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HIGHLIGHT THE GOVERNMENTS ROLE ON REDUCING POLITICAL RISK, INTEREST

RATE RISK AND FOREIGN EXCHANGE RISK
1. INTRODUCTION

In international business, investment, financing and money management, decisions are very
complicated by the fact that countries have different currencies, tax regimes, regulations
concerning flow of capital activities, levels of economic and political risks and so on (Kapala and
Hendrickson, 2001).
Compared with many other industries, the construction industry is subject to more risks due to
the unique features of cost activities such as long periods, complicated processes, abominable
environment, financial intensity and the dynamic organization structures. Therefore managing
risk in construction projects has been recognized as a very important management process in
order to achieve the projects objectives in terms of time, cost, quality, safety and
environmental sustainability (Woon et.al, 2012).
Therefore risk classification is a significant step in the risk management process as it attempts
to structure the diverse risks affecting a construction project. Some of the major risks include
financial, legal, management, market, policy, political, interest rate and foreign exchange risk.
2. AIM
This report is aimed at highlighting how to government can reduce political, interest rate and
foreign exchange risk in the country. This is shown as a tool that can attract investment in the
country. Firstly, above mentioned risks are highlighted, they show how they hinder foreign
investment in the country. Secondly, government strategies that mitigate these risks are
explained. They clearly point out how the country can favor foreign investment in the countrys
economy when the major investment risks are controlled. Furthermore, this report further
explores additional strategies the government can employ for the core purpose of attracting
investment opportunities in the country.
3. CLASSIFICATION OF RISKS
3.1 RISKS RELATED TO GOVERNMENT BODIES
Excessive approval procedures in administrative government departments and bureaucracy of
government are not seldom complained by clients and contractors. These risks are normally out
of the control of project stakeholders. To attract investment within their administrative
territory, the government agencies should always make great efforts to create a friendly
environment in which the approval procedures are reduced or at least the approval time is
shortened and bureaucracy minimized (Zou et. al, 2007).
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3.2 RISKS RELATED TO EXTERNAL ISSUES
Risks related to project stakeholders include price inflation for construction materials and is
identified to be related to external environment. The price of construction materials is always
changing in response to inflation and the relation between supply and demand in the
construction industry material market. As this risk is usually unavoidable, clients should choose
an appropriate type of contract such as lump-sum to transfer the risk to other parties (Zou,
2007).
Contractors are recommended to avoid using fixed price contracts to bear the risk. On fair way
to deal with potential price fluctuations is to add contingency premium
4. TYPES OF INVESTMENT RISKS
4.1 Political Risk
The risk of direct or indirect political expropriation is a concern for multinationals considering
potential investment in many countries. Political risk is the probability that that the state will
use it monopoly on legal concern to renege on prior agreements with private firms in order to
affect a redistribution of rent among private and public sector actors. Political risk takes many
forms including unfavorable revision of regulatory rules and nationalization of private owned
assets without due compensation each of which reduces financial returns for a given
investment (Holburn, 2001).
In diverse view, Kapila and Hendrickson (2001) state to say political risk is the likelihood that
political forces will cause drastic changes in a countrys business environment which would hurt
the profit and other goals of a business enterprise. Political risk may further include
inconsistency in policies, changes in law and regulations, restrictions in fund repatriations and
import restrictions.
In less extreme cases, Kapila and Hendrickson (2001), describes political risk as resulting from
increased tax rates, the imposition of exchange controls that limit or block a subsidiarys ability
to remit earnings to its parent company, imposition of price controls and governments
interference to existing contracts. The likelihood of any of these events is seen to impair the
attractiveness of a foreign investment opportunity.
4.2 Interest Rate Risk
Investment in fixed income assets such as bonds are risky because the volatility of their prices
can lead to unexpected capital gains and losses. Interest rate risk occurs because the prices and
reinvestment income characteristics of long term assets react differently to changes in market
interest rates than the prices and interest expense, characteristics of short term deposits.
Interest rate risk is therefore seen as the effect on price and interim cash flows caused by
changes in the levels of interest rates during life of financial asset (Morris, 1989).
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4.3 Foreign Exchange Rate Risk
Exchange rate risks result from fluctuation in currency exchange rates or conversion
restrictions beyond the control of an individual firm (Kapila and Hendrickson, 2001). Where a
company contracts to provide services with dollar expenses but with payments in foreign
currency, then a 10% drop in the exchange rate would result in a 10% reduction in the value of
contract revenues.
5. Government strategies that can mitigate investment risk
5.1 Political Risk Mitigation
One can be seen to treat all risks as a single problem by increasing the discount rate applicable
to foreign projects in countries where political and economic risks are perceived as high. The
higher the discount rate the higher the projected net cash flow must be for an investment to
have a positive net present value (Kapila and Hendrickson, 2001).
Holburn (2001) also points out to say that forming joint venture partnerships with local
companies, by employing less sunk technologies, by involving multilateral financial institutions
and by directly lobbying political actors, a firm would reduce the its political risk. Therefore it is
a great strategy for government to allow network of relationships to exist between firm
employees and national and local political, regulatory legal and interest group actors who
influence public policy.
5.2 Foreign Exchange Mitigation
Changes in exchange rates alter profitability of trades and investment deals. Therefore another
great strategy for government is promoting future exchange rates and currency swaps which
enable firms to insure themselves to some degree against foreign exchange risks that they may
be exposed to (Kapila and Hendrickson, 2001).
Foreign exchange exposure refers to the risk that future changes in a countrys exchange rate
will hurt a firm. These exposures include:
5.2.1 Transaction Exposure- this is where income from individuals transaction may be
affected by fluctuations in foreign exchange values
5.2.2 Translation Exposure- this is the impact of currency exchange rates on the reported
consolidated results and balance sheets of a company. It is concerned with the present
measurement of past events, where the resulting accounting gains and losses are said to be
unrealized. This exposure is seen to have negative effects on a firm.
5.2.3 Economic Exposure- this is the extent to which a firms future international earning
power is affected by changes in exchange rates. Economic exposure is concerned with long
run effect of changes in exchange rates on future prices, contracts and costs.
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6. STRATERGIES FOR REDUCING TRANSACTION AND TRANSLATION
EXPOSURE RISKS
Future currency exchange contracts (buying forward) is an important source of insurance
against short term effect of foreign exchange exposure. Buying forward involves a currency
contract for future sale or purchase of a foreign currency at a predefined exchange rate rather
than market rate at time of transaction.
Kapila and Hendrickson ( 2001) identifies some benefits of currency futures to include the
provision of overseas customers with stable long term prices for three (3) or more years
regardless of what happens to exchange rates. By purchasing a future currency exchange
contract, the firm could agree to sell these revenues in advance at a fixed exchange rate. As a
result, the firm is shielded from the possibility of adverse exchange rate shift.
Furthermore, it can be seen that future options also have an advantage that foreign exchange
movements might result in extra profits but with options having a corresponding charge.
7. STRATEGIES FOR REDUCING ECONOMIC EXPOSURE
This is seen to go beyond the realm of financial management by distributing a firms productive
assets to various locations so that the firms long term financial well-being is not severely
affected by adverse change in exchange rates (Kapila and Hendrickson, 2001).

8. OTHER STRATEGIES THE GOVERNMENT CAN USE TO ATTRACT INVESTORS
8.1 Centralizing Depositories
Firms prefer to hold cash balances at centralized depositories. Kapila and Hendrickson (2001)
support this view by stating that by pooling cash reserves centrally, firms can deposit larger
amounts in liquid amounts such as overnight money market accounts.
Kapila and Hendrickson (2001) further state that a firms ability to establish a centralized
depository that can serve short-term cash needs might only be limited by government imposed
restrictions on capital flows across borders. Also transaction cost of moving money into and out
of different currencies can limit advantage of such systems
8.2 Reducing Transaction Costs
Transaction costs are costs of exchange. Every time a contractor changes cash from one
currency to another currency, it must bear a transaction cost. These costs would include the
common fee paid to foreign exchange dealers and bank charges for moving cash from one
location to another (Kapila and Hendrickson, 2001).

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8.3 Reducing Rate of Taxation
Different countries have different tax regimes. Many nations follow the worldwide principle
that they have the right to tax income earned outside their boundaries by entities based in their
country. Double taxation occurs when income of foreign subsidiary is taxed by the host
countrys government and by the parent companys home government.
However double taxation is mitigated to some extent by tax credit, tax treaties and deferral of
taxes until profits are actually returned to the home country (Kapila and Hendrickson, 2001).
8.4 Minimizing Cash Balance
A firm need to maintain a minimum cash balance at all times for serving any accounts and notes
payable. During that period and as a contingency against unexpected demand on cash, typically
a firm invests cash in low interest money market accounts to earn interest because they
provide the flexibility of easy cash withdrawal. In contrast, the firm could earn a higher rate of
interest if it could invest its cash resources in long term financial instruments where the firm
cannot withdraw its money before the instrument mature without suffering a financial penalty
(Kapila and Hendrickson, 2001).
8.5 Providing Flexible Financing Decisions
When considering options for financing a foreign investment, an international contractor may
consider whether to borrow from sources in the host country or elsewhere.
If a firm seeks external financing for a project, it will want to borrow funds from lowest cost
sources such as global capital markets. The use of global capital markets can result in financing
from anywhere in the world at lowest overall cost.
However, host country government of many countries require or at least prefer foreign
multinationals to finance projects in their country by local debt finances or local sales of equity.
In countries where availability of capital investment funds is limited, local financing raises cost
of capital for a project. The firm may consider local borrowing or debt financing for investments
in countries where local currency is expected to depreciate on foreign exchange market (Kapila
and Hendrickson, 2001).

9. CONCLUSION
This reports had shown how political, interest rate and exchange rate risk could affect foreign
investment in a country. It further outlined how government policies and bureaucracy
contributes to an economys investment risk negatively. Nonetheless, strategic tools that
government could use to control various investment risks had been identified and their positive
impact in returning foreign investment in an economy observed. Therefore it had be clearly
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seen that even though not all risks were government induced, government could still employ
other management tools to curb the investment risk in a country.



10. REFERENCES

Holburn, G. F. L., (2001), Political Risk, Political Capabilities and Interview Strategy: Evidence
from Power Generation Industry.
Kapila, P. & Hendrickson, C., (2001) Exchange Rate Risk Management, Journal of Management
in Engineering, Vol. 17, No. 4, October,PP.1-6.
Morris, C., (1989) Managing Interest Rate Risk with Interest Rate Futures: Economic Review,
Kansas: Federal Reserve Bank.
Woon, J.C., Ali, S.A. & Rahim,M.A.F., (2012) Identifying Key Risks in Building Performance, Kuala
LumPur: University of Malaya.
Zou, P. W.X.,Zhang, G. & Wang, Y.J. (2007) Identifying Key Risks in Construction Projects: Life
Cycle and Stakeholder Perspectives, China: Shenzhen University.