    private      and
    official inflows          224.2 162.4       258.6 370.7 498.7         668.3   1157.7   727.3
    Net private inflows       197.3 156.8       269.1 396.5 569.7         739.2   1157.5   706.9
    Net equity inflows        172.3 161.5       181       254.7 347.2     462.7   658.6    599
    Net FDI inflows           166     152.5     155.5 216         279.1   358.4   520      583
    Net portfolio equity
    inflows                   6.3     9         25.5      38.7    68.1    104.3   138.6    15.7
    Net debt flows            51.9    0.9       77.6      116     151.5   205.6   499.1    128.3
    Official creditors        26.9    5.6       -10.5     -25.8   -71     -70.9   0.2      20.4
    Private creditors         25      -4.7      88.1      141.8 222.5     276.5   498.9    107.9
Table 1:         Net private capital inflows to developing countries, 2001-2008$, billion2

The table above shows the statistics of capital inflow volumes in developing countries
during the last 8 years from 2001 to 2008. According to the World Bank investigation,
“The developing part of the world absorbs almost half of the capital flows and tendency
remains increasing”3. This process would be impossible without efforts of developing



1
  See MIGA Global Risk report, pp. 14-15
2
  See Private and Official inflows report of World Bank
3
  See MIGA Global Risk report, p. 17
                                                   7
countries to increase attractiveness of their investment environment by minimizing
political and other risks as well.


2.2 Nature of Political Risk


Investors are concerned about political risks which are connected with high losses. They
have to manage risks by measuring them and covering losses. Such things as
nationalistic tendencies, terrorism, political instability and civil unrest always bother to
make safe business and to guarantee a repatriation of profits. That is why the problem of
risk-decreasing is essential for investors.


Usually political risk means uncertainty about actions of government and other political
institutions, restrictions on currency transfer and convertibility, expropriation, political
violence (war, civil disturbance and terrorism), non-honoring of government guarantees,
adverse regulatory changes, and restrictions on FDI outflows in home countries. This
definition is wider, than the one, given by insurance industry. According to their
definition, political risk is divided into4:
          currency convertibility and transfer
          expropriation
          political violence
          breach of contract by a host government
          the non-honoring of sovereign financial obligations


The nature of political risk makes it difficult to predict and quantify, so that concerns
are primarily based on perceptions.            These perceptions are influenced by broad
geopolitical and economic trends, as well as local conditions. The number of foreign
expropriations rapidly decreased in the 1980s, comparing to 423 cases of expropriation
of foreign assets in the 1970s. There were 17 accidents during 1980-1987 and zero
between 1987 and 19925. This tendency once again shows the stabilization of
international cooperation.



4
    See MIGA Global Risk report, p. 26
5
    See MIGA Global Risk report, pp. 34-35
                                                  8
Many developing countries are doing great efforts to dismiss obstacles in doing
business. There appeared multinational agreements in the sphere of international trade
of services, goods and intellectual property. A reformatting tendency is dominating
among different countries from the end of XX-th century till to-date, and it is reflected
in the number of surveys.


2.2 Political Risk Surveys


According to the surveys of nowadays, it is obvious that political risk is not only an
important detail in decision-making investment process, but it is the most essential
point, taking the leading positions of company‘s programs. In 2007 an Economist
Intelligence Unit made a survey called World Investment Prospects to 2011, 20076. The
results showed that political risks, according to the interviewed companies, tend to be
more essential and important problem in the future than at the time when the survey was
held, especially in emerging markets. Political risk was identified in the survey made by
Ernst & Young as the main investment limitation for companies based in developed
countries in their Ernst & Young, 20077. A report from Lloyd‟s, in cooperation with the
Economist Intelligence Unit, found that political violence is the greatest concern of
business worldwide. More than one third of respondents said that they were avoiding
overseas investments for fear of political violence. A report by Grant Thornton (2008)
claims that political and economic stability importance equals with importance of
market size and potential growth. A survey by Atradius8 and EIU held in 2008 found
that the greatest trouble of emerging markets is political instability bureaucracy.


On the diagram below it can be seen from the research of MIGA9 how do respondents
rank main risks of FDI on the emerging markets:




6
  See World Investment Prospects to 2011
7
  See Ernst & Young, 2007
8
  See Atradius Risk Report, 2008
9
  See MIGA Global Risk report, p. 28
                                             9
                 Major constraints on foreign investment in emerging markets
                                    Percent of respondents

                          Political risk

            M acroeconomic instability
                   Access to financing
                           Corruption

              Access to qualified staff

                Infrastructure capacity
         Limited market opportunities
     Increased government intervention

                                           0   10   20   30   40   50    60


              Next three years
              This year


Figure 1: Major constraints on foreign investment in emerging markets.


2.3 Methods of Political Risk Measurement


Worldwide practice shows that companies prefer to delegate political risk estimation to
agencies, which are more competent with those types of surveys. Below there is a list of
methods used while making FDI placing decision in agencies and inside the investing
company itself as well. There should be mentioned that it is impossible to give the
details of some methods as this information is top-secret. The reason for confidence is
that companies, making paid risk reviews and forecasts, would never share the
information as it will negatively result their profits.


1.         „The Grand Tour‟ method
According to this method, there usually forms a delegation, which consists of CEOs and
other responsible staff of company, whose intentions are to invest capital into some
country. This group of people goes on tourney to the recipient-country and meets local
government representatives and has negotiations with special bodies which are in
charge of the process of foreign investment. During this tour the delegation is able to
estimate risks themselves and to compare their personal risk marks with the data given
by rating agencies. In case political risk is high enough, then there are two ways of
                                           10
further actions: to change the market of FDI or to add to the price of the project ‗extra
risk reward‘. The negative aspect is that the taken decision about existing risk can be
subjective and non-impartial.


2.        „Delphi‟ Method
The most systematic method is Delphi. According to this method, company‘s analytics
chose the range of most important variables related to the investment problem, then a
group of experts range and them and give them certain weight. This method‘s weak
point is subjectivity either.


3.        BERI (Business Environment Risk Index)
BERI is the private source for comprehensive ratings, analyses, and forecasts for over
140 countries. They provide paid services of risk measurement. BERI S.A. provides
individual country risk reports from Business Risk Service (BRS) and Forelend reports.
They also make individual country ratings available from their Historical Ratings
Research Package (HRRP), Financial Ethics Index (FEI), Quality of Workforce Index
(QWI), Mineral Extraction Risk Assessment (MERA), Labor Force Evaluation Measure
(LFEM), and Government Proficiency Measure (GPM). BERI S.A. has two permanent
panels of experts that provide country ratings and qualitative observations. One panel
judges political conditions in countries, and the other offers perspective on the operating
environment.


4.        EUROMONEY
Euromoney10 is a business and financial magazine. Country risk survey methodology
was changed this year (2010) to increase the influence of political risk and some other
aspects. To obtain the overall country risk Euromoney assigns a waiting to six
categories, in which political risk takes 30 per cent of general waiting. Economists and
heads of research worldwide were asked to rate each country, of which they have
knowledge, from 1 to 100 across six categories: government stability, regulatory
environment, non-payment of loans/dividends/trade-related finance, non-repatriation of
capital, corruption perception, information access /transparency and judicial system.
These raw scores were then averaged to produce a total score and weighted to 30 per
cent. Then they counted the rest of indicators and rated countries.

10
     See Euromoney Country Risk Research
                                            11
2.4 Political Risk Measuring in Ukraine


According to AMB Country Risk Report11, countries can be marked:
          low risk (green) – CRT-1,2
          middle risk (yellow-orange) – CRT-3,4
          very high risk (red) – CRT-5




       Table 2: Country‘s risk classifications.




Figure 2: Country‘s risk classifications map.


Risk, estimated by AMB for Ukraine, considered being high (CRT-5). It is essential that
AMB explains high political risk by the following assumptions:


11
     See AMB Country Risk Report, p. 5
                                                  12
• Ukraine has deep historical, political and economic ties with Russia;
• The Ukraine government faced a serious political and financial crisis in 2009 as its
economic wellbeing is heavily dependent upon its energy transport contracts with
Russia and the assistance of the International Monetary Fund (IMF);
• The Ukraine government seeks to enter a process that would lead to eventual
membership in the European Union (EU)12.


                                           overall     political
                Place        Place         score       risk
                sep-10       mar-10        100         30
                78           98            50,7        14,4
     Table 3: Eromoney estimation of Ukraine‘ place due to its political risk 13


2010 INDEX OF ECONOMIC FREEDOM14 gives the following marks to the economy
of Ukraine:


38.7    Business Freedom             Avg. 64.6
82.6    Trade Freedom                Avg. 74.2
30.0    Financial Freedom            Avg. 48.5
77.9    Fiscal Freedom               Avg. 75.4
30.0    Property Rights              Avg. 43.8
41.1    Government Spending              Avg. 65.0
25.0    Fdm. from Corruption          Avg. 40.5
61.2    Monetary Freedom             Avg. 70.6
57.7    Labor Freedom                Avg. 62.1
20.0    Investment Freedom           Avg. 49.0


Ukraine‘s economic freedom score is 46.4, which makes its economy the 162nd freest
in the 2010 Index. Its score is 2.4 points lower than last year. Ukraine is ranked 43rd out
of 43 countries in the Europe region, and its overall score is lower than the world
average.


12
   See AMB Country Risk Report, p. 10
13
   See Euromoney Country Risk Research
14
   See 2010 Index of Economic Freedom
                                                  13
Ukraine has made some important structural reforms to strengthen its economic base
and has achieved annual growth of 5 per cent over the past five years. Positive steps
have included implementation of competitive tax rates and membership in the World
Trade Organization after a fourteen year accession process.

In its transition to greater economic freedom, Ukraine is behind other European
countries, particularly in creating an entrepreneurial environment and fighting
corruption. Privatization and attracting of foreign investment process was slow.
Bureaucracy makes many commercial operations and business challenging. The judicial
system needs to be more independent, while legal procedures should not be a subject of
corruption.


Business freedom — 38.7
In Ukraine it is hard to start, operate, and close a business. Starting a business takes 27
days, compared to the world average of 35 days. Getting a business license takes more
than the world average of 18 procedures and 218 days, and costs are high. Bankruptcy is
long-termed and expensive.

Fiscal freedom — 77.9
Ukraine has relatively low tax rates comparing with other European countries. The
maximum rate for income tax is 15 per cent, and the standard corporate tax rate is 25
per cent. Other taxes include a value-added tax (VAT), a property tax, and an
inheritance tax. In the most recent year, general tax income as a percentage of GDP was
36.9 per cent.


Government spending — 41.1
Total government spending, including consumption and transfer payments, are high. In
2009 government spending equaled 44.3 per cent of GDP. Despite widespread
privatization, government makes interventions in the private sector.


Freedom from corruption — 25
Corruption is a common phenomenon. Ukraine has got 134th place out of 179 countries
in Transparency International‟s Corruption Perceptions Index15. Corruption is observed


15
     See Transparency International‘s Corruption Perceptions Index
                                                    14
on all levels of society and government and all spheres of economic activity. It is
considered to be a major obstacle to foreign investment. Low salaries encourage people
for corruption in local administrative bodies such as police and tax administration, as
well as in the education system.


To sum up everything there can be used a diagram, provided by AMB:
Score 1 (best) to 5 (worst)



                                          Legal System
                                             5
                Regional Stability           4               International T ransactions Policy
                                             3
                                             2
            Social Stability                 1                       Monetary Policy
                                             0


        Government Stability                                     Fiscal Policy


                      Labor Flexibility                  Business Environment


                                           Ukraine
                                           World Average


Figure 3: Diagram of political risk in Ukraine compared with average16




16
     See AMB Country Risk Report, p. 32
                                                                15
3. Conclusion


To summarise, it must be said that Ukraine is doing slow but confident steps forward
the favourable atmosphere creating for FDI attracting. It is essential that Ukraine after
the post-soviet shock recovers so soon, even though its economical results are not high
yet.


Ukrainian market is well-known among foreign investors as prospective, but high-
risked. According to the latest surveys, held by leading risk-estimating companies, the
greatest trouble for investors is political risk. It is unfavourable for a country to have it
high and for investor it is as well unfavourable to place money into the region with non-
predicted actions of government as it can lead to losses.


Estimation of political risk is a part of preparation work before choosing the market for
capital placement. The cost of risk measurement for a country is pricy, but when it
comes to amount of invested money, no one chooses blind investing. There exist many
rating agencies, such as S&P, Euromoney, Ernst&Young, World Bank, A.M.Best, MIGA,
etc which provide paid and free-of-charge as well analysis of country risks and
prognosis of future risk development. Some companies prefer to delegate the authority
of     political risk investigation to professional agencies, but not all. There are few
methods of political risk estimating, which can be used and provided by organizations
themselves, such as ―Grand Tour‖ or ―Delphi‖.


Ukraine has got low trust ratings due to high political risks such as governmental
instability, bureaucracy, bad entrepreneurial environment and set of other negative facts.
Despite the worldwide economic recession, Ukraine has to struggle thorough the
disadvantages of its economy and governmental policy, which are pointed by the
surveys made in special rating agencies. Attracting FDI is one of strategically-important
ways to develop economy and to integrate to EU.




                                             16
References

Aharoni, Yair (1966), The Foreign Investment Decision Process, Boston, MA: Harvard
University.


AMB Country Risk Report (2009), available at
http://www.ambest.com/ratings/cr/CountryRiskGlobalReport.pdf, 14.09.2010


Atradius Risk Report (2008), available at
http://global.atradius.com/creditmanagementknowledge/publications/countryreports.htm
, 15.09.2010.


Alwis, Athula, Vladimir Kremerman, Yakov Lantsman, Jason Harger and Junning Shi
(2007), ―Political Risk Reinsurance Pricing – A Capital Market Approach‖ Paper
presented at the 28th International Congress of Actuaries, Paris, May 29-June 2.


Bremmer, Ian and Robert Johnston (2009), ―The Rise and Fall of Resource
Nationalism.‖ Survival: Global Politics and Strategy 51 (2), pp149–158.


Ernst & Young (2007), Risk Management in Emerging Markets. London: Ernst &
Young, available at:
http://www.ey.com/Publication/vwLUAssets/Tax_TP_Insight_0308/$FILE/TP-Insight-
0308.pdf, 01.08.2010.


Euromoney Country Risk Research (2010), available at:
http://www.euromoney.com/Article/2675660/Country-risk-September-2010-Full-
results.html, 07.09.2010.


Hansen, Kenneth W. (2005), ―Tales from the Dark Side: Lessons Learned from
Troubled Investments.‖ Available at:
http://www.vcc.columbia.edu/documents/IndianMNEReport-Final.pdf, 02.09.2010.


Index of Economic Freedom (2010), available at:
http://www.heritage.org/Index/Country/Ukraine, 13.10.2010.
                                        17
Kobrin, Stephen J. (1979), ―Political Risk: A Review and Reconsideration.‖ Journal of
International Business Studies.


Lloyd‘s (2007), Lloyds 360. Under Attack? Global Business and the Threat of Political
Violence. London: Lloyd‘s.


Lloyd‘s and Control Risks. 2009. Lloyds 360 Insurance Market. Global Recession: The
Magnifying Glass for Political Instability. London: Lloyd‘s.


MIGA Global Risk Report (2010), available at:
http://www.miga.org/documents/flagship09ebook.pdf, 15.09.2010.


Nigh, Douglas (1985), ―The Effect of Political Events on United States Direct Foreign
Investment: A Pooled Time-Series Cross-Sectional Analysis.‖ Journal of International
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Private and Official inflows report of World Bank (2009), available at
http://www.worldbank.org/eca, 31.09.2010.



Sethi, D., S.E. Guisinger, S.E. Phelan and D.M. Berg (2003), ―Trends in Foreign Direct
Investment Flows: A Theoretical and Empirical Analysis.‖ Journal of International
Business Studies, 34, pp. 315-326.


Standard and Poor‘s (2009) ―Emerging Market Sovereign Credit: The House Shook But
It‘s Still Standing.‖ S&P Credit Research (September).


Thomson, Stephen (2009) ―Keeping Markets Open at Times of Economic Crisis.‖
OECD Policy Brief (April).


Transparency    International‘s      Corruption   Perceptions   Index,   available   at:
http://www.transparency.org/regional_pages/europe_central_asia, 01.10.2010.


                                            18
UNCTAD (2004) World Investment Report 2004: The Shift Towards Services. New
York and Geneva: United Nations.


UNCTAD (2006), World Investment Report 2006. FDI from Developing and Transition
Economies: Implications for Development. New York and Geneva: United Nations.


UNCTAD (2009a) ―Historical Perspective, Recent Trends and Elements of Protection
in International Investment Agreements.‖ Unpublished report prepared for MIGA.


UNCTAD (2009b), Investment Policy Developments in G-20 Countries. New York and
Geneva: United Nations.


UNCTAD (2009c), World Investment Prospects Survey 2009-2011. New York and
Geneva: United Nations.


Wells, Louis T, Jr. (2005), ―The New International Property Rights: Can the Foreign
Investor Rely on Them?‖ In International Political Risk Management: Looking to the
Future, ed. Theodore H. Moran and Gerald T. West, pp. 87-102.


World Bank (2006), Global Development Finance: The Development Potential of
Surging Capital Flows. Washington, DC: World Bank.


World Investment Prospects to 2011 (2007), available at:
http://graphics.eiu.com/upload/WIP_2007_WEB.pdf, 21.09.2010.




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