Assignment 1: LASA 2—Risk Management Applications
While there are many factors that lead to an organization’s success or failure, it is important to identify the risk associated with the endeavor—financial or nonfinancial. Once the risks have been identified, management has a responsibility to develop measures to mitigate those risks.
Tasks:
Use the publicly-traded company you chose in Module 1 (Walt Disney) and imagine it has made a strategic decision to start doing business in China. Using the discussion, Currency Exchange Rates: A Case in China with Country Risk, (Chapter 7, Global Finance, page 192 of your textbook) as a model for the report you will write, prepare a report in which you:
- Develop a brief country risk assessment.
- Determine the political, economic, social, and capital risks associated with doing business in China. What are the most important factors to consider? Why?
- After years of keeping the Yuan pegged to the US dollar, in 2015 the Chinese allowed it to float freely in international currency exchange rate markets. You may read more about the Yuan reforms here. Many economists believe that keeping the Yuan pegged to the US dollar has caused it to be undervalued by 30 to 50 percent. Discuss what impact a revaluation of the Yuan might have on US multinationals doing business there, on China’s exports, and on Chinese citizens’ standard of living. What impact would a revaluation have on Chinese inflation and on purchasing power parity? Explain.
Your paper should be about 2,000 words. - Textbook:
Currency Exchange Rates: A Case in China with Country Risk
- Dad: Let’s look at an investment from a business point of view.Consider the following case: A multinational corporation needs to invest in many countries and for periods of many years. We will look at an investment in China. There is a long history, but we will look only at relatively recent background. I’ll pick a period with interesting times. Let’s assume that the initial investment was made on October 23, 1995.China has been a special case because the government has taken steps to keep its currency stable compared to the U.S. dollar.
China is a manufacturing superpower. Assume that you are CFO of a small engine manufacturer, Small Co., looking to build a $100 million plant in China. Let’s assume that your company requires a return of 10% on its investments in the United States and 16% on its investments in China. We will discuss the reasons for the 16% required return later in this section.Before you invest, your (simplified) balance sheet might look like Exhibit 7.7.We pick a date of October 23, 1995, for the investment, and your balance sheet looks like Exhibit 7.8 at the end of October:
Actually, the value of the investment will be in Chinese yuan renminbi (CNY), the currency of China. The accountants will convert that investment to dollars at the prevailing exchange rate at the end of each accounting period. If the $100 million were invested in China on October 31, 1995, it would buy CNY 831.490 million, and that would become the value of the plant. The exchange rate was CNY 8.31490 to one U.S. dollar on October 31, 1995. The balance sheet is important because public companies will report any gains or losses on investments on their income statements. So both the balance sheet and the income statement will change as a result of exchange rate movements. Of course, the major reason for this investment is to obtain goods for sale in the United States and in other countries at lower prices. Unlike Rodney’s investment in England, the government of China had a policy to hold the exchange rate constant with the dollar. This effectively created one currency for China and the United States for 10 years. This was a huge advantage to companies doing business with China.Look at the exchange rate of the yuan to the dollar in Exhibit 7.9.As you can see, there has been a 10-year period of very stable exchange rates. Let’s value your $100 million plant on December 31, 2004. Recall that the plant was actually valued at CNY 831.490 million on October 31, 1995. Assume no depreciation and no plant additions to allow us to see what happened because of exchange rates. We see that CNY 831.490 million divided by the December 31, 2004, exchange rate of 8.28650 converts to $100.34 million (Exhibit 7.10).The change since 1995 is so small as to be insignificant. I’m sure Rodney wishes that his investment in England had had this stability. However, from 2005 onward, the yuan has strengthened against the dollar. The effect from a change in the rate from 8.3 to 6.9 has been to raise prices of Chinese goods by 20%, assuming that all else is equal. By now you should be able to tell what happened to the value of the investment. Since the yuan increased in value, the investment translated to dollars increased in value. Now let’s convert the value of CNY 831.490 million as of December 31, 2008. The dollar amount becomes $121 million (Exhibit 7.11). Now we are seeing significant change, although it is helpful to the accounting statements.
The negative side is that this same movement increased the cost of the engines that Small Co. was exporting from China and importing into the United States. Just as the assets rose in value by 21%, the cost of the engines also rose by this same 21%. If we look at a five-year history in January 2001 at OANDA.com, we would see the summary shown in Exhibit 7.12.This table shows the success of the government of China in keeping the exchange rate stable. Of course, history can be a guide but not a guarantee of future events.
We could do a time line of cash flows if we had more information. For now let’s make some points that do not require us to make a time line.If Small Co. were importing the engines into the United States and buying them for $25 each, they would have been free of exchange rate risk for 10 of the past 13 years. The price of manufacturing the engines would still be subject to inflation in China. The cost of raw materials, parts, and labor might have risen, but there was no cost escalation from the exchange rate until relatively recently. By 2008, the price would have increased to $30 each even if there was zero inflation in China.Of course, other risks remained. Someone else could have invented a better process, and this is business risk. The United States could have imposed a tariff or tax on engine imports. Unrest in China could have been a problem. Another company could have reverse engineered your engine and gone into competition with Small Co.
- Dad: What risks do you see, Rodney?
- Rodney: Well, for a start, the leadership in China has changed and it is possible that the new leadership could be hostile to exports.
- Dad: Good thinking. Country risk is one of the first things to consider. If history is any guide, countries are more likely to seize the assets of companies than they are to stop exports. Also, some countries limit imports to favor local industry. Oil- and gas-rich nations have been known to limit exports in an effort to raise the price.
There are other country risks: There could be a war or rebellion and the assets could be destroyed. The government may refuse to allow the repatriation of profits earned in the country. International bodies may ask for import/export restrictions to protest pollution or treatment of political prisoners.Intellectual property is valued more highly in some countries than in others. A company with a secret manufacturing process will want to consider carefully where to locate its manufacturing operations. Contracts may be more readily enforceable in some countries and may be easily abrogated in other countries.Some people break country risk into repatriation risk and political risk.The risk that a company or person will not be able to freely move money out of a country is repatriation risk. This has been a significant problem in various countries historically. Often it is the first thing people worry about in doing business in other countries.Political risk comes from changes in the government or culture of a country and can take many forms, as described earlier.Regardless of the category, the question is: What risk is imposed by doing business in another country? And, as we will see later, the follow-on question is: What can be done to lessen the risk?
Exchange rate risk has been lessened as a result of Chinese government policy. However, even government policy sometimes must give way to practical reality. Although the exchange rate between the United States and China was stable for 10 years, the price of engines in comparison with the world market would vary based on the exchange rates between the United States and other countries. Exchange rate risk arises from unexpected changes in the exchange rates. It can dramatically change the effective price of a purchase. Looking at the yuan, the effective price of purchases manufactured in China rose 20% from 2005 to 2008 just due to the currency exchange rate.Dealing with risk is typically done in two ways. The first is to increase the required return necessary to make the investment, and we will discuss that now. The second is to look for other ways to lessen the risk.Companies calculate a weighted average cost of capital (WACC) and use this as the discount rate or hurdle rate when estimating the returns for an investment. When looking at an investment in another country, they should make an explicit decision to raise the rate of return required to take into account the risks we discussed earlier. Careful analysis of the proposed country is necessary.In our example we might use something like Exhibit 7.13.Our numbers are not the result of any careful study. They are chosen to simply make an example of what might be found. Ultimately numbers like these are the result of judgment after looking at all available information. Each of these risks seems small, but the chance of something unforeseen happening over 10 or 15 years is often much larger than one would estimate. There are ways to simulate what might happen. In any case, it is always good to ask, “What can go wrong?” The answer can be surprising.
Risk Minimization
One way to eliminate the exchange rate risk associated with the balance sheet is to borrow all or almost all of the funds in local currency. If the currency weakens, the value of the assets will decline and so will the value of the liabilities. The reverse is also true. In our China example, Small Co. could have borrowed the CNY 831.490 million in China. Since the assets and the liabilities are equal, there would be no effect on the equity of the parent from translating the values in the balance sheet to dollars.Many companies look to find places to manufacture with very favorable conditions. This serves to minimize the risk of adverse currency movements. These advantages might include a significant cost savings over manufacturing in the home country, tax savings, having a skilled and stable workforce, and a culture of hospitability toward the nation making the investment.
The use of local partners can be a third way to help minimize the risk. Their investment can spread the risk of currency and perhaps, more important, can lower political risk. Often the right local partner is better able to deal with emerging situations that could have an impact on the project.Therefore, it is important to understand the culture of the country. In some countries, business practices differ from the United States. Just as we leave tips for waitstaff, in some parts of the world it is expected that companies make payments to government officials in order to do business. The Foreign Corrupt Practices Act of 1978 makes it illegal for a U.S. company to pay a bribe. The local partner can often advise how to avoid situations that would put the venture into an unlawful situation. In some cases, this may mean forgoing an investment in a country that otherwise seems to hold great potential.There is a practical reason as well as a legal reason for avoiding payments to officials. These officials may be resented by the local citizens. If there is a change in the government, companies closely associated with the prior political leadership may be penalized. From time to time, there are news stories about attacks on American businesspeople and companies in countries in political turmoil.It is possible to find information on country risk by looking to the Heritage Foundation’s Index of Economic Freedom (www.heritage.org). The following information comes from the 2008 index:China has an overall score of 52.8%, which ranks it 126th in the world. This score rates China “mostly unfree.” The U.S. score is 80.6%, which ranks it 5th and rated “free.” Dead last, ranked 157th, is North Korea with a score of 3.0%. Exhibit 7.14 shows the categories of economic freedom, which put China’s score into perspective. Clearly China has a long way to go before it can be rated “free” or even “mostly free.”Useful information from the World Bank on the ease of doing business in many different countries can be found at www.doingbusiness.org/documents/Press_Releases_08/DB_08_Oveview_English.pdf.Also see the Index of Economic Freedom at www.heritage.org/research/features/index/chapters/pdf/index2008_execsum.pdf.Lesson from China case: Even though the Chinese government has been very favorable to business with its exchange rate policies and openness, there can be significant risks that should be considered. These risks add to the rate of return required on any investment.
