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Why political risk insurance will grow in the 1990s.

Why Political Risk Insurance Will Grow in the 1990s

What we are witnessing with the death of communism is much more than the end of an inherently flawed political and economic system. We are witnessing the end of the longest period of sustained peace Europe and much of the world has ever known and the creation of a new, still undefined economic and political order.

Say what you will about the tremendous costs borne by the United States and NATO to sustain the Cold War for the past 45 years, the expected "peace dividend," which is now the subject of much discussion, has existed in many nations since the end of World War II. The peace that we have enjoyed since 1945 has allowed foreign trade and investment to proliferate, resulting in unparalleled growth and prosperity for much of the world.

Thus, peace is an essential ingredient of foreign trade and investment; without it, international business cannot flourish. The ability to trade and invest internationally is also, in turn, a bedrock of sustained economic growth in the modern world. It is the basis of the Japanese postwar miracle, as well as the German revival. Likewise, it enabled South Korea and Taiwan, seen as developing nations only a decade ago, to become industrialized.

Does the death of communism mean the end of the peace dividend? It could. Consider Europe's experience from 1648 to 1945. In 1648 a radical change in the European balance of power took place with the end of the Thirty Years' War. Emperor Ferdinand III's authority became decentralized and was followed by the rise of the sovereign state. The 300 years following the Peace of Westphalia saw the development of a multipolar distribution of power with constantly shifting alliances. Europe was in an almost constant state of war during this period.

Are we entering another unstable period? The balance of power and relative stability that has existed for the past 45 years appears to be endangered. The current breakdown of the status quo leaves us once again vulnerable to the uncertain consequences of a multipolar distribution of power and shifting alliances. History has shown that dissolution of an existing order increases the likelihood of economic, political and social conflict. This could be the case in the coming decade.

With the death of communism, the Western alliance has lost a common enemy and with it a common bond, making latent economic rivalry that had already existed more pronounced. But overt economic rivalry among political allies is only one piece of the new scenario. The demise of communism has also unleashed new and longstanding social, religious and ethnic conflicts. Global democratization is releasing forces that had been thought buried in history. But, as it turns out, these imposing forces have simply been placed on the back burner. Witness the recent rise in economic nationalism, economic displacement, ethnic turmoil and an increasing global propensity toward separatism.

Closer Examination

Let us examine these developments in greater detail. For one, the volume of trade between and among developed and developing nations has grown astronomically since 1945, particularly in the past 20 years. In that time, developing nations acquired greater levels of technological and managerial expertise, which, when combined with their natural resource base, greatly enhanced their ability to compete in business with developed nations. The free flow of information and the reduced significance of political boundaries as a result of trade has also aided developing nations.

At the same time, the emphasis has shifted from military and political power to economic power and competitive advantage. The current round of General Agreement on Tariffs and Trade (GATT) negotiations is a good example of this principle at work. The EC nations view their ability to subsidize their farmers as integral to their ability to compete in agricultural trade. Now the United States wants the EC nations to eliminate their subsidies so U.S. farm products will become more price competitive. This is an example of how the economic battle has assumed nationalistic character. As a nation, the United States is in this instance defining a component of its strength by its ability to compete with EC farm products. Political relations between the United States and EC nations are being influenced by economic issues.

Developing nations, formerly too weak to enter into this dialogue, are now using the GATT negotiations to voice concerns about their ability to compete. Argentina, Brazil and India have demanded that any progress on an agreement on trade in services be linked with resolution of the agricultural subsidies issue. India, Pakistan and the ASEAN nations want Europe and the United States to abolish the Multi-Fiber Agreement, which they view as discriminatory.

Nations such as Taiwan and the Soviet Union have for the first time declared that they want to join GATT. They view membership as essential if they are to become more economically competitive. The point is that national economic battle lines are being drawn with greater frequency and by nations formerly considered peripheral players.

On the other hand, some nations being introduced to democracy and capitalism are responding slowly, perhaps too slowly, in making the structural changes needed for the shift from a planned economy. The world has changed very quickly and many are not prepared to accommodate the changes, either because they lack appropriate institutional structures or the sacrifices required to keep pace with the changes are too great. Fear of heightened political and economic instability is very real.

An Unequal Pace

Progress toward democracy will continue to be unequal, exacerbating existing economic disparities between nations. Most ethnic turmoil is the result of two factors. One is the resurgence of longstanding historical conflicts, such as the recent strife in Romania between ethnic Romanians and Hungarians. The second is the fear of economic displacement among indigenous populations who perceive that their status is being threatened by the presence of immigrants, such as last year's expulsions of Turks from Bulgaria. It is becoming clear that the politico-structural changes resulting from the proliferation of democracy and death of communism will in the short term serve to greatly increase ethnic turmoil.

In some cases, the renewed surge toward ethnic solidarity is leading to geographical and political separatism. The systematic changes taking place in Eastern Europe, for example, are so grand that some national constitutions are being rewritten. One of the by-products of this movement in Czechoslovakia has been the desire on the part of Slovaks to become a separate society. Today's Czechoslovakian government is essentially a coalition of two parties formed by two distinct groups of people - the Czechs and the Slovaks. The Slovak movement to separate from Czechoslovakia has grown in popularity and now has the legislative foundation to secede.

French-speaking Quebec's ongoing movement to secede from English-speaking Canada recently gained impetus in part because of the strength of such movements elsewhere. Quebec's success in bringing its secession movement to the forefront of Canadian politics has prompted the province's Mohawk Indians to pursue their own independence movement. Last year's signing of the U.S.-Canadian Free Trade Agreement may have further strengthened Quebec's independence movement by creating the perception that the province now has sufficient economic strength to thrive on its own.

Of course, ethnic and linguistic distinctness is also a cause of the secession movement. But consider the impact on Quebec's economic viability that free trade has had on its ability to realistically secede. Without healthy trade with the United States, Quebec's ability to survive economically while functioning as an independent entity would be in serious doubt.

Growing Pains

Where will all this lead? The answer is simple. Some nations accustomed to maintaining order through force are now turning democratic and capitalistic and must learn the art of negotiation and compromise. In the process, many will experience growing pains, sometimes violent ones. Some nations accustomed to order through force may perceive the global shift toward democracy as a threat to their sovereignty. Their unwillingness to democratize isolates them from the world community. As a consequence, they are likely to strike out in aggressive ways.

The recent Iraqi invasion of Kuwait underscores the absolute unpredictability of political events in the new world order and their instantaneous adverse effects on nations, companies and individuals. As recently as two years ago, Iraq was at war with Iran, with the financial backing of Kuwait. Now, Iraq, buried under $80 billion in foreign debt, has violently annexed its neighbor Kuwait in a desperate effort to raise world oil prices and enforce a centuries-old territorial claim.

The political, economic and military effects of this act had immediate global repercussions. World oil prices shot up, playing havoc with Western economies, and in an unprecedented move King Fahd of Saudi Arabia agreed to allow the U.S. military to operate on Saudi soil. In addition, the world imposed a nearly unanimous trade embargo on Iraq.

The effects on companies doing business in the region were devastating. Here are some examples. Three years ago, Company X signed a multimillion dollar supply contract with the Kuwaiti government. At the time of the sale, Company X posted an advance payment counterguarantee and a performance bond with a Kuwaiti bank in accordance with the terms and conditions of the contract. Company X purchased a political risk insurance policy against the wrongful calling of the counterguarantee and bond by the Kuwaiti government at the contract's inception. Coverage for the advance payment portion of the contract expired the week after Iraq invaded Kuwait. The company would have incurred more than $1 million in losses if its wrongful calling policy was not in place.

Now for the bad part. Under the letter of credit for the contract, more than $9 million was due to the company in mid-August. That money may never be paid and the company will have to declare a loss because it did not take out coverage against non-honoring of a letter of credit, another form of political risk coverage.

Two years ago, Company Y was asked if it wanted to take out a policy against confiscation of its new investment in Kuwait. Company Y had no idea that two years later its $15 million investment would become a gift for Iraq. Last, there is Company Z, which waited until the invasion to inquire about the availability of confiscation coverage for its recently leased equipment in Kuwait. As you might imagine, coverage was not available. Its investment also became a gift for Saddam Hussein.

Companies doing business anywhere in the Gulf region are now understandably concerned about the viability of their contracts. In the week following the invasion, Company Q inquired about contract frustration insurance in Turkey. The company was concerned that Turkey could become the target of trade sanctions, if, for example, Iraq retaliated due to Turkey's decision to halt the flow of Iraqi oil through its pipeline. It found that the coverage was available as the underwriters considered this situation an acceptable risk.

Perestroika's Effects

Consider the effect of perestroika on trade and investment in the Soviet Union during the past five years. Only a year ago the Soviet Union was believed to be a very good payment risk by traders and bankers. Political risk insurers had plenty of excess capacity available. In 1990 lengthy payment delays became commonplace with Soviet contracts; traders and investors sought political risk insurance in record numbers; and by March the marketplace was drained of capacity. Now the Soviets have resorted to selling $5 billion in uncut diamonds from their reserves to raise cash to pay off their mounting debts.

Because the Soviet Union's future remains uncertain, many traders and investors continue to be hesitant about committing funds there. Meanwhile, many businesses await increased political risk insurance capacity before moving forward with projects in the Soviet Union. As a result, Soviet capacity is expected to sell out again early next year.

Accommodations

As the new political and economic order develops in the 1990s, the risks inherent in trading and investing abroad will grow, as will economic nationalism, causing future trade disputes and prompting harsher retaliatory responses. In the past, when national trade disputes have arisen or new governments have assumed power, private traders and investors have often paid the price. Embargoes have been imposed (U.S./USSR, 1979), contracts have been unilaterally terminated (Libya/U.S., 1986), export licenses have been cancelled (U.S./India, 1989) and all trade has been prohibited (U.S./Nicaragua, 1984). In addition, assets have been seized (Iran, 1979) and profit remittances have been frozen (Brazil, 1990).

In the future, more economic policy changes will be implemented in an effort to accommodate changes in political structure. With the creation of each new state, a new set of foreign trade and investment regulations will be adopted, some of which will have an adverse impact on existing contracts and investments. Joint venture contracts could be torn up overnight (China, 1988). Investment regulations could change so significantly that once profitable enterprises will become a drain on corporate income statements (Brazil, 1990).

We have seen ongoing acts of political violence against foreign corporate targets in places like Colombia and New Guinea. Politically motivated strikes and governmental reactions have recently taken a heavy toll on operations abilities in Poland, South Africa and Brazil. As economic displacement affects greater numbers of people, acts of political violence are likely to increase.

Consequently, the political risk insurance marketplace will grow in the coming decade. Political risk insurance has for decades protected traders and investors against governmental actions that interfere in trade contracts or prevent investors from exercising their fundamental ownership rights. In a world creating more obstacles for international traders and investors, political risk insurance will continue to be a crucial element of balance sheet protection.

Daniel Wagner is a broker with the political risk unit of Johnson & Higgins in New York. He has master's degrees in international management from the American Graduate Schhol of International Management (Thunderbird) in Phoenix, AZ, and in international relations from the University of Chicago.
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Author:Wagner, Daniel
Publication:Risk Management
Date:Oct 1, 1990
Words:2330
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