Political Risks – Expropriation, Instability & Sovereign Risk

Political risk is the risk that government actions (or inactions) will negatively affect the project. These risks are especially high in emerging markets and cross-border projects.

Types of Political Risks

1. Expropriation (Nationalization)

Definition

Government seizes project assets without fair compensation (or with inadequate compensation).

Types

1. Direct Expropriation (Outright Seizure):

• Government simply takes over the project
• Example: Venezuela nationalized oil projects in 2007 (kicked out ExxonMobil, ConocoPhillips)

2. Creeping Expropriation (Indirect):

• Series of regulatory actions that effectively strip away investor rights
• Examples:
  • Excessive taxation (90% tax rate)
  • Impossible regulatory requirements
  • Denial of permits/licenses
  • Forced sale at below-market price

Historical Examples

• 1970s: Many Latin American, African countries nationalized mining, oil projects
• 2000s: Bolivia nationalized gas fields
• 2017: Zimbabwe expropriated land without compensation

Impact

• Total loss of equity investment
• Debt default (if project revenue stops)
• Reputational damage to country (hard to attract future FDI)

Mitigation

1. Political Risk Insurance (PRI):

   • Covers expropriation, war, currency inconvertibility
   • Providers: MIGA (World Bank), private insurers (Lloyds, Zurich)
   • Cost: 1-3% of insured amount per year
   • Example: Insure USD 100 million equity for 3% = USD 3 million/year premium

2. Bilateral Investment Treaties (BITs):

   • Treaties between 2 countries protecting investments
   • Investors can sue host government in international arbitration
   • India has BITs with 80+ countries

3. Multilateral Investment Guarantee Agency (MIGA):

   • World Bank arm providing political risk insurance
   • Government-to-government backing (strong deterrent)

4. Structured as Essential Service:

   • Power, water projects are essential - less likely to be expropriated
   • Expropriation would hurt country's own citizens

5. Avoid High-Risk Countries:

   • Check country ratings (Moody's, S&P, World Bank Ease of Doing Business)

2. Political Instability (War, Revolution, Civil Unrest)

Types

• War (interstate or civil war)
• Revolution / Regime change
• Terrorism
• Riots, strikes, civil commotion

Impact

Example - Syria:

• Before war (2010): Several infrastructure projects underway
• Civil war starts (2011)
• Result: All projects abandoned, total loss

Example - Iraq:

• Oil/gas projects require private military contractors for security
• Insurance premiums: 5-10% of project cost (vs 0.5-1% in stable countries)

Mitigation

1. War & Political Violence Insurance:

   • Covers damage to assets from war, terrorism, riots
   • Essential for projects in unstable regions

2. Escrow Accounts Offshore:

   • All revenues deposited to offshore escrow (outside country)
   • Protects cash flows even if project is damaged

3. Diversification:

   • Don't invest only in one high-risk country
   • Portfolio of projects across multiple countries

4. Exit Strategy:

   • Plan to sell/transfer project if early warning signs appear

3. Currency Inconvertibility & Transfer Risk

Definition

Government blocks conversion of local currency to foreign currency or prohibits transfer abroad.

Example

Venezuela:

• Government imposed capital controls
• Foreign investors earned profits in Bolivars
• Could not convert to USD or repatriate profits
• Profits stuck in Venezuela, worthless (due to hyperinflation)

Impact

• Equity returns trapped in host country
• Debt service impossible (if debt is in foreign currency)
• Project default even if commercially viable!

Mitigation

1. Currency Inconvertibility Insurance: Part of PRI coverage

2. Offshore Revenue Collection:

   • If possible, collect revenues in USD offshore
   • Example: Export-oriented projects (ship goods abroad, get paid in USD)

3. Local Currency Debt:

   • Match currency of revenues and debt
   • If revenue in local currency, borrow in local currency

4. Breach of Government Contract (Sovereign Risk)

Definition

Government fails to honor its contractual obligations.

Examples

Power Purchase Agreement (PPA) Non-Payment:

• State electricity board (DISCOM) signs 25-year PPA
• After 5 years, stops paying (financially distressed)
• SPV has no revenue, cannot service debt

Concession Agreement Breach:

• Government promised minimum traffic guarantee for toll road
• Refuses to pay when traffic falls short
• SPV sues government (takes 5-10 years in Indian courts!)

Sovereign Immunity

Problem: Government enjoys "sovereign immunity" - cannot be easily sued.

Solution:

• Waiver of sovereign immunity clause in contract
• Arbitration clause: International arbitration (enforceable globally)
• Escrow mechanism: Government's payment obligation secured via escrow

Mitigation

1. Strong Contractual Protections:

   • Clear payment obligations
   • Liquidated damages for breach
   • International arbitration clause

2. Counter-Guarantees:

   • Central government guarantees state government obligations
   • Example: Ministry of Finance guarantee for state DISCOM payments

3. Escrow Account:

   • Government deposits funds into escrow account
   • SPV has first claim

4. MIGA/World Bank Support:

   • If World Bank is involved, government less likely to breach

5. Terrorism & Sabotage

Risk

• Terrorist attack on infrastructure (9/11 example)
• Sabotage by opposition groups
• Example: Naxalite attacks on power transmission towers in India

Impact

• Physical damage to assets
• Business interruption
• Loss of revenue
• Increased security costs

Mitigation

1. Terrorism Insurance: Covers damage, business interruption

2. Security Measures:

   • Armed guards, fencing, CCTV
   • Intelligence coordination with police

3. Site Selection:

   • Avoid high-risk areas (conflict zones, militant regions)

Country Risk Ratings

Several agencies rate countries on political risk:

India's Ratings (2024):

• Moody's: Baa3 (Lowest investment grade)
• S&P: BBB- (Lowest investment grade)
• Ease of Doing Business: Rank 63 (improved from 142 in 2014)

Political Risk Insurance (PRI)

Coverage

Typical PRI policy covers:

1. Expropriation and creeping expropriation
2. War, revolution, insurrection
3. Currency inconvertibility and transfer restrictions
4. Breach of contract by government

Providers

Multilateral:

• MIGA (Multilateral Investment Guarantee Agency - World Bank)
• IFC (International Finance Corporation)

Export Credit Agencies (ECAs):

• EXIM Bank (India, USA, etc.)
• Euler Hermes (Germany)
• Coface (France)

Private Insurers:

• Lloyd's of London
• Zurich, AIG, Chubb

Cost

• Low-risk countries (USA, Europe): 0.5-1% per year
• Medium-risk (India, Brazil): 1-2% per year
• High-risk (Africa, some Latin America): 3-5% per year

Example:

Equity Investment: USD 50 million
Country Risk: Medium (India)
Premium: 1.5% per year
Annual Cost: USD 750,000
Total over 10 years: USD 7.5 million (15% of equity!)

Decision: For medium-risk countries, may not be worth it. For high-risk, essential!

India-Specific Political Risks

Positive Factors (Low Risk)

• Stable democracy for 75+ years
• Independent judiciary
• Free press
• No history of expropriation (post-1991 liberalization)
• Protected by constitution (Article 300A - Right to property)

Risk Factors

• Bureaucratic delays (permit raj)
• Corruption (improving, Corruption Index now 85/180)
• Contract enforcement slow (judicial backlog - cases take 5-10 years)
• Land acquisition disputes (farmers' opposition)
• State government finances weak (DISCOMs not paying developers)

Overall: India is medium political risk - stable democracy but weak contract enforcement.

Summary

• Political risks are government-related risks (expropriation, war, breach of contract)
• Expropriation: Government seizes assets (covered by PRI)
• Political instability: War, terrorism, civil unrest
• Currency inconvertibility: Cannot repatriate profits
• Sovereign risk: Government breaches contracts (common in India - DISCOM payment defaults)
• Mitigation: Political Risk Insurance (MIGA, ECAs, private), BITs, Arbitration clauses
• India: Stable democracy, no expropriation risk, but slow contract enforcement
• PRI cost: 0.5-5% per year (depending on country risk)

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