BUS614: International Finance

Foreign investors who opted for investing in the host state using the host state's currency may find themselves, sometimes, at risk of losing the value of their investment due to the loss of currency's value. This risk, depending on the nature of its occurrence and the underlying facts that helped in its manifestation, could either be a pure political threat, pure financial threat or a hybrid of the two.

The importance in understanding the nature of this risk will help investors know exactly the type of threat they are encountering and how they could protect their investments against it through insurance or through undertaking other protective measures.

a. Currency Exchange as a Political Threat

Generally, political risk can be defined as a threat to investments made by foreigners through means of interference by the host state's government or its representatives who are acting on its behalf resulting in limiting investors from benefiting from their property rights.

It requires a direct or indirect intervention by the host state in a manner that limits foreign investors from practicing and enjoying their property rights. Such risk generally includes acts like expropriation, nationalization and is influenced by the political environment of the host state in addition to the investorstate relationship and to the investment's sector.

Based on this brief introduction to political risk, it is understood that any action or underlying risk requires the intervention of the host state, or one of its representatives who's acting on behalf of the state and for its interest, to be regarded as a political risk. Failure to meet such condition means that the underlying risk may either be regarded as financial or commercial one.

In terms of currency exchange, for it to be considered as a political threat to investors, the host state needs to actively inflate or deflate the exchange rates of its currency. If the host state pegged its currency to a foreign one, like Argentina did between the 1990s and early 2000s, investors may be at risk of losing the value of their investment should the government decide to unpeg its currency. In this scenario, the deliberate decision of the host state's government to unpeg its currency resulting in limiting foreign investors from benefiting from their property rights deliberately, such intervention in the currency exchange rate could be regarded as a pure political risk. This is for example what the US gas transmission company CMS experienced in Argentina.

b. Currency Exchange as a Financial Threat

Normally, currency exchange is one of the threats to foreign investors falling under the label of financial risk. Financial risk in foreign investments are ones that are not directly related to the investment undertaken in the host state rather associated with external economic and financial factors of the host state itself.

The UK's currency, the Pound Sterling, is a free-floating currency and its value is determined by the markets' demand. The risk that investors encountered in the UK recently was the currency fluctuation that the Sterling experienced since the UK's decision to exit the European Union. The UK's government did not interfere in any way nor did attempt to manipulate the currency in order to keep it at a specific rate and as such, given the lack of intervention by the host state, losses that investors encountered due to the Sterling's fluctuation may only be regarded as a pure financial risk.

c. Currency Exchange as a Political Financial Threat

There may be instances where currency exchange risk may neither fall directly under the financial risk label nor the political risk classification since it shares qualities of both risks. As such, this threat, although it appeared due to direct intervention by the host state, it was not made for the purpose of depriving investors from their property rights. Rather intervention only took place in order to protect the host state's currency and markets.

In states that allowed its currencies to free float, like the Swedish Korona for example, government's intervention ranges from minimal to null depending on the markets performance. Normally, these governments will not interfere unless there was a catastrophic event threatening the economic and financial stability of the state as the Swedish Central Bank recently declared. But this is, in fact, an exception to the rule.

In states that opted for the pegged currency policy, changes to the exchange rate or to the monetary policy may not necessarily be for the purpose of depriving investors, foreign or local, form their property rights rather could be undertaken to protect the local currency and markets. Indeed, the East Caribbean countries whose currency was once pegged to the Pound Sterling made the change and pegged the currency to the US Dollar due to increasing trade relationship with United States.

In such cases, currency exchange threat may more accurately be regarded as a political financial risk given the host state's intervention in making the decision to unpeg the currency or to determine a specific ceiling which the currency is allowed to inflate or deflate within.

Similarly, in states where unofficial exchange markets were tolerated and relied on by investors where governments of these states decided later to deem such markets as illegal, such action may be regarded as a Political Financial Threat as is the case with Venezuela.