United Arab Emirates Risk Profile - Assignment Example

Material You are a consultant to a company that is considering United Arab Emirates (UAE) and Venezuela as an attractive opportunity for investment. Citing appropriate examples of other companies, contrasts the risks and opportunities presented by both countries. On the basis of your analysis, prepare a report for top management with suggestions where to invest and why" By: November, 2008 Table of Contents 1.0 Introduction 1.1.1 United Arab Emirates Overview 1.1.2 United Arab Emirates Risk Profile 1.1.2.1 Economic Risk 1.1.2.2 Political Risk 1.1.2.3 Business and Financial Risk 1.1.2.4 Other forms of Risk in United Arab Emirates 2.1Overview of Venezuela 2.1.1 Venezuela Country Risk Profile 2.1.2 Economic Risk 2.1.3 Political Risk 2.1.4 Business and Financial Risk 2.1.5 Other Forms of Risks in Venezuela 3.0 Contrasting the Two Countries 3.1.1 Decision to Investors and Conclusion 1.0 Introduction Firms face two main types of risk: systematic risk and unsystematic risk. Systematic risk, otherwise referred to as market risk on the one hand is the risk that a firm faces as a result of movements in the market such as movements in the value of a stock index (e.g., the FTSE100 index); fluctuations in interest rates, fluctuations in currency exchange rates, as well as changes in inflation rates. Market risk is considered to be un-diversifiable and therefore investors expect a risk premium to compensate them for taking on such risk. (Bodie et al., 2002; Ross et al., 1999). Unsystematic risk otherwise known as firm specific risk or operating risk is risk that can be diversified away and therefore investors should not be compensated for taking on such risk. (Bodie et al., 2002; Ross et al., 1999). Prior to the Basel II accord, more emphasis was placed on hedging market risk. However, following from the Basel II accord, Operations risk herein referred to as OR began receiving greater attention. (Neu and Khn, 2003). The aim of this study is to analyze the problems and risks foreign companies that want to do business in United Arab Emirates and Venezuela are likely to face. In addition, the risk that the company may face in these countries will also be analyzed with respect to each of the two countries. Risk associated with foreign investment whether direct or indirect are numerous. The paper will begin by presenting an overview of the risk situation of United Arab Emirates in part one, focusing on all the risks faced by foreign companies operating in this area. Part two analyse a similar situation as in part one, but focusing on Venezuela. Part three of the paper contrast the situation based on the information presented in part one and two, while the last section made an informed decision to investors as to which of the two countries to invest upon. 1.1.1 United Arab Emirates Overview United Arab Emirates, UAE is a country in the Middle East bordering the Gulf of Oman and the Persian Gulf, between Oman and Saudi Arabia (IMF Economic Report 2007). Potential market's indicators include United Arab Emirates Population (in millions) 4.5 Import of goods and services (millions $ ) 98.976 GNP (in millions of USD) 103.460 The U.A.E. is considered one of the highest per-capita gross national products in the world (IMF Economic Report 2007). Although still heavily dependent on revenues from oil and gas, the country is relatively well-insulated from periods of low oil prices because of successful moves toward economic diversification, large foreign exchange reserves and overseas investments. 1.1.2 United Arab Emirates Risk Profile This section of the paper looks at the overall risk situation of the UAE area. Attention is paid on key change drivers and risk indicators such as political risk, economic risk, competitive risk, exchange rate fluctuations etc. The section goes ahead and sees if there are some of these risks unique to the area. The Literature surrounding operating risk has centred on its management (e.g., Lewis, 2003), measurement (Neu and Khn, 2003; Chapelle et al., 2007; Rosenberg and Schuemann, 2006; Valle and Gudici, 2008), causes and consequences (see Lewis, 2003). As far as measurement is concerned, Jarow (2007) drawing on insights from corporate finance literature provides an economic and mathematical characterisation of operational risk useful for clarifying the issues related to estimation and the determination of economic capital. 1.1.2.1 Economic Risk Assessment of UAE According to World Bank (2007), the UAE's macroeconomy has performed strongly in recent years. This reflects sustained high oil and gas prices, increased oil production and strong investor confidence matched by steady inflows of foreign direct investment (IMF 2007). The country has a large current account and fiscal surpluses, which are used to accumulate substantial net foreign financial assets and official currency reserves, fund infrastructure investment and ramp up efforts to broaden the UAE's economic base (IMF 2007). In this area has been high and looks set to remain so, the pegged exchange rate to the US$, increasing the pressure on the government to introduce more flexibility into the exchange rate. Even so, with pressure from the World Bank and the IMF, a sudden or sharp revaluation appears unlikely (IMF 2007). Due to series of free trade policy granted by the government, the market situation looks favourable for investors. The economic situation is further strengthened to weather price shocks. The country's strong net foreign asset position and prudent fiscal policies means that the country is in a much stronger position than it might have been a few decades ago (IMF 2007). 1.1.2.2 Political Risk Assessment of UAE UAE political situation has not been very promising, though generally viewed as an island of relative stability in an otherwise unstable region. However, episodes of high oil and gas prices fuelled irrational fiscal policies and locked the emirates into a permanently higher level of spending, leaving them exposed when oil prices turned down. The situation remains doubting in a serious rise in geopolitical tensions in the region, due to a stepped up United States confrontation with Iran, or a terrorist attack, could undermine this reputation (IMF 20070. The country is governed by the Emirates' ruling families and seen some calls for wider political participation, most analysts consider that any moves to liberalise will be measured and staged so as to minimise the chance of political and economic instability (World bank 2007). No wonder, UAE credit and country risk ratings suggest that the UAE is both creditworthy and at low risk of external default. According to the latest credit and country risk classification, the OECD rates the UAE 2 out of 7 whileMoody's gives the UAE a foreign debt country ceiling of Aa2 IMF 2007). 1.1.2.3 Business and Financial Risk of UAE According to World Bank Report (2007), the area provides a unique business tax free zone. The country fiscal surpluses, which are being used to accumulate substantial net foreign financial assets and official currency reserves, fund infrastructure investment and ramp up efforts to broaden the UAE's economic base. Inflation has probably been exacerbated by the pegged exchange rate to the US$, increasing the pressure on the government to introduce more flexibility into the exchange rate. Along with its regional peers, Qatar and Kuwait, the UAE is experiencing high inflation. Since the UAE's monetary policy is effectively set by the US Federal Reserve, control of inflation is difficult. 1.1.2.4 Other forms of Risk in United Arab Emirates It has also been argued that, UAE's property sector is booming. Rapid population growth and infrastructure investment have spurred substantial construction activity and escalating property prices, especially in Dubai. If property prices and construction were to slump, banks could face significant losses. The absence of financial transparency is also seen as a major risk affecting the area. The IMF notes that weaknesses in fiscal data impede a timely and accurate assessment of overall fiscal developments. Institutional frameworks are relatively underdeveloped. It lacks an independent, efficient judiciary and legal system (IMF 2007).The area is very close to Irag and Iran pushing it in a situation visible to terrorists and Iranian counter attacks. The country could finally be the one to pay the price in rising sectarian conflict in Iraq. The increasing number of expatriate could be a source of change and represents a potential source of Political and Social instability. 2.1 Overview of Venezuela According to the World Bank, world economy report (2007), Venezuela is the World's seventh largest exporter with the fourth highest proven oil reserves in the world. Venezuela is bordered to the north by the Caribbean Sea and the North Atlantic Ocean, to the east by Guyana, to the south by Brazil, and to the west by Colombia (IMF 2007). President Chvez's "Bolivarian" foreign policy is to build a "multipolar" world with regional alliances that would counterbalance U.S. This pushes the country in a situation in which foreign press, have pushed the country into its present political position. 2.1.1 Venezuela Country's Risk Profile In this section, I look into the political, economic and geopolitical situation of the country with respect to risk. Venezuela is a federal republic with a "participative democracy" type of government. 2.1.2 Venezuela Political Risk Profile Political risk is quantified by a number of variables including economic factors such as inflation, interest rates, GDP, Per capita GDP growth, Government regulation, expropriation foreign exchange controls, etc. Political risk has to do much with expropriation and restrictions on foreign exchange. (Shapiro, 2003). The company has to determine the level of foreign exchange control in each country as well as the level of expropriation. Expropriation is often exercised through the levy of high taxes on the profits of the foreign company. Government regulation has much to do with the institution of taxation policies, labour requirements, technological transfer requirements, Export requirements, local procurement requirements, ownership restrictions, foreign exchange remittance, visa restrictions, etc. countries with very high tax rates and low investment incentives may be problematic for investment. (Fujita, 2007). The political situation of Venezuela is currently unstable due to President Chvez's "Bolivarian" foreign policy built on a "multipolar" world with regional alliances that would counterbalance U.S. Chvez easily won the last presidential election and, despite crippling national strikes in 2002-3, scored a major victory in the special presidential recall vote of August 2004. International electoral observers ratified the referendum results, but opponents charged that the use of untested electronic voting machines allowed fraud to take place. According to World Bank Report, in 2000 foreign direct investment reached US$4.7 billion but declined to US$3.7 billion in 2001 and US$0.8 billion in 2002, rising to US$1.3 billion in 2003 and 2004. The downturn in Venezuela's FDI in 2002-3 has been attributed to political and financial instability. 2.1.3 Venezuela Economic Risk Analysis Historically the IMF (2007) reports state that, inflation in Venezuela was low, averaging below 3 percent during 1958-1973. However, after the bolvar was floated in February 2002, persistently high rates of inflation have been a problem. The inflation rate (consumer prices) in 2004 was 21.7 percent, down from 27.1 percent in 2003; it is projected to be 19.4 percent in 2005 and 18.7 percent in 2006 (World Bank 2007). According to IMF (2007), budget revenues in 2004 totaled an estimated US$19.3billion, and expenditures an estimated US$24.3 billion, including capital expenditures of US$2.6 billion. With increased oil and non-oil revenue, the government intends to reduce its deficit from an estimated 4.3 percent of gross domestic product (GDP) in 2003 and 3.3 percent of GDP in 2004 to 2.8 percent of GDP in 2005 and 0.6 percent of GDP in 2007. The country's present-day agriculture is characterized by inefficiency and low investment, with 70 percent of agricultural land owned by 3 percent of agricultural proprietors (one of the highest levels of land concentration in Latin America). 2.1.4 Business and Financial Risk Venezuela improved its trade balance in 2004 to about US$22 billion, with exports totaling US$39.4 billion and imports, US$17.3 billion. While the business environments remain favourable, the high level of inflation and fluctuation of the national currency, pushed investors to an unfavorable situation. Venezuela's currency is the bolvar (Bs1=100 centimes). During the July 1996 to January 2002 period, the currency became increasingly overvalued in real terms. In February 2002, prompted by spiraling capital flight, falling reserves (under US$10 billion), and a deepening fiscal crisis, the government floated the bolvar. This forced governmental authorities to imposed draconian foreign-exchange controls and create Currency Administration Commission to Administer and implement foreign-exchange controls (IMF 2007). 2.1.5 Other forms of Risks in Venezuela Venezuela has long-standing territorial disputes with Guyana and Colombia, but it does not have a history of armed conflict with its neighbours (IMF Country Report). Relations with Colombia have been delicate since 1999, when President Chvez began criticizing Colombia's U.S.-funded antinarcotics strategy called Plan Colombia, which Chvez has opposed on the basis that it has resulted in incursions into Venezuela by displaced refugees and combatants. Country risk situation have been further strained over Chvez's denunciation of the planned Free Trade Area of the Americas (FTAA), his strident opposition to the U.S. conduct of the global "war on terrorism," and his close trading ties and relations with Cuba and Iran. 3.0 Contrasting the Two Countries This refers to differences in the level of economic development between home and host country. (Vachani, 2005). When there are differences in the level of economic development between the home country and host country, the subsidiary is likely to encounter a lot of problems owing to differences in technology, knowledge and differences in managerial capability. (Vachani, 2005). Firms operating in developed countries incur far less transaction costs than their counterparts operating in developing countries. (Vachani, 2005). A UK or French company that wants to operate in UAE or Venezuela must therefore consider this as a factor before deciding which country to choose. Managers in developing countries find it difficult to access information that is necessary for decision making on time owing to poor information systems development. (Vachani, 2005). What is eminent to the two countries is their situation prone to movement of the American dollar and economy. In the two countries, there is limited monetary scope to combat inflation, which places the burden of adjustment onto fiscal policy. But with no income tax and a complicated nonfederal structure in Venezuela, fiscal policy isn't responsive to the economy's needs. Introducing more flexibility into the exchange rate may become more pressing given the prospect of further US interest rate cuts and signs that the US$ will remain weak against the euro and pound. In addition, the two countries put the government at the centre of politics and business. The private sector has played only a narrow role. The government is at the heart of most economic activity in the UAE and likewise Venezuela, resulting in close links between business and politics and highlighting the potential for resource mis-allocation. In addition, some projects probably benefit from access to cheap petroleum or electricity inputs. While an independent, efficient judiciary and legal system is absent in UAE otherinstitutional shortcomings include the lack of parliamentary oversight of government finances and policy and the absence of a highly developed, deep and efficient financial system. Foreign companies wishing to invest in either of the two countries may also face competition from local firms producing the same products. This may have a negative impact on the company's sales as well as continuation as a going concern. Local competition may come as a result of local firm's ability to produce at a lower cost than the new firm that is still gaining grounds. To combat this competition, the company may embark on the introduction of high quality brand new products that are not available in the local market. By so doing the company can enjoy sustainable competitive advantage. Currency risk or foreign exchange exposure or better still foreign exchange risk refers to the risk that a company's cash flows, transactions and future business operations may be affected by changes in exchange rates. (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001). Foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are therefore clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, a firm based and selling goods in the United States may be competing with European firms and as such its expected future cash flows will be affected by exchange rate movements between the euro and the dollar by strengthening or weakening its competitive position against its European competitors. (Buckley, 1996). Exposure to foreign exchange risk is classified into three types including transaction exposure, translation exposure and economic or operating exposure. (Buckley, 1996; Shapiro, 2003). 3.1.1 Decisions to Investors and Conclusion Based on the analysis above, we can conclude that there are a number of problems and risks that a firm can encounter when trying to expand its operations abroad. These problems require that the firm adopts a global strategy as well as a series of risk management strategies to hedge against risk. Based on the analysis of the two countries, we can conclude that at present, UAE provides the most favourable investment environment as opposed to Venezuela. This paper therefore recommends UAE as a better investment country for foreign investors than Venezuela. Venezuela is currently not attractive enough for foreign investment. While Venezuela is currently reviving and dismantling its regulatory barriers, the fragile political situation in the country is larming and scaring. UAE is therefore the only country among the two that this paper can recommend for investment. In the absence of certain government information and statistics, foreign companies entering this area for investment need to train their personnel to enable them derive new models that can better estimate risk parameters, as well as test for their significance. Currency futures contracts are currently available for the American dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican Peso, New Zealand dollar, Russian rubble, South African rand, and Swiss Franc. (Shapiro, 2003: p. 267). However, these contracts have limited delivery dates and are traded only in small quantities. Thus designing a hedging strategy using futures contracts can be very profitable. (Shapiro, 2003). References Buckley A. (1996). Multinational Finance. Third Edition. Prentice Hall. Jarrow R. A. (2007). Operational risk. Journal of Banking & Finance Khn R., Neu P. (2003). Functional correlation approach to operational risk in banking organisations. Physica A, vol. 332, pp. 650-666. Lewis M. A. (2003). Cause, consequence and control: towards a theoretical and practical model of operational risk. Journal of Operations Management , vol. 21, pp. 205-224. Muller A., Verschoor W. F.C. (2005) Foreign exchange risk exposure: Survey and suggestions. Journal of Multinational Financial Management. Rosenberg J. V. Schuermann T (2006). A general approach to integrated risk management with skewed, fat-tailed risks Journal of Financial Economics, vol. 79, pp. 569-614 IMF (2007). UAE: 2007 Article IV Consultation Mission Preliminary Conclusions May 28, 2007 http://www.imf.org/external/np/ms/2007/062907.htm Shapiro A.C. (2003). Multinational Financial Management. Seventh Edition. Wiley and Sons Inc. Solt M. E., Wayne L. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Valle L. D., Giudici P. (2008). A Bayesian approach to estimate the marginal loss distributions in operational risk management. 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