Political uncertainty – and what to do about it

Political risk: a primer

Infrastructure investors operating in emerging markets know that, while the potential for strong return on investment is high, the risks are not for the faint of heart. Open the newspaper. Browse the internet. It’s easy to be concerned by reports proclaiming instability and insecurity in parts of the developing world.

Investors understand the nature of commercial risk, but what, exactly, is political risk? How does it affect infrastructure investment?

Broadly defined, political risk is the probability of disruption to operations by political forces or events, whether they occur in host countries, home countries, or result from changes in the international environment. In host countries, political risk is largely determined by uncertainty over the actions of governments and institutions, but also of minority groups, such as separatist movements. At home, political risk may stem from political actions aimed at investment destinations, such as sanctions, or from policies that restrict outward investment.

The insurance industry uses a narrower definition of political risk, focusing on actions that take place mostly within host countries. Accordingly, political risk insurance (PRI) usually covers restrictions on currency convertibility and transfer, expropriation, political violence, breach of contract, and the non-honouring of sovereign financial obligations.

The infrastructure industry is uniquely vulnerable to political risk due to its huge upfront costs and capital investment, long construction timeframes, and reliance on future cash flows to meet financial obligations and provide reasonable returns. Therefore, PRI plays a key role in bolstering the confidence of investors and lenders, and in facilitating investments with high development impact into under-served markets. In short, it can make the difference between a project going ahead or not.

The public and private segments of the PRI market have played complementary roles over time. Yet, while private insurers are susceptible to sharp reductions in capacity, public insurers generally are not constrained by this – or by shareholder pressure for profitability. This means they have an important role in stabilising markets during uncertain times.

Infrastructure: critical for development

Infrastructure development is essential in emerging economies to support productive investment in goods and services and to broadly share the benefits of growth among the population. Infrastructure development is also a priority for MIGA, given the estimated need for $230 billion a year of new investment to deal with rapidly growing urban centres and under-served rural populations in developing countries. Maintenance needs are of a similar magnitude.

Developing countries face significant challenges in attracting private investment in infrastructure to meet the enormous shortfall that governments alone cannot fill. In addition, the global financial crisis has had major repercussions on the infrastructure development plans of these countries.

MIGA’s experience in underwriting infrastructure investments in the developing world is extensive. Since inception in 1988, the agency has issued more than $5.6 billion in guarantees for infrastructure projects. MIGA’s coverage has ranged from large hydropower dams in sub-Saharan Africa, to toll roads in Latin America, to water supply and wastewater systems in Asia.

MIGA’s strategy builds on its market strengths: encouraging investments in more difficult, frontier markets, as well as supporting investments at the sub-sovereign level, which often involves inexperienced and therefore riskier partners.

Corporate perspectives on political risk

During the second quarter of 2009, MIGA commissioned a survey of executives from multinational companies to gauge how political risks may constrain their investment plans and what mechanisms they use to mitigate political risk. The resultant World Investment and Political Risk report offers a snapshot of the industry and its drivers – especially as they relate to the recent financial crisis.

Some of the findings:

Investors surveyed rank political risk among their top three concerns when investing in developing countries – it is cited more often than any other consideration, including macroeconomic stability and access to financing.

This is expected to continue over the medium term. In fact, the survey suggests that the prominence of political risk will increase over the next three years, as constraints related to the financial crisis gradually ease.

As the world economy recovers, some form of resource nationalism may endure. Opportunities for private investment in infrastructure and extractive industries, with their long-term horizons, large scale, and reliance on government licenses or guarantees may carry concerns over breach of contract, expropriation, and related political risks.

Concerns that governments may be tempted to impose transfer and convertibility restrictions have emerged in countries where the financial crisis has undermined liquidity and put pressure on the local currency. With unemployment rising, declining remittances, and pressure on social programmes due to shrinking government revenues, the risk of civil unrest may be more pronounced. Budgetary pressures have also raised concerns about the ability of governments and state-owned entities to fulfill their contractual obligations and honour sovereign guarantees.

Concerns over political risks, combined with sustained FDI into emerging markets over the medium term, suggest a growing need for political risk mitigation.

Only 6 percent of investors surveyed said they did not mitigate political risks at all. However, those who did manage these risks appear to rely primarily on their own capacity – even though a sizable minority judges that capacity as poor – and on informal mitigation mechanisms, such as engaging with local governments or partners. Insurance appears to be a niche product: 14 percent of surveyed investors contracted PRI, but almost twice as many did so when venturing into markets considered the riskiest. Notably, 40 percent of respondents indicated they would consider using insurance for future investments.

The bottom line

Infrastructure investment in emerging markets is often risky, but the opportunities are substantial and growing. The PRI industry is continuously evolving to keep pace with emerging challenges such as sub-sovereign risk, resource nationalisation and terrorism. PRI is not only a concern for the investor – the presence of PRI reassures skittish lenders that investors are committed and serious about risk mitigation.

In summary, PRI is often the lynchpin that brings together investors, lenders and governments to deliver sustainable infrastructure projects that build a stronger base for a country’s development.

Edith Quintrell is director of operations, MIGA