Michael P. Bond
Senior Vice President, Zurich International Surety
Michael Bond is responsible for the development of Zurich North America’s international surety platform and development of Zurich’s surety business in Asia and Latin America.
Balancing opportunity and risk in the emerging markets
Political risk is part of our world: social upheaval in Bolivia, reports of corruption in Thailand, interference by local authorities in china, terrorist bombings in Indonesia or a coup in Honduras. no region is immune. Yet in spite of these risks, many organizations are looking to emerging markets for future growth, often requiring new construction or the expansion of existing facilities to help drive that growth. in turn, construction project owners and contractors that had previously confined themselves to local or regional markets, are looking to emerging markets for future growth. And as companies of all types have expanded their global reach, their exposure to political risk has multiplied.
With economic growth within many emerging markets still positive, in spite of the global economic crisis, their appeal is strong. Continued positive growth rates in emerging markets are grounded in long-term demographic changes expected to take place in coming years. Estimates suggest that the world’s population will increase by two billion people over the next 30 years and another billion in the following 20 years. Nearly all of this increase will be in developing countries, according to the World Bank’s World Development Report 2006. For this transformation to take place, developing countries will continue to need an enormous investment in infrastructure. Companies expanding abroad to take advantage of emerging markets will also need to expand their overseas infrastructures, i.e. new construction or expansion of existing facilities. When functioning as project owner-managers, these companies face all the same political risks as their contractors.
Uncertain business climates
Economic and political reforms have thus far generally improved business climates in many developing countries, but the evolution has been an uneven process creating many uncertainties. Increased political stability and transparency in some emerging markets, such as the former communist states of Eastern Europe, have been matched by worsening conditions in parts of Africa, Central Asia and even Latin America. Changes in political leadership have often reversed the course of once-friendly governments, with contracts re-opened for negotiation, and government policies implemented to gain control of foreign-owned projects.
The biggest challenge and most common error that companies moving into emerging markets can make is to underestimate the political risks they face. Comfortable with the current political climate or the strength of their joint venture partner at the outset of a project, the companies often fail to assess adequately the potential volatility of the country, region or partner on a long-term basis. They fail to realize that a partner with impeccable political connections can quickly turn into a liability with a change in regime.
Assessing the risks
The typical engineering and construction company understands construction risk extremely well, its customers fairly well, and foreign countries little, if at all. These firms may be the best in their class at erecting steel towers or designing and building hydroelectric dams, but don’t necessarily know how to begin assessing the political risk of a contract in certain emerging markets. The construction risk is familiar and quantifiable; the political risk is indefinite and new. Therefore, it is incumbent upon the project owner-manager to seek out appropriate guidance and counsel regarding the political, economic and social risks within countries where plans call for new construction or the expansion of existing facilities.
Growth in the emerging markets is often predicated on an assumption of stability and that fiscal and economic reforms will continue. But history has repeatedly demonstrated that economic growth in emerging markets is uneven, particularly where growth is isolated in certain sectors of the economy. Even model economies have succumbed to sudden economic downturns – often the forerunner of currency controls and restrictions in converting profits to hard currency for dividend payment or debt service.
Given that political risk is largely unavoidable, the question hinges around how the risk can be mitigated. Evidently the contractor must be required to do a thorough analysis before any contracts are signed. Understanding the political, economic and legal context of a country is the key. Utilize multiple sources in the beginning, since relying on a single source of information or legal advisor may lead to a myopic view of reality. Secondly, plan for contingencies. Conducting business takes more time in emerging markets. This includes the most routine functions, such as buying cement, to the securing of licenses and permits. However, more dramatic contingencies also need to be considered, such as civil unrest that may prevent the movement of workers and material or a rapid change in the security situation. These contingencies will almost certainly mean lost time and money.
Products such as political risk insurance, covering such risks as expropriation, inconvertibility or political violence, can be a key component of a company’s global risk management program. Political risk insurance provides balance sheet protection for catastrophic risks a company may be exposed to when it is operating in the emerging markets – for example, the seizing of heavy equipment or the inability to repatriate profits.
Many governments of emerging markets are turning to the private sector to finance, build and deliver essential services, including telecommunications, energy, transportation and water services. Private sector builders and contractors are responding with a vigor not seen since the early 1990s to seize opportunities in developing regions, most notably in Asia, Central and Eastern Europe, and Latin America. While offering enhanced opportunities, these projects also come with formidable political risks. Consider:
- abrupt changes in a host government, or a host government’s mindset, can lead entities or agencies to breach contracts or expropriate a builder’s or contactor’s equipment and other assets in a developing market
- the unlawful calling of guarantees and non honoring of sovereign guarantees can cost a contractor its investment, in whole or in part
- an act of war, civil strife, sabotage or terrorism can damage or destroy a developer’s equipment or other physical assets
- a currency crisis can leave the infrastructure developer unable to convert currency or transfer it out of the country
- the wrongful calling of bonds, when a contractor operating in an emerging market is subject to the unlawful calling by the local government of various types of guarantees, such as bid and performance bonds.