The effect of asset and ownership structure on political risk

Journal of Banking and Finance 13 (1989) 651-671. North-Holland

THE EFFECT

OF ASSET AND OWNERSHIP POLITICAL RISK

Some Evidence from Mitterrand’s

Election

STRUCTURE

ON

in France

Frederick J. PHILLIPS-PATRICK* University of Massachusetts, Amherst, MA 01003, USA Received July 1988, final version received March 1989 Previous research suggests that political risk varies considerably from firm to firm. Yet few empirical tests of the cross-sectional variation in political risk exist. French assets were massively revalued the day after Mitterrand was elected in 1981, providing a unique opportunity to test for the effect of firm-specific factors on political risk. Although foreign ownership tends to increase political risk, other factors can reduce it. A simple model of political behavior is presented in which politicians value, among other things, economic growth. A foreign firm with significant future growth options is likely to experience less political risk than other foreign firms and, under certain circumstances, less risk than even other domestic firms. Tests of these hypotheses are conducted using data from the French and U.S. capital markets. The results are generally consistent with the hypotheses.

1. Introduction

On 10 May 1981, FranCois Mitterrand was elected President of France on a political platform widely expected to produce a radical shift in political policies and, hence, the political risks of both foreign and domestic firms.l On the day following his election, most stocks trading on the Paris bourse declined precipitously, reflecting investors’ perceptions of the altered set of opportunities and costs (including political) facing firms operating in France. Previous empirical studies of political risk have focused almost entirely at the country level. Yet some studies, e.g., Truitt (1970) and Farge and Wells (1982), suggest that political risk varies considerably from firm to firm even *This paper is derived from my dissertation at the University of Rochester. I would like to thank the members of my committee, Clifford Smith, Ron Hansen and Jerold Zimmerman for their many comments. I have also benefited from the comments of Ben Branch, Steve Kobrin, and the participants at the Conference on Research in International Finance sponsored by Centre HEC-ISA. The usual disclaimer applies. ‘For example, Mitterrand had promised to nationalize the banking industry totally and ten of the largest industrial firms in France. Langohr and Viallet (1986) analyze the compensation eventually paid the nationalized firms. 0378-4266/89/$3.50 0 1989, Elsevier Science Publishers B.V. (North-Holland)

652

F.J. Phillips-Patrick,

Political

risk

within the same industry; however, few tests of cross-sectional variation in political risk exist.’ Change in a firm’s political risk is often difficult or impossible to assess empirically because market data on individual firms, especially foreign subsidiaries, are not available. The dramatic change in firms’ values accompanying Mitterrand’s election provides a unique opportunity to test empirically hypotheses concerning the relative political risks of foreign subsidiaries vis-a-vis similar locally-owned firms. In general, foreign ownership is likely to increase a firm’s political risk. Yet, if local growth is valued by politicians, a foreign firm’s ability to shift future investments elsewhere is likely to mitigate its risk. Shapiro (1981), for example, conjectures that politicians tend to take non-political factors, e.g., economic considerations, into account when choosing the source of wealth transfers. This paper examines the relation between a firm’s political risk and its asset and ownership structure. A simple model of the political process is presented in which politicians act as brokers of wealth transfers.3 In general, foreign ownership is likely to raise a firm’s political risk because foreigners typically face higher political ‘transaction costs’ - costs of persuading host-country residents of the importance and value of foreign investment, of organizing local opposition to unfavourable legislation, etc. Politicians are then likely to face less opposition from these firms than from local firms. Politicians are thus more likely to secure wealth transfers from foreign firms than from local firms. A foreign firm which has significant future growth opportunities can affect the political process through its future investment choices. For example, if the firm is taxed too heavily, it may choose to locate future investments elsewhere. If local growth is valued by politicians, a foreign firm which has sizeable growth options will likely fare better in the political process than a foreign firm whose assets are already in place and host-country-specific. Moreover, if there are fixed costs associated with initiating foreign operations, a multinational firm with its existing real asset diversification can face lower marginal costs than local firms in locating non-country-specific assets elsewhere. Therefore a foreign firm may fare better in the political process than even an otherwise similar host-country firm. Tests of the theory will indicate whether a foreign firm whose value consists partially of growth options will face more or less political risk than a comparable host-country firm. The point at which the loss of future wealth ‘See Kobrin (1979) for a literature review of political risk and multinational corporations. 3Political risk can be considered as a form of post-contractual opportunistic behavior in which the parties to a contract (in this instance, a given set of property rights) have mcentives to renege on the contract after an investment is made. Refer to Williamson (1979) and Klein, Crawford and Alchian (1978) for an analysis of post-contractual opportunistic behavior. In fact, Klein, Crawford and Alchian make reference to the applicability of their analysis to direct foreign investment in their footnote no. 7.

F.J. Phillips-Patrick,

Political

risk

653

transfers to the politician exceeds the inherent lower cost of foreign opposition varies with each political jurisdiction. Nevertheless, the extent to which the foreign firm controls the local value of its foreign subsidiary through its future investment actions is likely to influence the political risk it faces. Using data from the French and U.S. capital markets, tests of the relative political risks of the French subsidiaries of U.S. based multinationals vis-avis similar French-owned firms were conducted on a firm by firm basis. In general, the results of these tests are consistent with the hypothesis that political risk increases with foreign ownership but is mitigated to the extent that the foreign firm offers substantial local growth opportunities. The remaining portion of this paper is organized as follows: in section 2, a simple model of the political process is presented. Several testable hypotheses concerning the relative political risk of foreign firms are developed. In section 3, the data and methodology used in testing these hypotheses are discussed. The empirical results are reported in section 4. Finally, in section 5, a summary and directions for future research are discussed.

2. The political process and multinational

firms

Governments assign property rights, adjudicate disputes and enforce these rights when necessary. Changes in property rights by politicians often result in wealth transfers. Assuming rational, wealth-maximizing behavior, individuals have incentives to engage in political lobbying activities to affect those decisions. The political process can be seen as a market in which groups of individuals both inside and outside of government compete for wealth transfers.4 As a consequence of this political activity, firms may face additional costs. These political costs can be considered in a stylized fashion as the sum of the net explicit and implicit taxes a firm pays in a political jurisdiction. The net explicit taxes are the difference between the wealth that is directly transferred from the firm and the benefits it receives. Implicit taxes include the direct costs the firm incurs to mitigate its political vulnerability (e.g., lobbying, campaign contributions) and the indirect costs that arise from activities induced solely by the firm’s political vulnerability. It should be noted that political costs can be negative. Politicians have incentives to take into account both the support and opposition generated by their activities, as tenure in office provides them with an opportunity to exploit their specific human capital. They will tend to alter property rights in such a way as to benefit those who will provide them “See Stigler (1971), Posner political process.

(1974) and McCormick

and Tollison

(1981) for such models

of the

654

F.J. Phillips-Patrick,

Political

risk

with the most benefits - at the expense of those who are least likely to oppose them. The extent of political lobbying activity (both support and opposition) depends upon information costs and the costs of organizing special interest groups. Groups with lower political transaction costs are likely to be successful in securing wealth transfers from those groups which have higher political transaction costs.5 The political transfers of wealth has additional effects, however. Individuals, in making their investment decisions, take into account the appropriability of the income the investments generate.‘j If certain activities are subject to greater wealth transfers, less investment is likely to take place. This reduction in investment can affect the local suppliers of inputs and local demanders of output and can also reduce the general level of wealth in a political jurisdiction. Hence, politicians have incentives to take into account not only the direct cost and benefits of wealth transfers but also these additional effects. If foreign firms face higher political lobbying costs than do domestic firms, then, ceteris paribus, they will be taxed more heavily than domestic firms. Political lobbying costs include the costs of organizing special interest groups and information costs, which include the costs of determining the effects of pending legislation and disseminating this information to the public. Downs (1957) points out that if perceived marginal cost of a political action is small, rational agents have little incentive to invest in acquiring additional information concerning the activities of politicians. For example, special interest groups seeking wealth transfers from foreign multinationals could advance the simple argument that multinationals are not currently operating in the ‘national interest’, as the control of subsidiary’s assets is held by ‘outsiders’. To oppose the changes, those potentially affected, must first respond to this general issue and then attempt to lobby against the particular alteration. This necessarily raises the cost of opposing any particular change.7 If multinational corporations face higher political transaction costs than comparable host country firms, then, for a given level of wealth transfers, a politician will face less opposition from the multinationals than from a comparable group of domestic lirms.8 Consider a foreign firm which has made investments in assets whose values are largely independent of the firm’s future investment activity, i.e., assets in ‘Refer to McCormick and To&son (1981) for an analysis of the role of politician as a broker of wealth transfers. In their analysis, differential political transaction costs among groups drive the level and direction of wealth transfers. A similar analysis is used here. ‘Magee (1979), for example, develops a theory of direct foreign investment based upon the appropriability of rents associated with the creation of information and technology. ‘See Jensen (1976) for a more detailed explanation of tis type of cost. ‘Some researches have examined domestic political risk. For example, Jensen and Meckling (1978) stress the high costs of forming political coalitions among the stockholders of a corporation. Zimmerman (1984) stresses the political visibility that accompanies the size of a firm.

F.J. Phillips-Patrick,

Political

risk

655

place.g If removing these assets is very costly, e.g., the assets are countryspecific, then political alterations in property rights to these assets would not significantly lower their local value. These types of assets offer substantial politically appropriable quasi-rents, These considerations suggest the following hypothesis: Hl: A foreign subsidiary whose value consists mainly of assets in place is likely to experience greater political costs and receive fewer benefits than a comparable host country firm. Hl implies, for example, that a production process which requires a relatively large investment in durable assets, such as a steel mill, is less likely to be organized through a multinational corporation. Note, however, that durable assets are not necessarily the same as country-specific assets in place. The value of the steel mill is assumed not to depend upon the continuing cooperation of the parent corporation, and, hence, the steel mill’s value is assumed to be largely independent of the parent’s future investment activity. Shapiro (1981), for example, suggests that a multinational firm should structure its foreign investment in such a way as to make the local subsidiary’s value dependent upon its continuing cooperation. Bradley (1977), in an empirical study, finds that there were no expropriations among foreign manufacturing plants which sold more than 10 per cent of their output to their parent companies. The political appropriability of growth options depends upon their country-specificity. If a firm’s assets are entirely within the host country, the firm probably has made investments in growth options which are more country-specific than those of a multinational firm. Likewise, a multinational firm, with its real asset diversification across political jurisdictions, can usually shift resources to other locations at a lower marginal cost than a completely domestic firm. lo This suggests that, of two types of firms with substantial growth options, the foreign subsidiary’s local value is likely to be more sensitive to local taxation than the host country firm?. These considerations suggest the following hypotheses: H2: A foreign subsidiary whose local value consists mainly of local assets already in place is likely to experience higher political costs and receive fewer benefits than a foreign subsidiary whose value consists mainly of future growth options. H3: A foreign subsidiary whose value consists mainly of real growth options ‘Myers (1977) suggests that the value of a firm is derived from two types of assets: its assets in place and the options the firm has developed on future real assets. A similar analysis is used here. ‘OLipsey, Kravis and O’Connor (1983) find economies of scale in direct foreign investment. They conclude, however. that: ‘These economies of scale seem to result from indivisibilities that have little or no influence once a firm has surmounted the initial barrier to becoming a foreign investor’.

F.J. Phillips-Patrtck, Political risk

656

will experience lower political costs and receive greater benefits than a host country firm with an equal amount of its value accounted for by real growth options. The above hypotheses provide a rationale for the observed phenomenon of host country governments subsidizing foreign firms and not domestic ones. Tests of theory will indicate whether a foreign subsidiary whose value consists partially of real growth options will face total political costs which are higher or lower than a comparable host country tirm’s. The point at which the loss of future wealth transfers to the politician exceeds the inherent lower cost to him of foreign opposition varies with each political jurisdiction. Perceived political costs can prohibit any foreign investment, or they can be low enough to induce foreign investment across a broad spectrum of industries. Nonetheless, real growth options are likely to affect a multinational firm’s political risk. In summary, the above analysis indicates that the political risk for a foreign subsidiary depends not only on the relative position of foreigners in the host country political system but also on the types of assets which comprise the subsidiary’s local value. The next section of the paper describes the data and methodology used in testing these hypotheses. 3. Data and methodology On 10 May 1981, FranCois Mitterrand was elected President of France. In the week following his election, two indices of the Paris bourse showed large declines: the Index Gtnerale, of Companie Des Agents De Change (CAC), declined 20.5 per cent; the Index Quotidiens-Franqaise dropped 21.7 per cent. The stock prices of those firms targeted for nationalization under Mitterrand dropped an average of 37.6 per cent for the week. The decline in the value of the stocks traded on the bourse was both broadly based and steep.ll “The Paris bourse suspends trading for the day for any stock that experiences a 10 per cent price decline from the previous day’s close. As a result, trading was suspended for most stocks on Monday after the election, and for many of the stocks on Tuesday as well. Consequently, accurate information concerning the decline in the value of French assets for the first part of the week is unavailable. In fact, stocks were freely trading only by the end of the week. Therefore, I use as an estimate of the immediate effect of Mitterrand’s election upon the market value of French assets the 21 or 22 per cent decline for the week registered in the two indices cited above. This fall in the value of French assets does not completely reflect the total change in value for these assets unless investors had assigned a zero probability to Mitterrand’s election. At least two prior events provided some information regarding the -probability of his eventual success. First, a general election was held two weeks earlier, on 26 Anril 1981, in which Mitterrand emerged as a strong contender for the runoff election to be held on 10 May. Second, on 28 April, France’s Communist Party endorsed Mitterrand for the runoff election. The Wall Street Journal reported that: ‘The unconditional support was seen as a surprise because Mitterrand has been feuding with Communist leader Marchais since 1978’. Both of these events are associated with only small declines (1.9 and 1.6 per cent, respectively) in the value of French assets, however.

F.J. Phillips-Patrick, Political risk

1501

657

Level

QO-

70’

' -50

I

I

1

-40

-30

-20

I

I

I

I

/

I

I

-10

0

10

20

30

40

50

CAC

Index

Event

+

SW

and U.S. stock market

-+-

500

In event

Fig. 1. French

Time

time,

0

l

indices around

May

11, 1981.

Mitterrand’s

election

on 10 May 1981.

Mitterrand’s election was widely expected to produce a radical shift in the political policies in France. Thus, it is likely to have had an impact on the political costs of firms in France. In an efficient capital market, political costs will be reflected in the firm’s market value in an unbiased manner.” The arrival of unanticipated information concerning changes in these costs will result in unbiased revisions in the values of firms. The data suggest that Mitterrand’s election was largely unanticipated and resulted in substantial downward price revisions, thus providing a unique opportunity to test the hypotheses developed in section 2. Fig. 1 shows the daily levels of the S&P 500 index and the CAC index around the election. This study will assess the relative position of U.S. multinational firms in the French political process by examining their reaction to Mitterrand’s election relative to comparable French firms.

3.1. Data sources The sample of the firms used in this study is formed in the following way: Dunn and Bradstreet International publishes an annual directory of the “See Schwert (1981) for a discussion of an event on the value of a firm.

of the use of security

price data in estimating

the impact

658

F.J. Phillips-Patrick,

Political

risk

10,000 leading firms of Europe, based upon annual sales, titled Europe’s 10,000 Lurgest Companies. The 1982 edition contains balance sheet information as of 31 December 1980. All data are converted to U.S. dollar terms using the exchange rate prevailing on that date. Data provided for each firm listed are total annual sales, exports and sales in other countries, the number of employees, the book value of the total assets, the book value of the owners’ equity and, lastly, the current pre-tax profits. Also included are the International Industrial Classification codes, identifying the principal activity of the firm, and, if the firm is a subsidiary of another corporation, the identity of the parent corporation. The French firms included in the 1982 directory were cross-referenced against a list of French firms actively traded on the Paris bourse. This cross-referencing resulted in a sample of French firms for which both security price data and firm data were available. A similar procedure is used in assembling the sample of 50 U.S. based multinationals with wholly-owned subsidiaries in France. In this instance, however, the subsidiaries are cross-referenced against data availability of daily returns on the CRSP daily file and for additional balance sheet information on the parent corporation on the Compusat Annual File for 1980. 3.2. Valuation effects on U.S. subsidiaries The values of U.S. subsidiaries in France are not directly observable. Hence, I use the reaction of the U.S. parent to the event as a proxy. In order to isolate this specific reaction, it is necessary to separate it from the effects of other information, both market-wide and firm-specific. Mitterrand’s election may in fact have had market-wide implications for the U.S. market. In this case, attempts to abstract the effects of market-wide developments from the prices of the MNC’s in the sample may remove part of the impact of the French election. But the firms with real assets in France are still likely to be affected substantially more than other firms, although employing my procedures, the measured effect would understate the actual effect.13 i3The rates of return for various European and North American stock market indices for the day following Mitterrand’s election were collected. Nine of the 12 returns were negative. Germany, England and Switzerland, the countries with the largest proportion of U.S. subsidiaries, all had negative returns on that day. If these negative returns are representative of the changes m the values of foreign subsidiaries in the various countries outside of France, then the abnormal return to the parent firm is likely to overstate the actual effect of Mitterrand’s election on its French subsidiary. To affect some of the empirical tests used in this paper, however, the bias would have to be related systematically to the asset composition of the French subsidiary. For example, if high beta firms tend to have most of their value accounted for by real options, then, given the negative market returns in most countries, the subsidiaries in those countries would have shown larger declines than average. For the sample of multinational firms used, however, the correlation between the gratio of the parent firm and the beta of its stock is 0.087, slightly positive, but not significantly so.

F.J. Phillips-Patrick,

Political

risk

659

To assess the impact of Mitterrand’s election on the value of the French subsidiaries of U.S. based multinational corporations, the following methodology is used: The first trading day after Mitterrand’s election, 11 May 1981, is designated as time 0 in the event chronology. The coefficients of the market model are estimated using data from t=350 to t= 101, or 250 trading days prior to the event period. The U.S. equally weighted market return from the CRSP tile was used as the market index. A hundred-day exclusion period was chosen as a compromise between the desire to exclude from the estimation period possible price changes due to the anticipation of Mitterrand’s election and the desire to calculate coefficient estimates using the most current data to minimize the impact of any non-stationarity problems in the underlying joint distribution of the two variables. Other longer exclusion periods of 150 and 200 days were also used, but the results did not vary significantly from those reported. Using the coefficients, estimates of the unexpected returns of the U.S. parent corporations with French subsidiaries were calculated.14

3.3. Proxy variables for asset structure Tests of the hypotheses also require a proxy variable for the foreign subsidiary’s asset structure. In the context of political risk, a foreign parent’s value to the host country can differ from the value of its existing local subsidiary. A foreign parent can not only expand its local subsidiary; it can also initiate a new, unrelated venture in the host country. On the other hand, a particular subsidiary may have relatively more growth potential than the parent as a whole. However, it is likely that the subsidiary’s options are more country specific. For this reason, I use the parent’s growth potential as a proxy for local investment options. The value of the parent’s growth potential is measured by the difference between the total market value of the firm and the value of its assets in place. The ratio of this difference to the total value of the firm measures how much of the firm’s value is accounted for by growth options.15

i4The abnormal return for each firm was also calculated by subtracting its average return (measured over the 250 day exclusion period) from its return on 11 May 1981. The results of the tests using this procedure did not differ significantly from those reported here. See Brown and Warner (1985) for a discussion of event study methodologies using daily data. ‘?3ee Errunza and Senbet (1981) for the use of a similar proxy in an attempt to measure the value of international diversification. In their analysis, if international diversification of real assets provided by multinational corporations is valued by investors, the market value of these firms would exceed the replacement cost of their physical assets. Here, the causation runs the other way. Firms with high growth options would tend to engage in international activity. Their

660

F.J. Phi&s-Patrick,

Political

risk

The firm’s market value is approximated by summing the market value of its stock and the book value of its long-term debt. As a proxy for assets in place, I will use the book value of the tangible assets of the parent firm.16 Although it has been previously noted that tangible assets are not necessarily assets in place, it is assumed that the proportion of the firm’s value accounted for by tangible assets is highly correlated with proportion of its value accounted for by assets in place. The difference between the total value of the firm and the book value of its tangible assets is used as a proxy for the value of its real growth options. Let g be the ratio of the value of the firm’s real growth options to the total market value of the firm. I will use the parent firm’s g ratio as a proxy for the importance of real options in the foreign subsidiary’s value. If a substantial proportion of the value of the foreign subsidiary depends upon future discretionary investment by the parent in real growth options, then that subsidiary will be less vulnerable than a comparable host country firm in that it has fewer politically appropriable quasi-rents. Therefore, a foreign subsidiary with a high parent g ratio should experience lower political costs while a foreign subsidiary whose parent has a low g ratio should face higher political costs. 3.4. The effect on comparable French firms Some French industries were affected more than others. Table 1 summarizes the negative returns for the different French industrial groups, indicating that the group of targets for nationalization suffered the largest decline and the food group fared the best but all suffered significant declines. If these differential effects are due to the various implications of Mitterrand’s election platform, then it is likely that there were political wealth transfers taking place among various industries. Therefore, I control for industry effects in this study. Controlling for industry factors is insufficient, however. To test two of the political cost hypotheses, it is necessary to measure the differences in the responses of firms that differ only in the nationality of ownership. The following methodology is used to estimate the effect of ownership. data suggest that high growth option value and international diversification are positively correlated. Smith and Watts (1984) also use a similar proxy for the future investment opportunities of a firm. An alternative proxy for the firm’s asset structure is the subsidiary’s capital/labor ratio. A relatively large group of local employees would presumably lower a firm’s political risk. Hence, a firm with a low ratio of assets to employees would likely face lower political risk than a firm with a high capital/labor ratio. Both proxies are tested later in the paper. I61 used both the depreciated and non-depreciated book values of the firm’s plant and equipment as proxies for assets in place. The overall results were unaffected by the choice of proxy. The results reported here are based on the depreciated book values.

F.J. Phillips-Patrick, Political risk

661

Table 1 French industry indices are calculated from equally weighted portfolios. Dollar rates of return are presented for 27 April (first election), 29 April (Communist support), and the week 11-15 May 1981, the week following Mitterrand’s election. Returns Q$’ Number of firms

Industry” ‘Target lirm~‘~ Chemicals, pharmaceuticals Electronics, computers Food group Industrials Mines, tire manufacturers Miscellaneous Oil group Textiles, retailers

10 5 18 17 16 4 17 7 7

4127

4129

5/11-15

-3.47 -2.16 -2.79 - 1.99 -3.04 -2.64 -2.00 -3.91 -0.33

- 3.45 -2.55 - 4.28 -2.11 -3.35 - 3.26 - 3.07 -4.83 -2.52

-37.61 - 28.37 - 28.45 - 15.00 - 24.43 - 22.50 -21.16 - 32.90 - 18.71

“Data assembled from various issues of Le Monde. The industrial class&ation of the firms is according to the one used by Le Monde. “Returns are calculated in U.S. dollars, using exchange rates prevailing at the close of the relevant trading day. “Target firms’ are the ten French corporations identified for nationalization in Mitterrand’s campaign platform.

The 50 French subsidiaries of the U.S. multinational corporations in the sample were concentrated in live industrial classifications: food products, chemical products, machinery and transport equipment, computer and electronic equipment, and miscellaneous consumer product manufacturing. A sample of 17 French firms from each industrial classification was selected from among the French firms traded on the Paris bourse. Those French firms targeted for nationalization were excluded from the sample. The U.S. dollar return for each firm in the sample was computed using stock price data published in Le Monde for the week following Mitterrand’s election. In other words, for each French firm j, in industry i, we have the dollar adjusted rate of return, To establish a comparable response, the observed declines in the equity values of these French firms were related to several firm-specific variables in a cross-sectional regression for each industrial group. For each industrial grouping of French firms, then, the following regression is run. All observations are taken from 1980 data. FFji.

FFji=/Ioi

+

+ Bli(D/S,r) +B,i(EXISfr)

P4dPRISfr)

+

+P~iln(EMfr)

&ji,

where D/S is the book value of debt deflated by the net sales of the firm,

662

F.J. Phillips-Patrick, Political risk

EX/S is the percentage of sales outside France, including both exports and sales by foreign subsidiaries, divided by net sales, ln(EM) is the natural log of the number of employees of the firm, and PR/S is the profit of the firm deflated by sales.17 This cross-sectional regression yields estimated parameters for these variables for the live different industrial classifications. Table 2 reports the results. Three of the live cross-sectional regressions were statistically signilicant at the 10 per cent level. It appears that the industrial groups which tended to be more strictly homogeneous, i.e., chemicals, food and computers/ electronics, gave rise to significant regressions. This suggests that industryspecific factors were important. Each U.S. based multinational is assigned to an industry according to the activity of its French subsidiary. The comparable French firm response is then estimated using the parameters from the French industry regressions and the values of the French subsidiary of the U.S. firm. In other words, for each U.S. French subsidiary k in industry i we have:

(2) This estimated response is then weighted by the percentage of the total sales of the multinational accounted for by its French subsidiary, i.e., SIF/TS. This provides a benchmark, response, FA,, for each U.S. multinational firm, k, in industry i. That is, FA,i=(FC,i)(SIF/TSki).

(3)

The difference between the actual abnormal return response of the multinational firms, PE,, and the comparable French response in the same industry, FA,,, is then calculated for each firm. “The choice of variables was guided by the following considerations. One, it is widely held that leverage in the capital structure of a firm affects the sensitivity of its stock return to changes in market conditions. Two researchers [Watts and Zimmerman (1978), Hagerman and Zmijewski (1979)] have identified size and profitability as factors likely to affect a firm’s political exposure. The use of the net sales as a deflator on the right-hand side of the equation is based upon the simplifying assumption that a firm’s net cash flows are proportional to net sales and that net sales follow a random walk. If the firm is expected to have an infinite life, then deflation by net sales (rather than by market value, as on the left-hand side), merely rescales the regression coefficients. The use of the log transformation implies a non-linear relationship between employees and the change in the value of the firm. For an example of the use of log transformations to capture level effects, see Leftwich (1981). Refer to Christie (1985) for a discussion of these issues.

F.J. Phillips-Patrick, Political risk

663

Table 2 Cross-sectional results for five industries. Seventeen French firms from each industrial classification were selected. Their stock returns for the week following Mitterrand’s election were regressed against four firm-specific factors: the ratios of debt, non-French sales, and profits, to total sales, and the natural log of the number of employees.

Industry Predicted sign

Bo

Chemicals -0.1769 0.3192 (2.12)*b (- 1.69) R-squared = 0.51 F ratio = 2.73* DF = 12

-0.0391 ( - 0.42)

-0.0371 (-2.59)*

-0.9107 (-2.37)*

-0.0119 (-0.15)

-0.0297 (-2.61)*

-0.1576 ( - 0.27)

-0.0198 (-0.25)

- 0.0528 (-0.35)

-0.0142 (- 1.08)

-0.3617 0.0678 (1.09) (-4.34)* R ratio = 7.29* DF = 12

( - 2.06)*

0.0155 (2.99)*

0.0592 (1.17)

0.0047 (0.39)

Food - 0.0957 0.2179 (2.25)* (- 1.52) R-squared = 0.46 F ratio = 2.56* DF = 12 Miscellaneous

R-squared=0.19

F ratio=0.71

0.0489 (0.38) DF=12

0.0800 (0.24)

Computers/electronics

R-squared =0.71

- 0.2500

0.7096 (1.21)

Industrials - 0.0653 -0.1043 (- 1.04) (- 1.47) R-squared = 0.26 F ratio = 1.06 DF = 12

-0.3595 (- 1x2)*

“FF = return for week following Mitterrand’s election; D/S = debt to sales; EXjS = non-French sales to sales; ln(EM)= the natural log of number of employees; PR/S=protit to sales. Year ending 1980 data were used. bT statistics are in parentheses. *Significant at the 10 per cent level.

4. Empirical results 4.1. Tests of the effect of growth options on U.S. subsidiaries The abnormal return of the U.S. parent corporation on the day after Mitterrand’s election should be negatively related to its relative exposure in France, given the large decline in the value of other French assets. The abnormal return, taking into account the exposure in France, should be positively related to the g ratio of the firm, as growth options should mitigate its political risk, according to H2 developed earlier. To test this hypothesis, the abnormal return of each U.S. parent corporation was regressed against its exposure in France, as estimated by the ratio of the sales of the French subsidiary to the total sales of the firm, and against the g ratio of the firm, that is:

664

F.J. Phillips-Patrick,

Political

risk

Table 3 Cross-sectional results for 50 U.S. multinational firms with French subsidiaries. The firms abnormal stock returns for 11 May 1981 are regressed on the firms’ relative exposure in France and on the extent to which the firms’ values are accounted for by growth options.

-0.02121 0.041 - 0.0608 (4.60)* (-4.71)*b (-2.01)* R-squared= 31.5 per cent. R-squared, adjusted for the d.f. = 28.6 per cent “PE =abnormal return to parent firm on 11 May 1981; (SIF/TS) =sales in France/total sales of parent for 1980; gratio=(market value of stock- book value of tangible assets)/market value of stock. bT statistics in parentheses. *Significant at the 5 per cent level.

PEi=fio +Pl(SIF/TSJ

+ Bz(gratioi) +&.

The results of this regression are reported in table 3. The coefficient of the exposure in France is negative, -0.06076, and is statistically significant at the 5 per cent level. The coefficient of the gratio is positive and significant, 0.041723, with a t statistic of 4.60. The adjusted R square is 28.6 per cent. Thus, the results are consistent with the hypothesis. One important concern is the relevant critical value for the t statistic for evaluating the statistical significance of the coefficient of the g ratio. For example, a systematic misspecitication of the model might result in a mechanical relation between the firm’s abnormal return and its g ratio. The estimated coefficient would then differ from zero, resulting in an inappropriate rejection of the null hypothesis. The above tests were replicated over 100 randomly chosen days. I assumed on these non-event days that the impact of changes in the French market would be approximately zero, i.e., an average daily return for the French market of 0.0005 weighted by the average firm’s exposure in France of 8 per cent gives an average impact of 0.00004, approximately zero. For each of these 100 days, the abnormal returns of the 50 firms in the sample were regressed against their g ratios. Under the null hypothesis of no effect on nonevent dates, the t statistics for the gratio coefficient should have a mean of 0, and should be distributed as a Student t. The replications indicate that the t statistics have a mean value of -0.164 and a standard error of the mean of 0.099; at standard levels of significance, the mean is not significantly different from zero. The t statistics follow the Student t distribution, as evidenced by a

F.J. Phillips-Patrick,

Political

risk

665

comparison of the expected number of observations based upon a two-tailed test with 40 degrees of freedom and the actual number. Using a Kolmogorov-Smirnov one-sample test, the null hypothesis of a Student t distribution cannot be rejected at the 10 per cent significance level. These results suggest that the t statistic on the g ratio of the regression should be interpreted in its normal fashion, and thus the observed coefficient is statistically significant. 4.2. Tests of the effect of ownership In essence, hypothesis 1 and that a French subsidiary of a declines as the proportion of opportunities increases. To test is run:

3 imply that the differential political costs U.S. based multinational corporation faces its value accounted for by future growth this, the following cross-sectional regression

(PE - F/t),, = /I0 + /I,(g ratio,,) + ski*

(5)

The left-hand side variable measures the net difference between the actual abnormal return to the parent corporation and the abnormal return estimated on the basis of local French ownership. The model predicts that the regression coeftkient on the gratio will be positive, as the difference in losses between the multinational and the host country firms should decrease as the gratio increases. The model also predicts that the intercept term will be negative, as, without growth options, U.S. subsidiary will fare worse than a comparable French firm. Table 4 reports the regression results. The coefficient on the gratio is positive and has a t statistic of 4.65; the R-square, adjusted for the degrees of freedom is 29.6 per cent. The intercept term is -0.0289 with a t statistic of -4.02. The results are thus consistent with the hypothesis that relative differences in political costs are a function of the growth opportunities of the firm, and that U.S. multinational subsidiaries with a small proportion of their values accounted for by growth opportunities fared significantly worse than comparable local (French) firms while U.S., subsidiaries with substantial growth options fared significantly better. 4.3. Alternative specifications of the model In the tests used above, an attempt was made to estimate the response of the U.S. subsidiary as if it were French owned. Although the data for both the French firms and the U.S. subsidiaries were drawn from the same source and presumably reflect the same accounting conventions, the information content of these data can differ systematically if the firms involved face

666

F.J. Phillips-Patrick, Political risk

Table 4 Cross-sectional results for 50 U.S. multinational firms with French subsidiaries. The U.S. firm’s abnormal return is adjusted by subtracting an estimated abnormal return based on local French ownership of its French subsidiary. This differential response is then regressed on the extent to which the firm’s value is accounted for by growth options. (PE-FA),=bO+/Il(gratioi)+&,

- 0.0289 0.05011 ( - 4.02)” (4.65) R-squared=31.1 per cent. R-squared, adjusted for degrees of freedom = 29.6 per cent a(PE - FA) =actual abnormal return on 11 May 1981 less the abnormal return estimated on the basis of local French ownership; gratio = (market value-book value of tangible assets)/market value. bT statistics are in parentheses. Both are significant at the 1 per cent level.

different sets of incentives in reporting these data. If these incentives are correlated with firms future growth opportunities, then the previously reported results could be spurious. An alternative specification of the model is considered to evaluate whether the results of the previous test are sensitive to the adjustment procedure. As a different proxy for the structure of ownership, I will use the capital/ labor ratio of the subsidiary. To the extent that a firm’s value is accounted for by the factors of production, a high capital/labor ratio suggests that a relatively large portion of the value of the subsidiary has been provided by the parent corporation. A low capital/labor ratio suggests that a relatively large portion of the subsidiary’s value has been provided by host-country residents, i.e., host-country residents have a larger stake in the firm. It is assumed that host-country residents have a comparative advantage in political risk bearing. The capital/labor ratio is estimated by dividing the total book value of the subsidiary by its number of employees. The firm’s book value includes its current assets, which are typically not assets in place, and, hence, should be excluded. Data, however, were not available for specific balance sheet items for the French subsidiaries. If firms with high growth opportunities tend to have a higher relative proportion of their book values accounted for by current assets, then the proxy used overstates the capital/labor ratio of high growth firms. Likewise, if low growth opportunity firms tend to have a lower relative proportion of their book values accounted for by current assets, then the proxy used understates their capital/labor ratio. This biases the test towards the null hypothesis.

F.J. Phillips-Patrick, Political risk

667

Table 5 Two alternative specifications of the cross-sectional regression for 50 U.S. multinationals with French subsidiaries. The capital/labor ratio is used as a proxy for the structure of assets. Model 1: (PE- FAi) = j$, + j?,(CAP/LAB,) +E,

0.00712 -0.OOOO4O5 (2.48)*” (- 1.84)* N = 50. R-squared = 6.6 per cent. R-squared, adjusted for d.f. = 4.6 per cent Model 2 PE, = PO+ /?,(SIF/TS,) +&(CAP/LAB,)

+ 8i

0.0012 -0.0178 -0.00004318 (0.42) (0.54) (-2.50)* N = 50. R-squared = 12.3 per cent. R-squared, adjusted for d.f. = 8.6 per cent. “(PE-FA) =abnormal return to U.S. parent firm less the predicted abnormal return had its French subsidiary been locally owned; (CAP/LAB) = book value of subsidiary/number of employees. bT statistics are in parentheses. *Significant at the 10 per cent level. ‘PE = abnormal return to parent corporation; SIF/TS = sales in France/total sales of parent (1980); CAP/LAB= book value of subsidiary/number of employees.

It is hypothesized that the losses experienced by the U.S. subsidiaries will increase relative to comparable French firms as the capital/labor ratio of the subsidiary increases; that is, in the regression:

(6)

tPE - FA)ki= BIJ+ Bl(CAPILABki)+ Ekiy

jI1 should be negative, where (PE-FFA),, is the abnormal return to the parent corporation on the day after Mitterrand’s election less the estimated loss to a comparable French firm. Table 5 reports the results from this regression. The coefficient on the capital/labor ratio is negative and statistically significant at the 10 per cent level. In an alternative specification of this model, it is hypothesized that the abnormal return of the parent firm will be negatively related to the firm’s exposure in France and also negatively related to the French subsidiary’s capital labor ratio. In other words, in the regression: PEki=fi, + /?l(SZF/TS),i + fi,(CAP/LAB),i

+ Eki

(7)

A and jIz will be negative. Table 5 also contains the results of this

668

F.J. Phillips-Patrick,

Political

risk

regression. The coefficient of the exposure in France is not statistically significant. The coefficient on the capital/labor ratio is negative and statistically significant, as predicted. These two tests, then, suggest that the ownership structure of a firm from a political risk viewpoint is more complicated than just the identity of the supplier of capital. 5. Conclusion and areas for future research This paper has examined the empirical relationship between the political risk of a foreign subsidiary and its particular asset and ownership structure. Because of the costs associated with controlling post-contractual opportunistic behavior among private individuals, an asset varies in the level of incentives it provides for politically opportunistic behavior. Because national identity affects local political transaction costs, an asset’s political risk also varies with its ownership structure. A model of the political process was developed to examine the relation among the political appropriability of different assets, the differential political transaction costs of foreigners and host-country residents, and the structure of the ownership of assets. The model provides conditions under which the property rights to certain assets of foreign subsidiaries are more secure than comparable assets owned locally and conditions under which the opposite holds. These implications permitted the construction of tests of the association of the assets of a foreign subsidiary, its political vulnerability and the ownership structure of the subsidiary. The model was tested using data derived from the response of the capital markets (both the Paris bourse and the New York stock exchange) to Mitterrand’s election in France. The results of the tests were generally consistent with the hypothesis that foreign ownership increases political risk but this risk is mitigated to the extent that the values of the foreign owned assets depend upon future discretionary investment in real growth options. These tests have been performed over only a single event and have involved only wholly owned U.S. subsidiaries, so the results should be considered suggestive rather than conclusive. Likewise, caution should be used in interpreting these results as there is no control for the extent to which a firm’s future growth opportunities are specific to France, a key element in the analysis. Finally, severe data limitations required the use of proxy variables which rely upon accounting data. These factors could have biased the tests. Nonetheless, the results seem to be fairly robust to alternative model specifications, and hence, justify further research in this direction. These results were also derived from the responses of the capital markets to the events surrounding Mitterrand’s election in France. The results may, in fact, represent only a reaction to a specific set of political policies, i.e.,

F.J. Phillips-Patrick,

Political

risk

669

Mitterrand’s industrial and economic plans. Caution must, therefore, be exercised in generalizing the results of this study. Additional areas for research include the examination of joint venture agreements between foreign- and host-country firms and the ownership structure of foreign subsidiaries as a function of their real options. The model developed in this paper implies that in joint venture agreements the hostcountry firm would tend to supply assets in place while the foreign firm would tend to supply intangible assets. This would occur because of relative differences in host-country political costs. Similarly, it is predicted that the local ownership of foreign subsidiaries would tend to increase as the proportion of subsidiaries value accounted for by assets in place increased because of a comparative advantage in domestic political risk bearing.18 Future studies can provide valuable evidence on the complex and powerful interaction of the political process and the choices involved in the international production of goods. I hope that this paper was a step in that direction. “Farge and Wells (1982) provide some empirical evidence which supports this conjecture. In their statistical study of local participation in the ownership of U.S. subsidiaries in Central and South America, they find a negative association between such factors as intra-company transfers and research and development spending and local participation in ownership. It is likely that these factors are highly correlated with a firm’s growth opportunities.

References Bradley, David, 1977, Managing against expropriation, Harvard Business Review, July/Aug., 75-83. Brown, S. and J. Warner, 1985, Using daily stock returns: The case of event studies, Journal of Financial Economics, March, 3-31. Buckley, P.J. and M. Casson, 1976, The future of the multinational enterprise (Macmillan, New York, 1976). Bueno de Mesquita, B., 1981, The war trap (Yale University Press). Caves, R., 1982, Multinational enterprise and economic analysis (Cambridge University Press, Cambridge). Christie, A.A., 1985, On cross-sectional analysis in accounting research, Working paper (University of Southern California, Los Angeles, CA). Downs, A., 1957, An economic theory of political action in a democracy, Journal of Political Economy, 135-150. Dunning, J.H., 1977, Trade, location of economic activity and the MNE: A search of an eclectic approach, in: B. Ohlin et al., eds., The international allocation of economic activity (Macmillan) 395418. Errunza, V. and L. Senbet, 1981, The effects of international operations on the market value of the firm: Theory and evidence, Journal of Finance, May, 401-417. Fama. E.F., 1976, Foundations of finance (Basic Books, New York). Farge, N. and L.T. Wells, Jr., 1982, Bargaining power of multinationals and host governments, Journal of International Business Studies, Fall, 9-23. Haendel, D.H., G.T. West and R.G. Meadow, 1975, Overseas investment and political risk (Foreign Policy Institute). Hagerman and Zmijewski, 1979, Some economic determinants of accounting policy choice, Journal of Accounting and Economics, Aug., 141-161.

JB.F-G

670

F.J. Phillips-Patrick, Political risk

Holthausen, R.W. and R.W. Leftwich, 1983, The economic consequences of accounting choice: Imulications of costly contractina and monitorina._. Journal of Accountina and Economics 5. no: 2, Aug., 77-117. _ Hymer, S.H., 1976, The international operation of national firms: A study of direct foreign investment, Ph.D. dissertation, 1960 (MIT Press. 1976). Jain, P., 1982,.Cross-sectional association between abnormal returns and firm specific variables, Journal of Accounting and Economics 4, 205-228. Jensen, MC., 1976, Towards a theory of the press, unpublished paper (Graduate School of Management, University of Rochester). Jensen, MC. and W.H. Meckling, 1978, Can the corporation survive, Financial Analysts Journal, Jan./Feb., 3 l-37. Kindleberger, C.P., 1969. American business abroad: Six lectures on direct investment (Yale University Press). Klein, B., R. Crawford and A. Alchian, 1978, Vertical integration, appropriable rents and the competitive contracting process, Journal of Law and Economics, Oct., 297-326. Knudsen, H., 1971, Explaining the national propensity to expropriate: An ecological approach, Journal of International Business Studies, Spring, 51-71. Kobrin, S.J., 1979, Political risk: A review and reconsideration, Journal of International Business Studies, Spring/Summer, 67-80. Langohr, H. and C. Viallet, 1986, Compensation and wealth transfers in the French nationalizations: 1981-1982, Journal of Financial Economics, Dec., 273-312. Lessard, D.R., 1983, Comments on ‘Implications for the adjustment process of international asset risks’, Research in International Business and Finance 3, 107-110. Lipsey, R.E., LB. Kravis and L. O’Connor, 1983, Characteristics of U.S. manufacturing companies investing abroad and their choice of production locations, NBER Working paper no. 1104, April. Magee, S.P., 1979, Information and the multinational corporation: An appropriability theory of direct foreign investment, in: International financial management, D.R. Lessard, ed. (Warren, Gorham & Lamont, Boston, MA). McCormick, R.E. and R.D. Tollison, 1981, Politicians, legislation and the economy (Martinus Nijoff Publishing). Mikhail, A.D. and H.A. Shawky, 1979, Investment performance of U.S. based multinational corporations, Journal of International Business Studies, Spring/Summer, 53-66. Myers, S., 1977, Determinants of corporate borrowing, Journal of Financial Economics, Nov., 147-175. Peltzman, S., 1976, Towards a more general theory of regulation, Journal of Law and Economics, Aug., 21 l-240. Phillips-Patrick, F., Ownership, asset structure and political risk, in: Advances in financial planning and forecasting: International dimensions (JAI Press), forthcoming. Posner, R.A., 1974, Theories of economic regulation, Bell Journal of Economics, 335-358. Ragai, G., 1973, Theories of the determinants of direct foreign investment, International Monetary Fund Staff Papers, July, 471498. Robock. S.. 1971. Political risk: Identification and assessment. Columbia Journal of World Business, July/Aug., 620. Schwert, G.W., 1981, Using financial data to measure effects of regulation, Journal of Law and Economics, April, 121-158. Severn, A.K., 1974, Investor evaluation of foreign and domestic risk, Journal of Finance, May, 545-550. Shapiro, A.C., 1978, Financial structure and cost of capital in the multinational corporation, Journal of Financial and Quantitative Analysis, June, 211-226. Shapiro, A.C., 1981, Managing political risk: A policy approach, Columbia Journal of World Business, Fall, 63-70. Smith, C.W. and L.M. Wakeman, 1985, Determinants of corporate leasing policy, Journal of Finance, July, 895-908. Smith, C.W. and R.L. Watts, 1984, The structure of executive compensation contracts and the control of management, Working paper (University of Rochester).

F.J. Phillips-Patrick, Political risk

671

Stigler, G.J., 1971, The theory of economic regulation, The Bell Journal of Economics, Spring, 3-21. Truitt, J.F., 1970, Expropriation of private foreign investment: Summary of the post-World II experience of American and British investors in the less developed countries, Journal of International Business Studies, Fall, 21-34. Wheatley, SM., 1984, A test of international asset market integration, Dissertation proposal (University of Rochester). Williamson, O.E., 1979, Transaction-cost economics: The governance of contractual relations, Journal of Law and Economics, Oct., 233-261. Watts, R. and J. Zimmerman, 1978, Towards a positive theory of the determination of accounting standards, Accounting Review 53, Jan., 112-134. Zimmerman, J., 1984, Taxes and firm size, Journal of Accounting and Economics 5, no. 2, Aug., 119-149.