Political Risk and Foreign Investment Decision 
of International Hotel Companies
58 events influential to the development and operations 
of the multinational hotel chain
by:
Jung Hwa Hong, School of Management Studies for the Service Sector, University of Surrey, UK
Peter Jones, School of Management Studies for the Service Sector, University of Surrey, UK
Haiyan Song, School of Management Studies for the Service Sector, University of Surrey, UK
 
May 1999 / Foreign investment is viewed as a major stimulus to economic growth in developing countries.  The significant role of the political dimension of the environment in the foreign investment decision has been clearly shown in previous studies. This paper is based on work in progress to investigate political risk assessment in multinational hotel development. The study uses an existing framework for an empirical study that will identify 58 political factors. These factors will he ranked by decision makers and experts in the international hotel business in accordance to the importance these variables have on the investment decision. 

Introduction 

The growing importance and necessity of foreign investment for strengthening economic stability and quickly evolving towards a developed economy in developing countries has generated interest in foreign  investment  decisions  of multinational corporations (referred to as MNCs hereinafter). Factors which prompt MNCs to enter individual countries have been reported by many studies in a variety of ways.  It is also clear that the level of hotel investment is not homogeneous,  some countries have significantly more development than others. For instance, "across the Americas in 1998 the travel and tourism industry will have generated US$ 1.2 trillion in GDP and 33.7 million jobs" (O'Hare, 1998).  But some 70% of new hotel development in Latin America is concentrated in two countries. Brazil in the next few years is expected to have 25,000 new rooms and Mexico 12,000, with Accor, Choice, Sol Melia, Holiday Inn and Hilton being the key international players (O'Hare, 1998). Why is such development concentrated in just two countries? 

The findings of previous empirical studies show that MNCs consider the political risk of the host country as one of the most important determinants in investment decision making. Such concern is due to the belief that unpredictability and volatility in the political environment of the host market increases the perceived risk and uncertainty experienced by the firm. In turn, this disinclines firms  from  entering  with  heavy  resource commitments  (e.g.  wholly  owned  subsidiary, majority equity participation in joint venture). 

This paper is based upon a research project examining hotel investment decision. The aim of this paper is to establish a comprehensive view of what determine target country's political risk and to identify the importance of variables from the decision makers of international hotel firms and experts in this area.  The first part of this paper is based on a thorough review of the literature concerning political risk and instability,  the importance of political risk in relation to inward foreign investment and tourism industry, and the way of measuring political risk. Also, the relevance and importance of perception to political risk assessment suggests an ideal methodology for the present study. 

The second part of the paper presents a framework and methodology for an empirical study. The framework developed by Kim and Olsen (1933) contains 58 political events represent influential political risk and uncertainty. The respondents will be asked to sort the variables and assign different weights along the seven-point scale according to perceived importance. 

In a concluding part, application for host countries will be made. This study is to determine the major political events and constraints for international hotel development and identified variables which can be utilised by government for eliminating and controlling negative political factors. It is suggested that  active involvement of host country government will be necessary' in order to lower political risk and promote more foreign inward investments. Host governments must fully evaluate all controllable factors and deal vigorously with problems of political risk. 

Political Risk and Instability 

Several scholars (Fatehi - Sedeh and Safizadeh, 1989; Formica, 1996; Kobrin, 1979; Robock, 1971; Sethi and Luther, 1986) claimed there is no single universally accepted definition of political risk. It is most commonly conceived in terms of (usually host) government interference with business operation (Carbon, 1979). Very simply, 'political risk' refers to the possibility that political decisions or events in a country will affect the business climate in such a way that investors will lose money or not make as much money as they expected when the investment was made. 

The existing definitions of political risk focus on the concept of political risk from two different perspectives (Carbon,  1979). One group views political risk in terms of governmental or sovereign interference actions. This concept, which is related to all undesired outcomes of political activities of the host government with private businesses, is represented by confiscation, currency repatriation, limits to business transactions and so on. The second group identifies political risk as occurrences of any political events imposed upon the firm. The examples are violence, terrorism, and guerrilla groups. 

In the process of defining political risk it is useful to distinguish it from political instability. Carbon (1979, 1980) argued that instability is a feature of the general environment, whereas risk is something narrower in focus which directly affects the MEN. In other words, political instability, for example, by an unexpected change in government leadership, may not involve political risk for international business. Furthermore, Lewis (1979) claimed that political stability in itself is not a sufficient guarantee to tourism or any other kind of industry, especially in the absence of favourable economic conditions. 

Political risk is also defined more precisely. Schmidt (1986) defines political risk as "the application of host government policies that constrain the business operations of a given foreign investment". He subdivides risk into three main categories: "transfer risk", concerning risk to capital payments; "operational risk", with threats over local source or content; and "ownership control risk", highlighting  possibilities  of  expropriation  or confiscation. Moreover, according to Kennedy (1988) political risk can be defined as the risk of a strategic, financial, or personnel loss for a firm because  of  such  non-market  factors  as macroeconomics  and  social  policies  (fiscal, monetary, trade, investment, industrial, income, labour, and development), or events related to political instability (terrorism, riots, coups, civil war, and insurrection). These two types of non-market factors can be called legal -  governmental and extra legal political risks. Legal - governmental risks are caused by events that are considered illegitimate by the existing political system. 

The difficulty in finding a proper and commonly accepted definition of political risk has presumably prevented many researchers from contributing to this issue and it is also troublesome for building a solid model easily applicable. Furthermore, the scope of political risk may be another deterrent for the development of research in this field. 

Political Risk Related to Foreign Investment 

The growing amount of resource commitment assigned to foreign investment by the increasing number of MNCs has generated particular interest in assessing the relationship between the foreign investment and factors influencing the investment decision. Among these factors, political conditions have demonstrated to be one of the leading factors in assessing a company's foreign direct investment in a foreign company (Erol, 1985, Kobrin, 1979). 

Interviews and  surveys of executives of multinational corporations have found political events to be one of the most important factors in foreign investment decision (Aharoni, 1966; Basi, 1963; Bass et al., 1977; Schollhammer, 1974). In particular, executives cite the stability of the host government and the attitude of the host government toward to foreign investment as most important considerations in the investment decision. 

Kobrin (1978) claimed the presence of a negative relationship between political instability and foreign direct investment. After controlling for the effect of economic variables on the flow of foreign investment,  the statistical result supported the association between political stability and foreign direct investment is more likely to be conspicuous when there is an economically rooted conflict and the  government  has  sufficient  administrative capability to indirectly respond to it. 

There are a number of political events and constraints which will eventually cause a loss or harm to a business operating in a foreign environment. Nationalisation and expropriation became the greatest fears for foreign companies in the developing world during this era. The impact of politics on business operations has almost always been seen in the negative.  Unexpected political activity by guerrilla or other political groups is another means of political risk. Discriminatory taxation, absence of patent protections, and limits on foreign national employment have also crucial impact on international business in foreign country. 

This importance of political risk of host country is more significant in tourism investment. Richter (1994) states that political instability is of the foremost importance to any investment, but it is of special consequence to tourism because of what is being sold: serenity, leisure, fun and comfort and these can only be marketed under stable conditions. Moreover,  hotels,  a major form  of tourism investment, are unusually vulnerable to political risk due to substantial investments in fixed assets (Poirier, 1997).   For instance, despite recent economic problems in Brazil, hotel development is strong -  aimed largely at capturing the huge domestic business traveller segment. As there is effectively no debt financing available as interest rates are too high, most hotel companies are injecting equity funds into projects, sourcing the finance from private equity, pension funds, or development funds (O'Hare, 1998). 

Political Risk Measurement 

A rational, sophisticated approach to foreign investment decision process requires a careful examination by the firm of numerous factors which relate to both the general environment of a proposed investment and the specific operating functions of the firm in that environment. A vital element of the environmental analysis is the question of political risk.   The majority of studies of dealing with political risk focus on determining the variables composing that specific risk, or aim to find an association between political events and foreign investment. While the significance of political risk is generally acknowledged, the studies aiming to analyse it are too often vague and difficult to examine and apply in practice. 

Analysts providing political risk assessments to MNEs have attempted to overcome the problems of accurately  predicting  future  scenarios  which incorporate the dualistic, and often incompatible, components of academic theory and business clarity. Numerous political risk analysis approaches are  utilised,  either by  in-house  or outside specialists. These range from qualitative, subjective, and discursive briefings by respected "experts" at one end of the spectrum, to quantitative computer-based assessments drawn from a numerical ranking of various societal variables. The more sophisticated quantitative  approaches  are  not  significantly different from econometric forecasting used by economists; however, political risk analysis instead tracks political trends with multivariate data analysis techniques. Rummel and Heenan (1978) integrate objective and subjective methodologies which allows for the best features of management science to be combined with insights and intuition of regional experts. 

In political risk studies, generic approach can cause inaccurate determinants. As Erol (1985) stated traditional studies assessing political risk and its relation with foreign investment have contemporarily taken into consideration a variety of data from different countries and industries. This generic perspective has led to a failure in determining reliable assessments of the dimension of political risk and its relationship with investments from outside the host country.  The author maintains that political risk assessment must address both the peculiar characteristics of the host country and attribute of the investment project. The project play plays a critical role in determining potential risks because different projects can be differently affected by the political events of a host country. 

Interestingly some industry types may be more vulnerable than others to specific problems in a country's political economy, especially if political stability is the major concern. The study led by Fathei - Sedeh and Safizadeli (1988) has found that multinational corporations belonging to different industries do not perceive the same degree of risk when facing the same political turmoil in a given country. Hence, in order to identify and assess political risk in international hotel investment, a new framework based on the specific variables of the hotel business and its unique characteristics is necessary. 

Table 1. presents some summary statistics on the political risk ratings in Latin America by two well-known organisations which are specialising in political risk assessment and rating. It shows that the average risk level during the period of from mid 80'(except Peru) up to July 1995 by Institutional Investor's Country Credit Rating {IICCR) and International Country Risk Guide (ICRG). In both schemes, lower figures represent higher political risk in the country. Interestingly, Brazil is the third highest average risk country in Latin America in IICCR and ICRG over last 10 years. 
 

Table 1. Average of Political Risk in Latin America  
(Start date - July 1995)
Country
Sample Start
IICCR
ICRG
Argentina Jan-84 25.0 52.8
Brazil Jan-84 29.6 59.0
Chile Jan-84 36.1 62.2
Columbia Jan-85 38.7 62.5
Mexico Jan-84 36.9 64.1
Peru Jan-93 19.7 57.6
Venezuela Jan-84 36.4 64.4
Source Erb et al (1996)
 

Perception on Political Risk 

While the threat of political risk warrants such concern, it is not a mystical phenomenon and it susceptible to objective analysis. lndeed, such analysis is already being conducted by a relatively small number of firms. However, the accurate evaluation and comparison of political climates is largely an immature art for businessmen. 

The assessment of political risk and more importantly, investment decisions, depend upon prevailing  attitudes,  first  impressions,  and generalisation on single events occurring in the host country (Formica, 1996) Also, according to Kobrin (1979) most managers' understanding of the concept of political risk, their assessment and evaluation of politics, and the manner in which they integrate political information into decision making are all rather general, unsophisticated, subjective, and superficial. Many empirical studies supported that the evaluation of political risk is based on generalisation and impressionistic knowledge of a developing nations. The finding of Keegan (1974) indicates the executive responsible for international operations of multinational companies rely very little on systematic environmental scanning methods. Similar findings were reported by Root (1967). The findings indicated that executives' attitudes play a major role in their evaluation of risk and profitability of the investment opportunities. 

Based on the research discussed in this paper and the experiences made by the consultants interviewed, we argue that political risk assessments are not necessarily based on structured decision- making processes. Often times, managers are not provided with, or are unable to interpret, the information required to make the optimal choice. 

However, most previous empirical studies assumed  that  the  relevant  factors  for  the measurement of political risk could be adequately captured  with  archival  data.  In  doing  so, researchers disregard the crucial role of the perception of decision makers. Irrespective of the actual circumstances, as Rummel and Heenan (1978) suggest the forecasts of the underlying factors on which the predictions are based are frequently judgmental so decision makers take decisions that are based on their own judgement of the situation. Ignoring the decisive influence of perception is a weakness in most political risk studies. Hence, the present study recognises the relevance of perception and risk assessment and a survey will be conducted to obtain data from decision makers and experts. 

Proposed Framework 

Despite the value of political risk analysis, a few frameworks have been proposed to measure country's political risk (Rummel and Heenan, 1978; Micallef, 1981; Erol, 1985; Sethi and Luther, 1986). However, there is no consistent framework in the way that the international hotel companies can use to evaluate political risk of foreign country when they intend to make foreign investment decision (Formica, 1996). 

Though there are numerous variables are existing in determining a country's political risk, not all of them are taking into consideration of decision -makers. While some variables may be considered more important for some decision-maker, the others are ignored  when they determine a country's political risk. Moreover, each determinant may have different degrees of influence on decision making due to the perception. Hence, it will be interesting to identify the important political indicators in hotel development decision making. 

The present study uses Kim and Olsen (1993)'s framework to explore measurement of political risk The model uses experts in order to identify and appraise all the major political environment dimensions that determine hotel development project and business operation of the multinational hotel chain and its subsidiaries. Despite those political factors have been derived from the specific location, they represent the valuable list of potential political risk factors in the hotel field. Under four classifications of political environment (law and regulation, administrative, judicial, and lobbying) 93 factors were suggested. After the two rounds of Delphi process, 58 events were agreed to be influential to the development and operations of the multinational hotel chain. Of the 58 events selected, 26 are under law and regulation, 14 are under administrative, 10 are under judicial, and 14 are under lobbying (see Table 2.). Details of four categories are presented in Appendix 1. 
 

Table 2. Political Environment Variables
Category
No.  of  factors
Law and regulation 26
   Financial 7
   Operational 10
   General / strategic 9
Administrative 14
   Financial 4
   Operational 3
   General / strategic 7
Judicial 10
Lobbying 8
Total
58
Source Kim and Olsen (1993)

Methodology 

Important steps in the process of data collection are selecting the respondents and ensuring their participation in the survey. Research sample will be consisted with two groups of profession who are engaged in international hotel business. First group is foreign investment decision makers in UK based multinational hotel firms. Second group is consultants who conduct feasibility studies and advise for new projects. 

The respondents will be asked to identify and rank important political events or constraints in their investment decision making and assign different weights along the seven-point scale 
according to perceived importance of these 58 variables 
 
 

Appendix 1. Four Political Categories
Law and Regulation 

1. Limits on convertibility of local currency into foreign currency. 
2. Restrictions on repatriation of capital, profit, and management fees. 
3. Price controls for rooms and other charges in a hotel. 
4. High corporation tax on hotel firms. 
5. Taxation laws intended to attract foreign capital for investment in hotel projects. 
6. Tax credits for creating new jobs or providing training and education. 
7. Licensing restaurants, swimming pools, barber shops, night clubs, bars, etc., in a hotel. 
8. Labour law being restrictive regarding hiring employees (e.g. racial quotas) 
9. Labour  laws  protecting  employees  by establishing an employee welfare fund. 
10. Minimum standards required for registering with the government to be officially recognised as a high standard hotel. 
11. Labour law protecting employees by setting a minimum wage. 
12. A hotel project should be approved by the government before the construction is started. 
13. The  impact  of hotel  construction upon transportation and physical environment in and around the site should be examined by the government. 
14. Constantly changing regulations. 
15. Legalising casino gambling. 
16. Reduction of red tape to get government permits. 
17. Whether the country is a signatory to any international convention or protocol. 
18. Local tax holidays. 
19. Budget proposals to fund tourist promotion activities and education of local hotel employees 
20. Setting standards for food handling and cleanliness for restaurant workers. 
21. Limits on the number of foreign employees who may be employed in a hotel. 
22. Labour law being restrictive regarding creation of a union and its activity. 
23. Setting standards for safety of guests, especially fire safety. 
24. Availability of policies forces to ensure security in cities and neighbourhoods. 
25. The hotel construction site should be located in the areas where the relevant laws permit. 
26. Budget  available  to  country's  tourism department to promote the hotel's service overseas. 

Administrative 

1. Price controls for rooms and other charges in a hotel 
2. Continued uncertainty and instability on the political socio - economic front - history of coup d'etat, military power and influence in everyday life. 
3. The government dictates the hotel grading system based only on the type and size of facilities disregarding the level of service. 
4. Currency controls (e.g. requiring hotel to collect all changes only in the domestic currency). 
5. Waiver of import duties of materials for establishment of new hotels and refurbishment project. 
6. Tightening of monetary policy affecting economic expansion 
7. Restrictions on business hours or days for F&B outlets, night club, and health centre in a hotel. 
8. Excessive requirements for licensed and permits before allowing full operation of the hotel 
9. Controls on purchasing systems in hotels 
10. National airline policies which would encourage or discourage tourists from coming to a country. 
11. In  creased  crime  controls  in  tourist environments. 
12. Discouraging major companies from investing in property development such as hotels. 
13. Civil service employees with poor English language skills or with poor knowledge about tourism and the hospitality industry. 
14. Enforcement of safety laws and regulations affecting building and operation of hotels. 

Judicial 

1. Interpretation of trademark rights 
2. Interpretation of resident versus non-resident marketing/franchising agreements. 
3. Court decisions interpreting the enforceability of hotel contracts. 
4. Legal precedents placing liability on hotels for providing alcoholic beverages to drunk drivers who later commit acts of destruction or injury. 
5. Court decisions enforcing union rights and responsibilites. 
6. Court decisions encouraging (or discouraging) consumers to sue large hotel companies. 
7. Cases of disputes over employment rights of hiring and importing foreign personnel. 
8. Court decisions interpreting legal principles regarding hotel overbooking and damages relating thereto. 
9 Overall integrity of the judicial system and the quality of the judiciary. 
10. Enforceability  of  foreign  judgements  or arbitration awards. 

Lobbying 

1. Integrity of local business environment 
2. Need for a truly independent association that looks out for the travel industry. 
3. The ability to discuss problems and concerns with decision or policy makers. 
4. Maintaining access to government officials at the decision (or policy) making level either directly or through an organisation. 
5. National laws governing lobbying. 
6. Using a hotel (or tourist) association as an organised lobbying group. 
7. Ability to hire executives who are knowledgeable about government impact on a hotel's business and how to manage government's involvement. 
8. Maintaining access to government officials in the various agencies and bureau at the decision making level. 
 

Application to Host Countries 

The trend towards globalisation has meanings to both MNCs and host countries. MNCs are taking a global view of their strategies, whereas host countries are beginning to recognise the importance of global dimension in their economic development planning. Several studies show that firms that have a higher preference for investment entries are sensitive to investment attributes. Hence the government of host countries will not only have to develop policies that make it attractive for foreign firms to invest their markets, but more importantly, will have to reduce their risk perceptions through regulations that permit repatriation of profits, majority ownership and control, patent protection and  enforcement  of  contracts.  From  the government's perspective, it should be noted that, regardless of the stage of economic development of the country, policy variables that reduce the risk will have a positive impact on inward foreign direct investment. 

Recent trends indicate a move by developing countries to do just this, whereby conditions are being created for a more favourable investment climate through relaxation of investment controls and provision of investment incentives including better protection of property rights and enforcement of contracts. Under these circumstances, firms with higher ownership advantages are willing to enter these countries and enjoy the benefits and advantages as the first mover. 

Conclusion 

Of course political factors are not only determinants  which  decide  whole  investment decision. Many studies report that political, as well as economic stability are necessary conditions to attract direct investment from abroad. However, many studies have found the correlation between political factors and investment decision Especially, accurate political risk evaluation is more important concern for unstable developing countries.  Some factors which influence a country's political risk cannot be adjusted at all. However, some of factors which decide a country's political risk can be changed in order to lower political risk and promote more foreign investment in the country. 

If a country does not confront its political problems, it is obvious that the country will be excluded in the list of future investment plan of multinational hotel companies. To determine and get rid of the major political barriers and risks to foreign investment development is the first step which developing countries should exercise in order to attract more inward foreign investment. 

References 

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©First Pan-American Conference
Latin American Tourism in Next Millenium: 
Education, Investment and Sustainability
May 19-21, 1999 / Panama City, Panama
Editor: Professor Kaye Chon, University of Houston

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