CHAPTER THREE INVESTMENT RISK IN DEVELOPING COUNTRIES

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1 CHAPTER THREE INVESTMENT RISK IN DEVELOPING COUNTRIES 3.1 INTRODUCTION The mining industry associated with the investment environment is unique when compared with the environment encountered by other industries. It is recognized that the mining industry across the world is an industry where a high capital investment is needed initially. It involves taking a great risk. It also deals with the extraction of a non-renewable resource (O Neil, 1984). Depending of the uniqueness of features and characteristics of mining industries, many countries apply tax policies which treat the mining industry differently (KPMG Aiken & Peat, 2004). Consequently, the success of a mining industry depends on number of factors: modern successful exploration in mining involves high skills levels, advanced technology, innovation, considerable capital and major risk-taking by exploration companies (ExxonMobil Australia Pty Ltd, Submission No. 18, p.136). Gentry and O Neil (1985) noted that there are a number of other risks in addition of those risks associated with capital intensity and lead times. Some of these risks may be under the control of the foreign investors while others are clearly uncontrollable. They argued that in general, the mining industry often faces serious risks of two types. The fist one, which the mining industry has considerable experience is the geologic risk. The geologic risk refers to the risks associated with the ore deposit including grade and tonnage, and the uniformity, nature and genesis of ore body. 45

2 Ore deposits being found today are deeper and lower grade. It is not easy to analyze the continuity of ore deposits, as well as the ground control (Halupka, 1999). The second category is the political risk. Given the increasing international and local increase in the use of natural resources (based on sound economic principles), the concept of political risk has become more intense in recent years (Hoti, 2004) This paper analyses the issues of political risk more comprehensively. An attempt is made to identify within the literature potential source of political risk, which provide the basis for simulation study. This could be used for application to specific risk assessment studies in the light of various problems faced by investors in different countries. 3.2 RISKS FACED BY INVESTORS A literature review revealed the following risks perceived by investors when globalising into the developing world. Foreign companies engaged in international activities are exposed to risks. They perceived the developing region to have an investment environment posing the highest levels of risks anywhere in the world. This part of the world, the developing world, poses difficult issues to attract foreign investors in the mining industry. The Table 3.1 shows the more important risks facing by investors today in the developing region. Those risks are of two types (Mistry and Olesen, 2002): a) One with which the foreign investors have considerable experience is commercial risk. The three principal categories of commercial or economic risks confronted by investors include: Operational Risks: risks that impact on the operational environment of an investment. These could include interruption in power supply, 46

3 harbour facilities or telecommunication services or any factor which lead to the total closure of production facility. Business Risks include risk such as policy change, infrastructure Service failure, environmental factors, financial system, currency Fluctuations. Financial Risks include capital adequacy, problems of liquidity, interest rate, loan default or delayed payment of suppliers credits, repudiation of contracts by government, losses from exchange controls (ICRG, 2002). The components of commercial risks differ in nature and magnitude in various phases of a mining project. Risks in the development or construction phases are higher than those in the operational phase. b) The second type of risk confronted by foreign investors is noncommercial risks. The main Non-commercial risks for foreign investors in developing nations are segregated into two groups: The first group is the country risk. This category of non-commercial risk includes risks such fragile political systems and structures, expropriation, war and border conflict, weak governance, poor administration, weak regulatory regimes, poor infrastructure services, corruption, confiscation, deprivatization, instability of government, violation of some host countries to respect to investment agreements, unrest, and many other problems. The second group is event risks relative to natural event such as calamity, flood or famine, to civil society pressure such as boycotts, sanctions, threats to property, or to policy failure event such as banking crisis, financial crisis, fiscal crisis, labour crisis. 47

4 All of these factors increase non-commercial risk, but they also impact the commercial risk by increasing factors such as operating and capital costs of an investment. Given the significant increasingly changing business and economic environments, as well as the global demand of investment needs, the noncommercial risks, or the ultimate risk, political risk, have become more intense in recent years. Consequently the number of the private political risk insurance has growth rapidly in mining sector in the past few years (MIGA, 2002). Investors continue to expand and improve their efforts in potential violent conflict, often in countries where they have invested for many years. Substantial progress has been made on some areas over the past decade, the quality of the private political risk insurance has been improving, while other new challenges remain. Commercial and non-commercial risks are different in nature as well as in magnitude. Their nature depends on: The type of investment The country in which the investment is being made The structure of competition in the sector The sector or industry in which the investment is being made 48

5 Table 3. 1: Risks face by foreign investors in developing world Commercial Risks Non-Commercial Risks Financial Risks Operational Risks Business Risks Country & Event Risks Risk Sub-Risk Risk Sub-Risk Risk Sub-Risk Risk Sub-Risk Balance Sheet Structure, Asset Business Strategy Marketing Legal Documentation Confiscation, coup d Etat Liability Mkt.Demand Judiciary, Laws Expropriation,Revolution Provisions Write-downs Derivatives & Market Product, Price Resource, Tech- Nology, Support Enforcement Litigation, Liability Political Nationalisation, Break Civil Unrest, Corruption Instability, Sabotage Income Statement Structure Profitability Debt Service Revenue Risk Mgt.Systems Operations & Production, IT Human, Financial Training, Security Control, Int.Audit Policy Change Taxation, Inflation Exch. Rate, Ind./ Sector Labour, Social Regulatory, tariff Creditworthiness Sovereign Provincial Local Municipal Capital Adequacy Credit Equity Quasi-equity Debt Burden Off-B/Sheet Borrower Guarantor Supplier Customer Agent Technology Fraud Corruption & New proven Equipment Sequence Training Shareholder Employee Supplier, Customer 3 rd Party, Govt. Financial System Business Support Payments, Services Credit Soundness Access Accounting Auditing IT Support Recruitment Consulting War & Conflict Natural Event Civil war, insurrection foreign pressures Civil disorder Terrorism, revolution Earthquake Coastal, Flood Calamity Mudslides Drought, Famine Liquidity Cash, Cash-Flow Curr.Assets Curr.Liability Intrst Cover Interest Rate Domestic Foregin Long-term Short-Term Business Disruption Int. Factors Ext. Factors Acts of God Infrastructure Accidents Infra-structure Service failure Environmental Factors Transport Power Water, Drainage Telecoms Air and water Pollution Soil erosion Land Rehab. Acid rain, Radiation Mine leakage Policy Event Global Impact Failure Event Banking crisis Financial crisis Cap. Mkt. Crisis, Fiscal crisis Labour crisis War, Dollar crisis September 11 th Oil Price, Shock Global Cap. Currency Volatility,3 rd urrency Convertibility Remittance Compe-tition Foreign, Domestic New entrant Dropout Civil Society pressures Boycotts, Sanctions Threats to Property Threats to People Source: Mistry and Olesen,

6 3.2.1 The concept of non-commercial risks In the literature, the non-commercial risk is often referred to as political risk, country risk or policy risk. But in reality, as indicated in the Table 3.1, the political risk or country risk is only one of the two components of non-commercial risk. In this study, the term non-commercial risk will be used in place of political or country risk. Definition of Non-Commercial Risk As noted in the introduction to this research report, non-commercial risk is defined as any actions or attitudes from the host government that significantly decreased the cash flow of an investment or project. However, in the literature, two definitions of non-commercial risk generally exist, and it is important to explain how the above definitions were chosen. The first definition, most often associated with the attitude of host country, defines non-commercial risk as the probability that a project s economic value to the investor will be adversely affected by unilateral governmental actions over which the investor has little control or influence (Otto and Cordes, pp 5-11, 2002). According to this definition, non-commercial risk can arise from external threats (such as terrorism as in the case of September 11 th in the United States, civil war and border conflict as in the DRC case). Non-commercial risk can also arise from internal threats (such as fragile political systems and structures such as in the more developing countries, expropriation, and nationalisation as in the Zimbabwe case). However, most investors associate risk solely with uncertainty about negative event such as flood, famine, sanctions, and others. Alternatively, a commonly used definition of non-commercial risk, as provided for example by Nagy (1984): Political risk is the exposure to a loss in cross-border lending, caused by events in a particular countries 50

7 which are at least to some extent under the control of the government but definitely not under the control of private enterprise or individual. Nagy sees political risk, defined as the inability of foreign investors to accomplish their obligations due to government actions. Political risk is one of the most important drivers of non-commercial risks, Nagy said. Examples of political risks include where the need to hang on to power at all costs has created instability and rapid economic decline such as in Kenya and Zimbabwe, conflict over unconstitutional third terms for incumbent presidents has destabilised countries, such as happened in Zambia and Malawi and where new and inexperienced governments are afraid to fail and simply do not perform in line with expectations, such as Ghana, Dianna said. Dianna also noted that Political risk is the problem most often cited by business people. Unstable and greedy political regimes are on the one end of the spectrum, where the risk is highly visible and companies, particularly those operating in the mining and oil and gas sectors, are able to factor this into their planning. (Games 2003, pp. 4). Common examples of political risk include factors such as expropriation, or possibility of nationalisation, breach of contract, confiscation, civil war and civil disturbance, terrorism, and corruption. This list is not exhaustive and the risks are not given in order of importance. The interest of each component varies from county to country, from project to project. Mechanisms to identify them depend from company to company, depending also on the availability and accessibility to viable information of the country in which the investment will be taken. Each factor of political risk not only directly affects the project, but affects the other risk factors (MIGA, 2003). In short, non-commercial risk refers to every risk different from geological or commercial risks 51

8 Source of non-commercial risk In the past, risk management in the mining industry was mainly focused on commercial risk such as financial and business risk. The Pacific islands from his Forum Secretariat Ministers Meeting (2003) note that, given the increasingly global nature of investment flows, and the competitive environment for foreign direct investment, the concept of non-commercial risk has an important influence on the overall level of investment in a country. The non-commercial risk, not only determine the ability of a country to attract foreign investors, but also the quality and stability of investments in that countries. Otto and Cordes (2002) note that political risk assessment emerged as an integral part in the process of investment decision-making in the aftermath of the assertive policies during the 1960s and 1970s. When serious investors are looking for a country in which to invest their money, they are confronted with many opportunities. They are not only looking to the mineral potential of a target country. They have to find and identify the best investment opportunities in an organised ways. One of the factors they considered is the probability of getting their money back as soon as possible (minimum payback period) in accordance with the contract in which they invested in that country. Investors are also looking to the debt levels of an investment country. Under the direction of Khaya (2001), the South African Industrial development Corporation (SADC, 2001) described the political and economic requirements to be fulfilled in order to attract FDI. The document focused on the efforts that African countries should make to improve the mining sector in order to attract foreign investors in the sector. Khaya noted that Investors to day increasingly differentiate between potential investment destination on the basis of micro-economic or competitiveness factors rather than on the traditional macroeconomic factors. In the 52

9 globalised economy, foreign investors view macro issues as given and they should be reluctant to invest in economies where fundamentals to business are not in place, he said. By reviewing a large number of reasons that foreign investors considered the mining sector in the developing region to be high-risk enterprise, the concept of non-commercial risk has become more important. This concept has the advantage of including the interaction of political, economic and social factors country-specific factors. The impact of each factor varies from country to country. Non-commercial risk also refers to the ability of a country to repay its debts in full and on time. Since non-commercial risk still remains largely in an investment country, foreign investors will be concerned about how they could manage those risks, particularly to how they could be mitigated. Many countries have established Investment Promotion Agencies with mandates ranging from providing initial applications and related services focused on attracting investors, participing in the screening and approval of investment projects, to post-approval services and supervision. Others used mining agreements or using private insurers such as the Multilateral Investment Guarantee Agency (MIGA) 3.1. The success of those agencies have been limited, partly due to the wide scope of their mandate, but also due to inherent conflicts with the well-established traditional mandates of line ministries (Economic Committee, Gaborone, 1998). 3.1 The Multilateral Investment Guarantee Agency (MIGA) is a part of the World Bank Group, a major global development institution. MIGA, as an agency, underwrites the private sector and guarantees the investments of corporations and banks against political risk. Since 1985 inception, this agency has provided more than $7 billion in political risk insurance for projects in 75 countries (World Bank report, pp.1-9, 2001). 53

10 The risk versus the profit is some time strong in the mining industry. In some instances the risk in the sector has been too great and companies have been constrained to pull out due to non-commercial risk such as civil war, as in the case of Angola. The host governments have to position their countries as an attractive and competitive investment destination. Traditionally, foreign investors considered expropriation to be the primary non-commercial risk. But, it has become clear that political risk can occur in forms other than expropriation. In particular, foreign investors should consider non-commercial risk as variants of creeping expropriation. In place of a simple expropriation, the host countries may resort to contract frustration. Rather than taking over projects when finished, host governments can delay their completion and operation, putting foreign investors under undue financial pressure either to renegotiate terms or to make sidepayments to get physical and financial completion certified and permit operations to start. This form of politically motivated business interruption (enhanced breach of contract) is a political risk but one that event triggered risk insurance does not provide protection against (L.Paul Bremer III, 2003). Paul noted that there is also an increased risk of political violence as states come under pressure. Recent events in Yugoslavia, Zimbabwe, the DR Congo, and Sierra Leone show how growing ethic, religious and borders tensions ant the fight for a share of the economic pie can translate into political violence. Other new sources of non-commercial risk keep emerging in the world environment investment such as September 11 th. As provided for example by Stijn & Geert (2002), the government cannot service its own debt because lack of the required amount of foreign exchange or unwilling to service its debts. They concluded that these events would be classified as foreign default, then non-commercial risk. 54

11 Measures of non-commercial risk Evaluation of non-commercial risk over time is very difficult but crucial to both investors and host governments. The difficulty arises because, the techniques (or mechanisms) of risk measurement depends of the nature/type of mining company and the availability of information. There are different measures of non-commercial risk, but all of them include some of the government s tendency to avoid risks such as expropriation, confiscation, war and nationalisation. There are many risk rating agencies that measure non-commercial risk and therefore investor exposure to risk in any one of the host countries. The perception of relevant non-commercial risk may differ from one agency to another, while they provide useful insights used by foreign investors and international financial institutions to be informed and make immediate decisions regarding the creditworthiness or competitiveness of an investment country. These insights must be integrated into countryspecific factors. Quantity indicators are based on the ordering of company priorities and their willingness to accept a diversity of risks which they feel capable of managing. The purpose is to provide a framework that aligns the interests of foreign investors, their priorities as well as their concerns with known or possible risk factors relevant to the proposed project (Otto and Cordes, 2002). In addition, the International Country Risk Guide (ICRG), an index that measures non-commercial risk, provides some measures of political risk. The ICRG notes that these measures are determined by an interaction of political risk, economic risk and financial risk. From the background of their report, the Pacific Islands Forum Secretariat (2003) noted measuring country risk can be an extensive and expensive task for investors, 55

12 depending on the availability and accessibility to qualitative and quantitative information of a targeted investment country. However, there are an increasing number of independent rating companies that undertake in-depth country risk studies and issue assessments in the form of a single index or a rating. These countries ratings are usually made publicity available and provide a convenient and simpler level of comparability between countries. The assessment of the overall non-commercial risk rates the potential for crisis in a country s political environment, where foreign investors may have exposure The non-commercial risk rating 3.2 A wide range of agencies provide non-commercial risk. The overall aim of the non-commercial risk rating is to provide a means of assessing the political stability of the selected countries covered by various risk rating agencies on a comparable basis at a specific time. International investors have invested extensive resources in evaluating risk data to better estimate business opportunities and non-commercial risk ratings and government performance indicators are thus the subjects of renewed interest (Anja, 2002). All of risk rating agencies employ different methods in determining non-commercial risk ratings. The risk ratings are determined by country experts. Those experts analyse the changing nature of threats to international investment in countries around the world. The following are examples of the main types of risk ratings agencies. Standard & Poor s Rating Group Moody s Investors Services Euromoney Institutional Investor 56

13 Business Environment Risk Intelligence (BERI) Potential Index International Country Risk Guide (ICRG) World Investment Report (WIR) Economist Intelligence Unit (EIU) Each of the risk rating agencies providers combined a number of qualitative and quantitative information regarding alternative measures of political risk into associated composite risk ratings. They are usually made publicly available and those publicly made by various risk-rating organisations could provide a convenient level of comparability between countries. As we will be using the results of some of risk ratings agencies, we review or analyse in detail the methodologies used by some of them. I. International Country Risk Guide (ICRG) The Political Risk Service Group (PRS Group) published two risk methodologies for evaluating the risks face by investors in countries around the world: Political Risk Service (PRS) and the International Country Risk Guide (ICRG). Both PRS and ICRG use an entirely different risk methodology to measure the non-commercial risk. The sum of the risks points assigned to each risk component within each risk category determines the overall risk rating for that category. The PRS Group produces limited publications containing valuable market information provided to a select group of countries. The group also provides analysis for the political, economy and financial risk situation in different countries. 3.2 It should be emphasised that the information contained in this section represents an accurate summary of informations from the BERI S.A., PRS Group. Thanks are given to the Euro money Group, especially to Stephen J. Weber, Representative for BERI S.A., for providing some of the data used in this section. 57

14 The concept of the International Country Risk Guide (ICRG) has been evolving over the past twenty years, and there are many raisons why it has become a major issue for companies throughout the world. The need in recent years for companies to improve both their efficiency and skilfulness in the business. Since 1980, the ICRG has been compiling monthly data on a variety of political, economic, financial, and composite risk factors to evaluate risk indices in each of these categories for 90 to 140 countries around the world. The ICRG rating system comprises 24 factors representing three major components of political, economic and financial risks. Thirteen political, five financial and six economic factors are used. Each factor for the non-commercial risk rating is assigned a numerical rating within a specified range and the overall factors weighted to give a total mark of 50 points. Each factor of the financial risk ratings is assigned a numerical rating and the overall factors weighted to give a total mark of 25. The economic risk ratings component also accounts for 25 points (see Table 3.2). Non-commercial risk -rating category aims to provide an assessment of the political stability in a specific country at a specific time. For the economic risk-rating category is to provide a means of assessing country s current economic strengths and weaknesses and the main for the financial risk-rating is to provide a means of assessing a country s stability to finance its commercial and trade debt obligations (Linder and Santiso, p.8, 2002). 58

15 Table 3. 2 : The ICPG Rating System RISK % Composite POLITCAL Economic expectations versus reality 6% Economic planning failures 6% Political leadership 5% External conflict 3% Corruption in government 3% Military in politics 3% Organized religion in politics 3% Law and order tradition 3% Racial and nationality tensions 3% Political terrorism 3% Civil war 3% Political party development 3% Quality of bureaucracy 3% Total Political Points 50% FINACIAL Expropriation of private investment 5% Repudiation of contracts by host country 5% Loan default or unfavourable loan restructuring 5% Delayed payment of suppliers credits 5% Losses from exchange controls 5% Total Financial points 25% ECONOMIC Inflation 5% Debt service as a % of exports of goods and services 5% International liquidity ratios 3% Foreign trade collection experience 3% Current account balance as % of goods and services 8% Parallel foreign exchange rate market indicators 3% Total Economic Points 25% Overall Points 100% Source: Political Risk Service group, Inc.,

16 Following the literature in empirical modelling of the composite risk rating, some measure of CRR is regressed on a number of variables identified as determinants of political, economic and financial risk expressed as (Claude & Campbell, 1996): CRR = 0.5 * (PR + ER + FR) (1) With PR = SUM J PR J, ER = SUM J PR J, FR = SUM J FR J Where CRR is composite risk ratings PR is political risk ER is economic risk FR is financial risk Numerical rating mark assigned to political risk s factors is based on subjective analysis of available information. Numerical rating mark assigned to each factor of financial risk is based on analysis of both quantitative and qualitative information, while for the economic risk the analysis is based upon objective analysis of quantitative information of economic risk s factors(prg, 2003). The numerical equivalents of the three components are then used to calculate the CRR marks, compiled with political, financial, and economic risk factors. The ICRG is the unique system that provides countries risk rating combined with the political, financial and economic risk factors. The maximum number of points in one hundred: the higher the total numbers of points, the lower the risk of a given country, and the lower the number of points, the higher the risk of a country. The ranges of the different risk levels are described in Table 3.3, as follow: 60

17 Table 3. 3: Risks Ratings Ranges TABLE 3.3: RISKS RATINGS RANGES Category Political risk Economic risk Financial risk Very high risk High risk Moderate risk Low risk Very low risk Source: PRG Group, Business Environment Risk Intelligence S.A. (BERI S.A.) The Business Environment Risk Intelligence (BERI) rating system comprises 57 criteria representing three major components of measures of risk. Using a permanent panel of +/- 150 experts around the world who measure the country s risk of 53 to 56 countries during 23 years. Panel members are from companies, banks, governments, and different institutions with international experience. The BERI provides two services, the Business Risk Service (BRS) and the Foreland Risk Rating. The BERI Business Risk Service provides qualitative analysis for fifty countries three times per year. The system also uses three indices to measure the risk of the countries. Following are the three primary causes of risk for international companies. THE POLITICAL RISK INDEX (PRI) The Political Risk Index (PRI) rating system comprises 15 criteria and the purpose of the PRI is to measure the concept of socio-political conditions in a country, to create a flexible multicomponent system to weigh the key factors by using a permanent panel of expert with international experience. 61

18 The PRI also provides information that can be used by companies independently of other risk measures from BERI S.A. OPERATIONS RISK INDEX (ORI) The purpose of the Operations Risk Index (ORI) is to estimate the operations climate for foreign companies in a country by measuring the degree to which complex operating conditions affect both production and profits earned in the country. As the previous system, the ORI also uses a permanent panel of experts (from different institutions such as Banks, Governments, Companies) around the world for 15 criteria. REMITTANCE & REPATRIATION FACTOR OR R FACTOR The objective of the Remittance & Repatriation Factor or the R Factor is to measure the risk affecting access to foreign exchange and remittances profits and the R Factor also measures a country s willingness to allow foreign companies to convert and repatriate profits and to import production components. 3. Institutional Investor (II) The Institutional Investor system published country risk ratings based on a survey of a permanent panel of bankers with extensive international experience. They have to rate each country on a scale. The only challenge here is to define the parameters to be taken into account. Claude and Campbell (1996) noted that the bankers rank factors used differently in different group of groups of countries and that ranking have changed over time within country groups. 62

19 4. World investment report (WIR) The World Investment Report (WIR) analyses the business climate by measuring the level of both foreign multinational companies and local companies in developing countries. According to the UNCTAD (2003), the issue of linkages between foreign firms and domestic firms is a main challenge to be considered in developing region in order to benefit efficiently from FDI. The method used by WIR to rank countries is based on two index include the performance and potential index which rating governments by how they do in attracting foreign companies in their countries. Attracting foreign companies in the business may contribute to increase the efficiency and competitiveness of the country host. Following is the methodology used by both performance and potential index to rank countries. THE INWARD FDI PERFORMANCE INDEX The main objective of the Inward FDI Performance Index is to rank and score developing countries according to the level of foreign investors that in countries can receive relative to its economic size. This method compared the level of FDI and Gross Domestic Product of each country. Then, the Inward FDI Performance Index is the ratio of a country s share in global FDI inflows to its share in global GDP (WIR 2001, p. 23). This is given by the expression below: IND j = FDI GDP j j / / FDI GDP w w (2) 63

20 Where IND j = The Inward FDI Performance Index of the j th country FDIj = The FDI inflows in the j th country FDI w = World FDI inflows GDPi = GDP in the i th country GDP w = World GDP If the Inward FDI Performance Index (IND) is greater than one (IND > 1) this means that the given country receives more than its relative size of economic or to GDP. A value of IND below one (IND < 1), means that the country receives less foreign investors than its relative economic size. The only problem with this method is that this index does not consider other factor such as political stability, infrastructure, corruption, mineral potential. The index considers the market size of the country, assuming that other things being equal. Maura (1995) found that there is a negative association between corruption and investment as well as growth. A one-standard-deviation increase in the corruption index will generate an increase in the investment rate of 2.9% of GDP. Wei (2000) found that corruption acts like a tax and its impact of FDI inflows can be measured as such. Comparing corruption levels between Singapore and Mexico, Wei (2000) concludes that raising the index of corruption from the Singapore level to the Mexican level is equivalent to raising the marginal tax rate on enterprises by 50 percentage points (Mitchael, 2002). THE INWARD FDI POTENTIAL INDEX The Inward FDI Potential Index ranks and scores countries using twelve factors (apart from market size). Because perceptions of the determinants of this index are important, the factors have been selected among those could affect an economy s attractiveness to foreign investors. The Inward 64

21 FDI Potential Index used twelve factors. As it will be using the same set of variables, following are replicated factors used by the potential index and their definition (Table 3.4). Table 3. 4: Description of variables used by Potential Index Table 3.4: Description of variables used by POTENTIAL INDEX GDP per capita, an indicator of the The share of tertiary students in the total sophistication and breadth of local demand Population Commercial energy use per capita Political Risk The share of exports in GDP, to capture The world market share in exports of natural openness and competitiveness Resources The average number of telephone lines per The world market share of imports of parts 1,000 inhabitants, as an indicator of modern and components for automobiles and information and communication infrastructure electronic products The rate of GDP growth during the past 10 The world market share of exports of years, a proxy for expected economic growth Services The share of R&D spending in GDP, to The world market share of exports of capture local technological capabilities services and the share of world FDI inward stock Source: UNCTAD s 2003 World Investment Report The mathematical formula of this method is (Mitchell J. Harrison, pp.2, 2002): Score = V V j max V min V min (3) Where V j = the value of variable for country j V min = the lowest value of a variable among the countries V max = the highest value of a variable among the countries 65

22 Comparison Performance and Potential Index Comparing the performance index and the potential index in shown in a four-fold matrix of inward FDI, and countries selected are categorized by the UNCTAD as Front-runners include countries with high FDI potential and high FDI performance. Above Potential includes countries with high FDI performance but low FDI potential. Below Potential includes countries with high FDI potential but low FDI performance. The last group, Under-Performers includes countries with both low FDI potential and performance. Front-runners Below potential FDI POTENTIAL High Low Above Potential Under-performance High Low FDI PERFORMANCE Figure 3. 1: Matrix of Inward FDI Performance and Potential Source: UNCTAD s 2002 World Investment Report The matrix of inward FDI should be used to categorise the selected countries into a high/low FDI and non-commercial risk ratings. 66

23 Comparison of Non-Commercial Risk Rating A formal comparison of different measures of non-commercial risk requires the review of factors used by each agency to rank the countries. Different measures of non-commercial risk provide an independent analysis of ranges of factors or variables of a country. A non-commercial risk rating may differ from another because agencies use different factors; and they also differ in purpose and scope. A comparison of risk rating agencies such as the World Investment Report (WIR), the Business Environment Risk Intelligence (BERI) and the International Country Risk Guide (ICRG) is given below. The relative advantage of the Business Environment Risk Intelligence and the International Country Risk Guide agencies is assessed. The two agencies are driven by similar factors, but the BERI has the advantage of using a compilation of 57 factors, using a permanent panel of +/- 150 experts. The ICRG s agency used 24 factors, representing the three major components of political, economic and financial risks. The ICRG also takes into account the concept of debt. A study by Burton and Inoue (1985) found that a primary function of country risk assessment is to anticipate the possibility of debt repudiation, default or delays in payment by sovereign borrowers. The ICRG is the only risk-rating agency to provide consistent monthly data for a large number of countries. Ratings from the ICRG are used by some 80 percent of the world s largest global companies (PRS Group, 2001). While the WIR s agency used only 12 variables factors to rank countries. Among the most risks face by investors in the developing region, some of them are resumed by the three agencies, such as corruption, expropriation, civil war, etc. 67

24 3.3 CONCLUSIONS Chapter 3 analysed the concept of non-commercial risk, which has become a subject of major concern in the global economy and in the mining industry over recent years. Various rating agencies employ different methods to measure political risk by combining a range of factors representing the most risk perceive by foreign investors in the developing region. Today, more international investors are increasingly relying on country risk data to gauge business opportunities (Linder, 2002). In this section, the notion of risks in the mines and the mining industry was reviewed. Risks faced by foreign investors in developing countries were identified. The mining industry is risky business and the risks perceive by foreign companies in the developing region are of two types, the commercial risk and the non-commercial risk. Political risk is one of components of non-commercial risks. The literature on non-commercial risk rating was reviewed to identify the factors driving political risk. The non-commercial risk ratings are an important component of political risk management because political risk rating summarise the conclusions of the political risk analysis and they provide a framework for establishing country exposure limits that reflect international institution s tolerance of risk. The relative advantage of the BERI s country risk agency was assessed, which use a large number of factors. The BERI and ICRG rating agencies are driven by similar factors. 68