Introduction to Political and Economic Risk/Corporate Risks
|Unit 1.1- Intro to Political and Economic Risk||
Investing in assets overseas is a form of direct foreign investment that can be done through subsidiaries, joint ventures, manufacturing or license agreements. The political environment will often dictate which form companies pursue or the level of risk an investing company is willing to take. The pursuit of manufacturing in a foreign locale presents some unique problems for a company. Incentives are often given to encourage investment. It is always important to evaluate the costs associated with these incentives. One example could be that government land is being donated. But in order to access this land the roads, utilities and labor have to be supplied by the potential manufacturer in order for the land to be useful. Housing, transportation and food may have to be supplied as well as some other essentials to entice labor to come and work for the company.
International business generally is a separation of societies not only by borders but terrain. This separation by ocean, mountains or deserts creates more distance than just physicality. Overcoming the challenges to please a buyer does not ensure payment on the debt incurred. The ability to collect on a debt has added problems because the laws in the country of the buyer may not be the same as those in the country of the seller, thereby creating additional legal expenses in order to collect the debt. There is also an exchange/loss risk potential if foreign exchange contracts were made to cover the uncollected debt. The recovery of merchandise is costly as is transport back to the seller. Sudden political or civil unrest may prevent the payment from being delivered to the seller. These are only a few of the potential problems that sellers face when extending credit to a foreign buyer.
The use of foreign credit insurance can provide many options for a seller. The foreign credit insurer will evaluate the foreign buyers and provide credit limits to the seller for them, thus eliminating the need for an internal credit department to evaluate and collect on the debts. It also allows the foreign receivable to be eligible for financing by a bank. It allows the seller to expand into the foreign markets with much less risk. Ex-Im Bank originally was the only resource for foreign credit insurance, but now many private companies compete for this business. The annual deductible for this insurance is generally less than the cost of hiring a credit clerk.
Letters of credit--both commercial and standby--are often used to control corporate risk. Letters of credit do not prevent fraud, so there is still a need to know the buyer. At a minimum, letters of credit tell you that a buyer has a relationship with a particular bank to the extent that the bank will issue the letter of credit. The buyer will either have put up cash collateral for the amount of the letter of credit or have a credit facility for the amount of the letter of credit. Remember that the bank promises to pay if there is not strict compliance with the terms of the letter of credit and is a more reliable source of payment than the buyer.
Cash payment in advance provides the most protection and the least cost for a seller but the most of risk for the buyer. Selling on open account is at the opposite end of the payment term spectrum, providing the least protection for the seller. Documentary collections are more risky than letters of credit but not as risky as selling on open account. Documentary collections, when the shipment is under a “negotiable” transport document, will ensure that the seller will maintain title to the goods until payment is made at sight. Documentary collections under an accepted time draft are similar to selling on open account. The only difference is that the buyer’s bank is engaged to act as the collecting agent for the seller but provides limited communication and collection processing capabilities. The collecting bank takes no financial responsibility in the transaction, a fact that a seller must always keep in mind.
Whenever a purchase or sale is made, there are risks. This type of risk is referred to as commercial risk. The risks include the obvious ones:
- a buyer being unable or unwilling to pay the seller
- a buyer placing an order that must be delivered at a specific time and the seller being unable or unwilling to fulfill the order
- a seller being unable or unwilling to provide the necessary warrantee service
- a seller being unable or unwilling to refund advance payments or deposits
- a buyer being unable or unwilling to accept delivery of product when it is ready for shipment
- a seller being unable to collect payment, necessitating legal action that is costly to pursue.
These risks are common to all transactions involving the purchase and sale of goods or services. Some of the payment vehicles mentioned help mitigate some of these risks.