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Effects of Political Risk on Foreign Investment in Europe

November 06, 2016
Brexit, the “Black Swan” event, has aroused investors’ concerns about the potential political risks in the European region, in addition to the uncertainty of the Greek debt crisis and the shadow of terrorism.

By Boyi Wu

For those foreign investors who have directly invested in the politically trembling regions, it’s hard to get prior protection from the investment country’s government if a real crisis happens. Foreign investors always have potential exposures to highly volatile exchange rates, transfer and convertibility restriction, fluctuation of commodity prices, and potential changes in government policies and trading barriers.

If a country is under certain extreme circumstances, such as a financial or debt crisis, people tend to exchange their domestic currency to foreign currency in order to prevent their liquidity from shrinking. Since stable exchange rate levels are used in the expected profit functions of firms that make investment decisions today in order to realize profits in future periods, foreign investors need to take the exchange rate into full consideration before they make their final decisions to pursue overseas operations.  If exchange rates are highly volatile, the expected values of investment projects are reduced, and foreign investment is reduced accordingly [1]. Just after the nation voted for a Brexit, sterling reached $1.3229, the lowest level since 1985, and weakened 6.2 percent to 81.27 pence per euro, for the biggest decline on record [2]. As the sterling depreciated, an increase in import prices and a wage adjustment are expected. The huge depreciation in sterling is a disaster to foreign investors who already started projects in Britain, since they are struck by both the depreciated profit and by soaring commodity prices.

Furthermore, the lack of foreign exchange will lead to a transfer and convertibility restriction set by the investment countries. These countries have a small amount of international reserves to prevent large amount of currency exchange made by foreign investors. Just a year ago during the Greek debt crisis, the Greek government announced capital controls to order its banks to impose strict limits on daily withdrawals and overseas transfers of cash. Individuals are allowed to take out only €60 (£42 or $66) a day for this period, and although they can bank online more freely, they cannot move money to accounts abroad into a different currency [4]. Since Greece’s Central Bank doesn’t have enough international reserves to cover a quarter’s imports, it can’t assure that international trade would not be interrupted by a shortage of the inflow of foreign exchange. Foreign investors started to become concerned about the Greece’s Central Bank’s ability to fully covering their foreign exchanges, leading to decreased attractiveness of Greek projects and assets. Total inflows of foreign investment capital, which essentially reflects the real performance of the country in attracting investment, decreased by 73% in 2015 in comparison to 2014, reaching approximately 605 million Euros [5]. Freedom of currency exchange ensures the capital inflow and outflow of multinational corporations. Transfer and convertibility restrictions will interrupt the circuits of capital and lead to breaks in the credit chain of these corporations.

Besides the freedom of currency exchange, the stable trading environments and government policies are also important to foreign investors. Political risks, such as Brexit, will bring changes to the intergovernmental policies and the regional trading environment, which in turn brings uncertainty to the future earnings and operation strategies of foreign investors. Although the further steps of Brexit are still under discussion, several changes in international trading policies and government regulations between Britain and European Union are foreseeable. Before Brexit, firms and investors in many non-European Union countries used Britain as a gateway to Europe, benefitting from the zero-tariff environment and free movement of labor and capital [3]. Britain may lose its pivotal role as a financial and manufacturing center across Europe, since international trading policies and extra transaction costs will affect the trade between Britain and the EU in the future. As trade costs rise (due to non-tariff and possibly tariff barriers), locating production in the UK is less attractive because it becomes more costly to ship to the rest of Europe [6]. But even worse, foreign direct investment inflows would dry up, and parent companies may even close-up shop and move their production or offices elsewhere [3]. On the EU side, half of all the European headquarters of non-EU firms are in the UK, with the UK hosting more HQs than Germany, France, Switzerland and the Netherlands put together. The cost of adjustment for European corporates could be considerable. [7].

Even though foreign investments are considered relatively safe in the European region, which has a well-established legal system and less civil disturbance, foreign investors still need to be aware of the potential political risks. To deal with these risks, they can hedge their currency exposure to mitigate the risk caused by exchange rate. Purchasing political risk insurances from national export credit agencies or multilateral agencies, such as MIGA, is also a good way for foreign investors to concentrate on the commercial aspects of investments, with the comfort that political risk insurance providers will help them avoid potential losses, or reimburse them in case of a covered loss related to political causes.

References 

  [1] Linda S. Goldberg, “Exchange Rates and Foreign Direct Investment,” Princeton Encyclopedia of the World Economy, 2006. [Online]. Available: https://www.newyorkfed.org/medialibrary/media/research/economists/goldberg/ERandFDIArticleGoldberg.pdf [Accessed July 29, 2016]. 

  [2] Lukanyo Mnyanda and Lucy MeakinBloomberg, “Pound Plunges to 30-Year Low as U.K. Stocks Slide on Brexit”, Bloomberg, July 31, 2016. [Online]. Available: http://www.bloomberg.com/news/articles/2016-06-23/pound-tumbles-on-results-from-northeast-england-in-eu-referendum [Accessed July 29, 2016]. 

  [3] “The economic impact of ‘Brexit’”, Woodford Fund, February 2016. [Online]. Available: https://woodfordfunds.com/economic-impact-brexit-report/#foreign-investment [Accessed July 29, 2016]. 

  [4] “Greek debt crisis, what are capital controls?” BBC, June 30, 2015. [Online]. Available: http://www.bbc.com/news/business-33303540 [Accessed July 29, 2016]. 

  [5] “Foreign Direct Investment,” Enterprise Greece, [Online]. Available: http://www.enterprisegreece.gov.gr/en/greece-today/why-greece/foreign-direct-investment [Accessed July 29, 2016]. 

  [6] Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen, “The impact of Brexit on foreign investment in the UK,” the London School of Economics and Political Science, April 2016. [Online]. Available: http://cep.lse.ac.uk/pubs/download/brexit03.pdf [Accessed July 29, 2016].

  [7] “Brexit: the impact on the UK and the EU,” Global Counsel, June 2015. [Online]. Available: https://www.global-counsel.co.uk/sites/default/files/special-reports/downloads/Global%20Counsel_Impact_of_Brexit.pdf [Accessed July 29, 2016]. 

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