Most companies understand that engaging in international transactions involves planning for delays in shipments or possible odd local regulations. The more sophisticated international businesses learn to consider changes in exchange rates and any good attorney or accountant can provide in contracts various formulas which allow the exchange rate to be taken into account when developing payments that may occur months or even years after the order is placed. (A few companies known to the author actually make more money on intelligent use of exchange rates than on the products they purchase or sell.)
But the wise international business person realizes that there are far more extreme problems that can be confronted in such transactions and that such issues require advance planning. Too often business people, especially in the West, used to relatively stable governments and currencies, become far too confident in the continued viability of engaging in business in locales in which the laws or the currency are as volatile as the politics. Even nations with relatively stable governments, such as Argentina or Brazil, face currency and banking issues that have immediate and widespread catastrophic effects on business operations in those nations.
This article shall describe some of the common dangers the businesses faces with local governmental and currency issues in international business and proposes some suggested defensive moves. It is already presumed that the reader will have created a currency formula in the contract that will take into account alterations in exchange rates. The issues below which are considered are related to more extreme problems with the local government or currency than alteration in exchange rates.
Problems With Currencies and Governments:
1. Inconvertibility of the Currency. If the country hosting the project or performance of the contract experiences foreign exchange shortages, one must examine the risk that the parties will be unable to convert local currency revenues into the foreign exchange required to make necessary payment or debt service and other foreign currency payments. In assessing this risk, the parties must analyze the host country's foreign exchange reserve position. Those countries experiencing acute foreign exchange shortages may block conversion either passively (e.g., the borrower's or party’s application to the central bank is accepted, but the central bank lacks the foreign exchange to effect the remittance) or actively (e.g., through the imposition of exchange controls or the declaration of a moratorium).
2. Transfer Risk. Transfer risk is the risk that the central bank of the host country will notionally convert the borrower's or parties’ local currency into foreign exchange on its books, acknowledge the central bank's foreign exchange obligation to the lender or party, but will not transfer the foreign exchange out of the host country. This is often a prelude to a country's general rescheduling of its foreign exchange obligations. The risk mitigation techniques and available political risk insurance coverages are the same as for the risk of inconvertibility and are therefore discussed jointly below.
3. Devaluation Risk. Whenever a lender lends in foreign exchange and relies for repayment on a borrower that generates earnings only in local currency, there is a risk that the local currency may depreciate in value and that the borrower will be unable to generate sufficient local currency for conversion into foreign exchange to service the debt. In developing countries with soft currencies, the likelihood of devaluation is high and the ability to hedge against or insure the risk is very limited. Although generally devaluation leads to inflation and therefore increased local currency earnings for the borrower, the lender must carefully analyze this risk whenever structuring the financing for a project or entering into a long term contract that does not generate foreign exchange -- such as projects that produce power for domestic consumption.
4. Expropriation. The risk of expropriation is greatest in high profile projects that are often associated with public ownership (e.g., oil projects, mining projects, power projects, etc.) but easily effect even the smallest supplier or vendor to said projects. The risk is that the host country government will nationalize the assets or equity of the other party in an arbitrary or discriminatory manner or without the payment of "just compensation." This recently occurred in Russia with large oil and gas companies and is not uncommon in Africa. Note this also happened in Cuba when Castro took over the government, as well as Libya, Iran, and China. Essentially, a change in government or a civil war can result in one’s contractual partner becoming a hostile adversary.
Most recently, the Europeans consider the current attitude of the Iraqi government (and its sponsor, the United States) as to existing debts and contracts an example of massive expropriation and this is one reason for the strained relationship between the EU and the United States as to Iraq policy.
Expropriation can be by a single governmental act or a series of hostile acts designed to force the shareholders to abandon the company or project ("creeping expropriation"). Failure by the government to pay "just compensation" for the taking is a violation of international law. Although what constitutes "just compensation" has been a matter of some controversy over the years, the traditional U.S. position that "just compensation" must be "prompt, adequate and effective" is evolving into the accepted international standard. Under this standard, shareholders are entitled to the going concern value of the interest expropriated, paid in a convertible currency. When a government expropriates a project, it will often, for pragmatic reasons, keep current on debt service payments to the lenders and other parties, as it is often in the government's interest to try to maintain an on-going relationship with the lenders and vendors in order to maintain access to external financing or obtain the supplies.
5. Acts of Government Making Contract Untenable. Perhaps an even greater risk than expropriation is that the host country government will take lawful actions that have the consequence of rendering the project or contract unprofitable, such as import and export restrictions, price controls, or excessive taxation. Insurers providing expropriation coverage generally are not willing to insure this risk as they would be left without recourse to the host country government in the event of a claim (the insurer's claim against the host country government in the event of expropriation is based on the illegality of the government's action). If, by agreement with the project sponsor, the host country government agrees not to take certain regulatory actions against the project, however, political risk insurers may be willing to cover the risk of abrogation or repudiation of that agreement. For most smaller transactions, this is simply a risk factor that must be considered in the cost benefit analysis of the entire transaction.
6. Government Control of Critical Raw Materials. Many developing countries are in the midst of a period of transition from centralized economies to more market-based economies. Many of the goods and services that are critical to manufacturing or project financing, such as fuel supply, transportation, construction and electric power transmission are currently controlled by the host country government. Reliance on government-owned suppliers and purchasers heightens the risk of government interference detrimental to the project. Often, at the time the transaction is being structured the government's intention to privatize all or part of critical fuel suppliers or off take purchasers is well known, but the impact of such privatization on the project or contract is unclear. In certain nations, such as China, the government is an inevitable partner in almost every large contract and will certainly control access to vital raw materials for any manufacturer.
7. Tax Regulations and Alterations. Cross-border financings also raise significant tax issues. Governments may excessively tax a project or contract relationship into unprofitability. Absent an exemption, lenders or parties are often subject to withholding taxes on interest payments. A variety of stamp duties and other, often excessive, taxes may be payable in connection with closing the transaction.
8. Security Problems With Your Personnel. As discussed in our articles on Security and Safety for Business Travelers Abroad it is vital for any business person to ensure the safety of the employees and agents of the Company during negotiations and facilitation of these transactions.
Such added security may be next to impossible, leading to delays in the contract performance or substandard performance due to lack of supervision or inspection. Even if security can be achieved, the added expense of security precautions may make the contract unprofitable. And, of course, if personnel are injured or killed, the result is catastrophic for the business. Such issues are far from uncommon in perhaps half of the globe. Russia, the Ukraine, Khuzestan, most of the Arab countries, Israel, much of Africa, Indonesia, much of the Philippines…all these nations and more have large dangerous areas for the foreign business person.
9. The Federal Corrupt Practices Act. This Act is discussed in more detail on the Newsletter Page of this Website but suffice to state that any gift, however innocent, to a governmental official or functionary related to the contract, even if legal or not prosecuted in the local nation, can result in prosecution in the United States under the above law. This often puts local efforts of the company or its agents at a decided disadvantage when seeking governmental cooperation and is seldom enforced against other than United States companies. As one client put it, “The playing field is uneven if my own government is looking over my shoulder ready to fine or arrest me while my competitors are free to do what they want.” Any entity engaging in international transactions should have a basic understanding of the Act.
10. Changing Local Laws Affecting Personnel. As discussed in Security and Safety for Business Travelers Abroad local laws are not only fully enforceable against your personnel visiting the foreign locale, but can alter without your local personnel even knowing it. Once violating the law, engaging in handling the local legal complications can be both expensive and frustrating, especially when the restrictions of the Federal Corrupt Practices Act may also be involved. One client during a two months sales trip to Khuzestan failed to read or write the language and was unaware that new currency restrictions, enacted after he left the United States, had made his proposed method of payment illegal. The resultant fine nearly bankrupted his company.
Solutions to Consider:
- INSURANCE: Insurance can be obtained which takes into account some, but not all, of the governmental risks involved in the transaction. For large business ventures, this is well worth considering, though the average small transaction will not have sufficient profit margin to make the expense worth while. The United States government often underwrites insurance in certain areas of trade, such as the Caribbean, and the United States Chamber of Commerce has excellent information on that program.
- JOINT VENTURES. The use of a local partner not only gives one local knowledge and contacts but can avoid some of the currency issues since one can maintain sums in the local area while getting indirect benefit by later transactions in reverse. (One client who found his profits caught in an African nation due to currency law changes had his local partner hold the money for six months until he found a product he could import which was free of such restrictions and engaged in that transaction to retrieve those profits. He was able to do so with little fear of loss and no tax liability by simply having the Partner not make the allocation of profits until shortly before the second transaction.)
- EDUCATION. Many of our clients refuse to engage in business in any locale unless they know there will be enough repeat business to make learning the local culture and legal/financial system worth while. Once a full “campaign” of entry into that market is decided upon, the clients form teams of US counsel, US CPA, local counsel, local CPA to create a full analysis of the dangers and pitfalls with an action plan to avoid them. One client commented wryly that entering some country’s markets was like “hitting the beach” in an invasion, and that one does not make such a move without advance strategic planning and the combat troops in place.
- LOCAL ASSETS FOR LOCAL CURRENCY. If there is significant danger that one’s currency may have danger of being trapped in the local area, it makes sense to determine local investments ahead of time so that the currency does not deflate to little value while one waits to get it out. One client, caught by Apartheid restrictions in South Africa, had already arranged for the purchase of a small local business and simply owned that entity while awaiting changes in the law allowing retrieval. In the end, it became quite a profitable investment.
- INDIRECT TRADE. If a nation is simply too dangerous or unstable for direct trade, neighboring countries, who are usually familiar with local conditions and have local contacts, may be the correct source point for trade or business with that nation. Trade in Uganda using a business forwarder in Kenya, or trade with Khuzestan using a Russian partner are typical efforts to achieve that goal.
- LETTER OF CREDIT TERMS. By appropriately negotiated Letters of Credit, the transaction can be cancelled if certain currency or local regulations make performance unprofitable. The disadvantage is that one still loses the various expenses of setting up the Letter of Credit and negotiations, but note that Letters of Credit are normally going to be required in any transaction in any event and that cost is minimal compared to currency trapped in the local nation. See our article on Letters of Credit.
- PERFORMANCE TERMS IN CONTRACTUAL DOCUMENTS. As with Letters of Credit, artfully drafted contractual documents can often lessen the risk caused by local conditions, allowing the parties to cancel the transaction before transfer of monies (or, if a Letter of Credit is used, cancel the Letter of Credit) with minimal loss. The usual terms as to impossibility are simply enlarged to cover the entire plethora of events that can occur in the local nation. See our article on International Commercial Transactions Standard Terms and Conditions.
- SET ALARM POINTS. It is vital to keep track of changes in the local environment and not let other business distract you from the need to monitor events. A good expedient is to set “critical points” at which an escape plan is implemented automatically. One experienced client had his computer programmed to monitor currency rates so that any ten percent change would pop up on his computer automatically and routinely utilized his carefully negotiated terms and conditions to delay or cancel contracts the moment such events transpired.
Conclusion: Learning the Trade.
The above issues clearly make engaging in such trade a higher risk than that seen in the staid and dependable business climate of the United States and Europe or Japan but risks inherently bring larger profits since competitors will be discouraged and customers more eager. As one young trader commented to the writer, “No risk no glory, no big profit.” Many people engaged in such trade see themselves as the modern counterparts to the Venetian or Genoese traders who risked death and destruction by enlarging trade to the East in the Fifteenth and Sixteenth Centuries.
What is vital, however, is to prepare oneself for the various eventualities ahead of time and take nothing for granted. Only the well prepared can withstand the inevitable problems and delays that such trade entails. To engage in such trade without full advance preparation, including a full team of experienced advisors and well written international documents, is to court disaster. Even Marco Polo took the time to learn the locale before seeking to trade and his books were best sellers precisely because his audience…the traders of Italy…wanted to learn the country before risking their wealth. Today the same requirements apply.