INTERNATIONAL REAL ESTATE INVESTMENT AND POLITICAL RISK

PRELIMINARY DRAFT FOR DISCUSSION PURPOSES ONLY

Kenneth Acks

ABSTRACT

International real estate investment poses many risks which are not present when domestic projects are financed. The expected returns from foreign investments cannot be forecast without considering political trends. Clever investors can reap huge windfalls from knowledge of political trends and their economic ramifications. Investors who ignore political risk, on the other hand, can lose every dollar placed in a foreign country. Billions were lost in the wake of the Iranian revolution.

In this paper, we briefly describe the scale of international real estate investment, outline the dimensions of risk in international investment, and finally describe means to measure and to reduce the risk.

INTERNATIONAL REAL ESTATE INVESTMENT AND POLITICAL RISK

I. INTRODUCTION

International real estate investors and financiers face many risks which domestic investors have no reason to fear. If investors fail to monitor these risks they may suffer devastating losses. Billions were lost in the wake of the Iranian revolution, and the shocking speed of Communism's demise might very well be repeated in the other direction. One cannot analyze the economics of foreign investments without considering political trends. The temptations of foreign investing, including higher growth rates, vast unmet needs, possibilities to implement existing technologies, and cheap labor are great. However, the potential for disaster can be commensurate with the rewards. Conversely, clever investors can reap huge windfalls from knowledge of political trends and their economic ramifications.

International investments are fundamentally different from ventures in the U.S. In domestic investment and lending bankruptcy, securities, and other laws prohibit enterprises from repudiating debts or failing to relinquish a share of profits. Bankruptcy laws provide an institutional framework defining this condition, and creditors are compensated to the extent that assets allow. These laws prohibit enterprises from shedding liabilities while maintaining full control of its assets. The situation is quite different in the case of international lending. As Eaton and Gersovitz (1981) noted in a landmark paper, "unless the governments of private creditors are willing to coerce debtor governments into repaying loans, there is no explicit mechanism deterring a government from repudiating its external debts." Their analysis also holds for direct investments in plants and equipment or in stocks.

Greater risk is attached to international real estate investments than other ventures due to lack of liquidity and mobility. One cannot transfer this asset abroad in advance of danger, whereas nimble investors can abandon other assets.

Even though the Cold War has ended, socio-political factors will play a large role in determining the success of international real estate investments. Despite the cessation of hostilities with Russia, U.S. forces have seen action in Iraq, Somalia, and Bosnia. Ominous threats in Haiti and North Korea cloud the horizon, and bloodbaths have occurred throughout the world including Rwanda, Bosnia, East Timor, Armenia, and eastern Turkey to name but a few.

Below, we will briefly describe the scale of international real estate investment, outline the dimensions of risk in international investment, and finally describe means to reduce the risk. We will focus upon the socio-political dimensions of the risks, as we assume readers are aware of the economic dangers.

II. THE SCOPE OF INTERNATIONAL INVESTMENT

As the world has become smaller real estate investors have increasingly cast their eyes upon foreign markets. In addition, corporate real estate decisions are dominated to a growing extent by global considerations. NAFTA, GATT, a united Europe, and other agreements, in concert with revolutionary changes in communications technology, promise to accelerate globalization of real estate investment.

Virtually all investments involve a real estate component. Businesses must generally purchase or lease sales facilities, administrative offices, warehouses, and/or factories, and have a place for employees to live in order to function properly. Location can be critical in determining the success of these ventures.

The U.S. Department of Commerce tracks direct investments, which means the ownership or control, directly or indirectly, by one person of 10 percent or more of the voting securities of an incorporated business enterprise or an equivalent interest in an unincorporated business enterprise. Direct investment position is the value of U.S. receivables due from, foreign affiliates, less foreign affiliates' receivables due from their U.S. parents. In 1993 the value of direct investment abroad was $716,163,000,000 at current costs and $993,151,000,000 at market values. Direct investments account for 37.5% of all assets abroad at market values. Direct investment at current costs rose 7.2% between 1992 and 1993, and was up 108 percent from the level in 1979. On an historical cost basis approximately 12.8% of all direct investment was in Canada, 46.7% in Europe, 18.6% in Latin America, 1.0% in Africa, 1.2% in the Middle East, and 16.8% in Asia and the Pacific. Direct investment rose 12.2% in Latin America, and 15.4% in Asia between 1992 and 1993.

The breakdown by industry is presented below:

Petroleum	11.4%
Manufacturing	35.8%
Wholesale Trade	10.5%
Banking	4.8%
Other Finance (non real estate)	28.4%
Services	3.3%
Other	5.8%

Capital expenditures by majority owned foreign affiliates of U.S. companies in 1993 were $64,338,000,000. The gross product of nonbank majority owned foreign affiliates in 1989 was $1,364,878,000,000 (1.36 trillion dollars) for all U.S. multinationals, up 33.9% from 1982 and up 60.2% from 1977.

In 1990 total assets abroad of U.S. affiliates amounted to $1,529,778,000,000 up 84 percent from 1986. The gross book value of plant and equipment was $518,378,000,000, and of land was $53,964,000,000. U.S. corporations owned 16,861,000 acres of land.

Investing abroad has become a bit of a fad as brokers tout portfolio diversification. Americans poured a net $20 billion into emerging country stock markets. Fidelity's emerging market fund grew from $15 million to $2 billion in 1993.

Total assets of real estate companies were $111,489,000,000 in 1990 up 64.5 percent from 1986, and sales were $11,621,000,000. Employment in these companies stood at 34,700. The gross book value of real estate company plant and equipment was $52,739,000,000, and of the land was $16,819,000,000. The gross product of U.S. real estate companies abroad was $666 million in 1989, up from $135 million in 1982 and $85 million in 1977.

Increasingly, Real Estate Investment Trusts (REITs) are investing abroad. While Fidelity Real Estate Investment Fund had only 1 percent invested overseas, the Templeton Real Estate Securities Fund recently had 43 percent of its portfolio in foreign markets.

Many investments often paid off handsomely. An index of emerging market stocks compiled by the International Finance Corporation, the private sector arm of the World Bank rose 75% in 1993. The Polish stock market gained 889 percent, Turkey by 224 percent, and the Philippine by 130 percent. The capital value of Hong Kong's residential property market rose 400 percent from January 1984 through March 1994, as rents increased 900 percent. However, between December 31, 1993 and June 14, 1994 the Polish Market fell 40 percent, China by 50 percent, and Turkey by 60 percent, as the overall index dropped by 12 percent.

III. DIMENSIONS OF RISK

Many pitfalls await international real estate investors. Some of these risks are extreme and can result in confiscation or destruction of property, while others are more subtle and could produce slight decreases in returns. Risks can be roughly divided into four types--1) Political, 2) Socio-cultural, 3) Economic, and 4) International. Political risks include nationalization, expropriation, revolution, lack of law enforcement, unfair administration of laws, taxes (including tariffs), quotas, regulations, bureaucratic bumbling, corruption, and fiscal irresponsibility. Among the social risks are ethnic violence, religious fanaticism, nationalism, cultural differences, and conflicts over the distribution of income. Economic risks include weak or negative growth, inflation, exchange rate fluctuations, overindebtedness, and asymmetric knowledge in transactions (foreign nationals will likely know more about their own countries, giving them an advantage in negotiations). International risks range from hostility--to breaks in relations--to war. Below we will list dangers in selected countries. And, investors should remember that political change in one country can affect others through exported revolutions, or wars.

The most glaring socio-political risks can be observed in formerly Communist countries. Problems in Russia have been well documented. Inflation has exceeded 8 percent per month, and real income has fallen more than 30 percent since 1989. Virulent nationalists and former communists registered strong votes at the polls.

Writing in the New York Times, on August 7, 1994 Marshall Goldman, Professor of Russian Economics at Wellesley College, Associate Director of the Russian Research Center at Harvard University and one of the foremost authorities in this country on the Russian economy, notes that "unless a company foresees great profit and has great pluck, it should probably steer clear of Russia. For now." He estimates that Russia's 4,000 racketeering gangs have gained great sway over 70 to 80 percent of domestic businesses. These groups are now demanding tribute from or partnership with foreign businesses. If they resist, foreign businesses "may find their building firebombed, their windows smashed and their employees assaulted and even murdered -- as an American accountant was recently." He adds that Russian planes are poorly maintained, that airports are irregularly supplied with fuel, and that safety is spotty. Bank check clearing takes four to eight weeks, a particularly costly fact of life when inflation is as high as it has been. Valid contracts are often broken. Despite having a year remaining on their lease, several senior American executives found themselves on the street this spring when their landlord found someone else willing to pay a higher rent. A state monopoly on vodka was ended, but then reinstituted at the expense of its new competitors. Russian payroll taxes are 38 percent, profit taxes are 35 to 38 percent, property taxes 2 percent and the value added tax 23 percent. Additional levies are imposed at the local level. Some oil executives calculated that, if paid, all their taxes would total 120 percent of profit.

Furthermore Russia's population is plummeting, as the life expectancy of adult males has fallen to 60 years, and the number of children born to each woman has fallen from 2.17 in 1988 to 1.4 in 1993. Deaths exceeded births by 800,000 in 1993 out of a population of 148.4 million. The death rate soared to 14.6 per 1,000 in 1993 an increase in 20% over 1992. The birth rate was only 9.2 per 1,000 a drop of 1% from 1994.

To be sure, not all is gloomy in Russia. The pace of privatization has been impressive, inflation has abated somewhat, the decline in GNP has slowed, many enterprises have been very successful, and a large number of the most dire predictions have not been realized. More than 100,000 state companies have been transferred to private ownership. And, two-thirds of the work force is in private enterprises, up from zero percent in 1992. Private foreign investment is rising. CS First Boston purchased more than $500 million in Russian stocks and privatization vouchers in the first five months of 1994. Some foreign investors have gained quick short term profits of 200 or 300 percent. Shares in the St. Petersburg Phone Company rose from $1 per share in December 1993 to $15 in June 1994.

Investors in the East Bloc should also remember that former communist leaders have been elected behind much of the old Iron Curtain. Among the 22 countries in the former Soviet Union and its eastern bloc, only five have eliminated communists from a significant share of power. The newly elected leader of Hungary opposed the anti-Communist revolution of 1956, and served in a militia that rounded up the insurrectionists. He was a leading Communist apparachik for decades. In July 1994 the Ukrainian Parliament, dominated by former Communists, voted to freeze the sale of state enterprises, despite agreements with the IMF and the slow pace at which the sales had proceeded. Even an East German city, Hoyerswerda, elected a Communist mayor in 1994. Communists won 40% of the vote in East Berlin.

Disaffection throughout the bloc has been high. Nostalgia for the past rampant. Economies have been weak. Unemployment is high, and many disappointments have been suffered. Security has been lost. Output fell more than 20 percent in The Czech Republic, Hungary, and Poland, 30 percent in Romania, 40% in Bulgaria, and 50% in the Ukraine. Inflation was 8,940 percent in the Ukraine and 35 percent in Poland during 1993. Inflation in the Czech Republic, Hungary and Slovokia was nearly 20 percent. Success in a world of intense global competition is far from assured. Crime is rampant. Warsaw tourist shops recently closed for a weekend in a protest against crime. It is not inconceivable that many of these nations may one day decide that the capitalist experiment has failed, and return to communism. The leaders of such a counterrevolution are surely in place. Significantly, communists began their reign in Eastern Europe as coalition partners in ostensibly democratic governments. They subverted these coalitions through diabolical means not as readily available to most true democrats. History may very well repeat itself.

Similarly, the path of Communist China has been guided by a ninety year old man, Deng Xiaoping. Hard line Communist factions continue to play a role and many feared that they would dominate when Deng was less visible, perhaps due to illness, in the late 1980's. Tien a Min Square shows the attitudes of many leaders. Strong vested interests can push through policies contrary to the interests of foreign investors. The Economist noted on August 6, 1994 that "many Chinese officials seem hostile to the whole idea of foreign firms making money." In July 1994 Prime Minister Li Peng declared a 12 percent cap on profits for foreign financed power projects. China's stock market fell 51.6% in dollar terms between December 31, 1993 and July 31, 1994, and 80% from its high in May 1992. On August 1, 1994 the China Securities Regulatory Commission announced a series of measures to support the markets, the most significant of which was a ban on new listings of "A" shares until at least the end of 1994. The markets responded to this political measure by rising 35% on that day.

Political risks are no less evident in what had been known as the Third World. M.L. Williams (1974) found that between 1956 and 1972 $10 billion in assets were nationalized by developing countries. This figure compares with a total foreign investment stock at year-end 1972 of $21.9 billion. Compensation was paid only for 41.8% of these assets.

A different type of threat to investments is illustrated by the recent history of certain countries where the Islamic religion has been dominant. Iran was once one of our most stable and secure allies in the Islamic World. Seemingly overnight, billions in investments were lost and lives of Americans were threatened. Similarly, in Algeria, dozens of westerners have been slaughtered by Islamic militants. They won elections in 1993, and would have acceded to power had a military government not abrogated the constitution. Most knowledgeable sources believe that they will soon attain power. Fundamentalist movements are strong in Egypt, and did well in Jordanian and Pakistani elections. They control Sudan. Lebanon was once a bastion of prosperity and the financial capital of the Arab world until religious hostility tore it asunder and destroyed its economy.

Another threat is posed by dictatorial Moslem regimes in Syria, Iraq, Egypt, Libya, Saudi Arabia, and Indonesia. These regimes are subject to the whims of individuals who may have a lust for power so overwhelming that it can threaten the interests of investors. Billions were lost due to such circumstances in Iraq. These rulers can also sow the seeds for fundamentalists and other idealogues who feed upon the inequality, unfairness and corruption which tends to accompany these regimes. The Syrian government is dominated by a minority ethnic group which has ruled through brutality. Their domination may be threatened when Hafez el-Asad dies. Furthermore, Sadam Hussein still heads Iraq.

Although remarkable strides have been made in Latin America over the past three years, dangers lurk there too. The debt crisis produced negative growth of real GDP per capita in Argentina, Bolivia, Brazil, Ecuador, Mexico, Peru, and Venezuela between 1980 and 1993. Average real income per capita in Latin America is still five percent below the level in 1980. Not long ago many respected observers felt that the international financial system was on the brink of collapse due to Latin debt. Major banks were thought to be in danger of failing. Many major banks had loaned more than 300% of their capital to Less Developed Countries.

Unfortunately the experience of the nineteen eighties was not an aberration but part of a continual cycle of debt and default, which might very well be repeated in the future. Peter Lindert, Peter Morton and Barry Eichengreen have described this history in a number of illuminating articles (see Lindert and Morton (1987), Lindert (1986), and Eichengreen and Portes (1986)). Lindert and Morton (1987) point out that there was a post-Napoleonic wave of lending to Latin America in the 1820's followed by widespread default, when most of these governments defaulted. Lending "returned to high tide in the 1850's, in the late 1860's-early 1870's, in the late 1880's, in 1904-1914 and again in the late 1920's." Each wave ended with "at least some occurrence of repayments breakdown." Several southern states in the U.S. defaulted in the 1830's and 1840's and again during Reconstruction. The 1910's brought wholesale defaults in the Mexican Revolution, the Russian Revolution and the fall of the Ottoman Empire. The broadest wave came in the early 1930's in which essentially all of Latin America, most of Eastern Europe, Turkey and China defaulted. They point to "a curious tendency toward historical consistency in the identities of the defaulters."

Debt remained at 430 percent of exports in Argentina during 1991, 334 percent in Brazil, 224 percent in Mexico, 479 percent in Peru, and 187 percent in Venezuela. Inflation in Brazil rose to 3,678 percent between the first quarter of 1994 and the first quarter of 1993, and prices had risen 134,800 percent from 1990 by March 1994. Consumer prices rose 48.6% in Peru and 38.1% in Venezuela in 1993.

Another danger in Latin American investment is posed by the left. Years of domination by right wing oligarchies have produced a pent-up demand for change which may one day revise the economies to our south drastically. In Mexico, PRI domination is facing unprecedented electoral threats, and armed rebellions. On January 1, 1994, in Chiapas the Zapatista National Liberation Army proclaimed their intent to foment sweeping revolutionary socialist change, and seized several towns including the state capital. Mexico nationalized its banking system less than a decade ago. A leftist party has a good chance of capturing power in Brazil, and the Sandinistas are making a comeback in Nicaragua, as the government of Violetta Chomorow has produced disappointing economic results. The leader of the Brazilian Workers Party, Luiz Inacio Lula da Silva, though apparently moderate, has denounced bankers, multinational corporations, the international financial order, land barons, and the market economy. On July 6, 1994 more than 40,000 people marched on the Presidential Palace in Argentina which has benefitted from an "economic miracle" over the past three years.

The situation in Venezuela provides an excellent illustration of the dangers inherent in Latin American investment. In the early 1990's Venezuela was one of the region's hot investment markets. GNP soared approximately 25 percent between 1990 and 1992. However, Preseident Rafael Caldera took office in February 1994 and reversed free market policies. According to The New York Times, "it has slapped so many controls on the economy that the Government's discretionary power over business ranks behind only that of Cuba in the region". The Times also reports that American businessmen are very disillusioned, The Venezuelan government took control of eight banks in June, 1994, as it spent a tenth of the country's GDP on rescues. In late June the Government imposed controls on all foreign currency transactions and on hundreds of prices. To combat "hoarding" President Caldera also decreed that the Government would seize private property without compensation. It also appropriated the power to detain people without charge, to infringe domestic privacy, to prevent free movement, and to confiscate property without recourse.

Although politico-economic risks in Europe are certainly lower than in other parts of the globe, many perils await unwitting investors. Just ask Olympia and York, and their partners in the Canary Wharf disaster of London. This huge seven billion dollar mixed use debacle played a large role in bankrupting that company. Office rents declined 40 percent between December 31, 1989 and December 31, 1993 in Britain and by 20 percent between 1991 and 1993 in most major German cities. In 1981--just 13 years ago--France nationalized 5 industrial groups, 36 banks, and 2 financial holding companies, raised taxes on the wealthy significantly, lifted wages and social security benefits, and strengthened trade union rights. The franc fell more than 40% between 1980 and 1982, and the budget deficit grew from $4 billion to $12 billion. Many investors lost huge sums.

Unemployment currently averages more than 11 percent in Europe, and has reached 25 percent for younger workers, and in some regions. In July 1994 it was 12.7 percent in France, 11.6 percent in Italy, and 24 percent in Spain. Unemployment has remained at or near double digit levels for more than a decade. This unemployment has created a class of unskilled disaffected individuals, who have provided a strong base for radical groups on the left and right. Their anger has fueled violent anti-immigrant feelings in many areas. Fascists are in the Italian government. The socialist-leaning British Labor Party trounced conservatives in recent local elections, and is far ahead in the polls, albeit with a moderate leader. Scandinavian voters are putting left-of-center parties into office again. Opinion polls indicate that Social Democrats should do well in Germany's upcoming elections.

In addition, unemployment, generous welfare states, and aging populations threaten the fiscal stability of some countries, and thus their economic health.

Although conservative parties have dominated European politics over the last fifteen years, and conservative ideology appears ascendent, politics, like real estate, tends to cycle. Surely one day pressures to redistribute wealth and for an activist government will revive. Real estate investors will be wise to pay heed to these political cycles, because they will surely affect before and after tax rates of return. If nothing else political results can produce self-fulfilling changes in confidence. Investors suffered huge losses in 1981 when the pendulum swung towards socialism with the election of Mitterand. In any case it is questionable whether conservative governments can halt the growth of the state. Both taxes and government spending grew as a percentage of national income in a Britain ruled by Margaret Thatcher's Conservatives between 1979 and 1994.

Even though the United States has been remarkably stable and successful economically and politically this country is not immune to socio-political risk. The gap between rich and poor has widened in the past twenty years. Average real wages have not risen in that time period by some measures. Average compensation for manufacturing workers fell at the rate of .6% per year between 1979 and 1989. Prospects for the population without college degrees are bleak. Our educational systems lag behind those of our competitors, portending future economic weaknesses. According to the U.S. Census Bureau, 6.3 million, or 27 percent of all children under the age of 18, lived in 1993 with a single parent who had never married, up from 3.7 million in 1983 and 243,000 in 1960. Approximately 66 percent of these children live below the poverty line. Forty percent of all children are borne into welfare. Racial tensions often explode, and rage even among the black middle class is high. A four trillion dollar national debt illustrates our inability over the past fifteen years to resolve political conflicts without shifting burdens to future generations.

South, Southeast, and East Asia appears to be on an inexorable and blazing rise to prosperity. However, political instability has kept growth in the Philippines far below that in neighboring countries. South Korean growth plummeted when political conflict surged, and riots and strikes ensued in 1989 and 1992. Political dangers from the north are well known. India and Pakistan have often been on the brink of war over the past thirty years, and may produce the world's first nuclear battle. War may also be brewing in the oil-rich South China Sea, where several nations claim sovereignty. The future of Hong Kong is far from certain when it falls into Communist hands in 1997. Political instability has racked Japan, producing the election of a socialist prime minister and causing the yen to soar due to the expected inability of the government to achieve trade agreements. In March 1994, Hong Kong's governor said that "exceptional measures" would be needed to cool the colony's soaring properties markets. The government subsequently imposed several measures which affected investment returns.

Finally, throughout the world, ethnic violence continually rears its ugly head. It has cost thousands of lives, destroyed lives, devastated economies, and diverted resources to unproductive activities. Yugoslavia had greater potential than any other East bloc nation in the 1990's due to its years of independence from Russia, its high standard of living, its education, its relationships with the west, and its decentralized semi-independent worker-managed institutions. But ethnic conflicts have torn that nation asunder and devastated its economy. Many other parts of the former Soviet bloc have suffered from ethnic conflicts which were suppressed under Communism. Latvia and Estonia have passed restrictive citizenship laws and voting restrictions. Fighting broke out in Moldova from December 1991 through July 1992. Newly independent nations in the southern Caucuses--Georgia, Armenia, and Azerbaijan have been racked by ethnic violence. Tensions have arisen between Ukraine and Russia over Crimea and other issues. Russia is home to 100 different ethnic groups, and many provinces (including the northern Caucuses and Tartarstan) are in effect semi-independent nations. The Middle East, Northern Ireland, the Basque territories in Spain, Indonesia, Ethiopia, Bulgaria, Malaysia, Tibet, Turkey, India, Brooklyn, and other areas all suffer from serious ethnic conflicts. Virtually every corner of the globe has been affected by this plague.

IV. WHAT TO DO?

Investors are pouring billions into other nations. Stock brokers are touting the benefits of diversifying portfolios. Because they are starting from such a low base and because they are in vogue, these salesmen can point to huge rates of return, and lead buyers to think that such growth will continue.

Although risks are large, returns to international investing can be very attractive. Growth in the U.S. will not match that in many countries due to their potential to utilize existing technologies which can improve productivity and lower wages. How can investors select areas for investment which will produce high returns, and succeed in diversifying portfolios, without exposing themselves to imprudent risks?

Insurance

First, for large investments, the United States Overseas Private Insurance Company provides insurance against losses induced by political events. The American International Group, an insurance and financial services company, has a political risk division to insure against a variety of eventualities. Other companies offer several types of protection.

Sources of Economic Information

Second, real estate investors should obtain information from economic and political risk specialists. Major sources of international economic information include international organizations such as the United Nations (UN), the International Monetary Fund (IMF), the World Bank, the General Agreement on Tariffs of Trade (GATT), the International Labour Organization, the Organization for Economic Cooperation and Development (OECD), and the Bank for International Settlements. All of these organizations produce large statistical compendiums and special studies. Many of the compendiums include socio-political information. The U.S. Department of Commerce and the Central Intelligence Agency also have a wealth of information regarding economies, and policies in other nations available to the public. Each country also publishes more detailed statistics and studies through central banks and units equivalent to our Treasury Department or Department of Commerce, and Labor Office. Most nations, including Great Britain, have Central Statistical Offices responsible for the majority of records. Naturally an increasing amount of data is available on computer disks, CD-ROMS and through on-line services. Dialog has a variety of international statistical sources. On the Internet users can obtain data through economics and business gophers, EconData from the University of Maryland, the National Trade DataBank from the U.S. Department of Commerce, the CIA World Factbook, Overseas Business Reports from the University of Missouri at St. Louis, International Market Insights, the National Institute of Economic and Social Research in Britain, the University of Michigan and other sources. A number of services provide on-line export contacts, and some of them are free. The Economist magazine provides exceptional coverage of events throughout the world.

Several private firms maintain databases on foreign economic developments and can produce excellent special studies. Major economic consulting firms include Data Resources Incorporated (DRI), and Wharton Econometric Forecasting Associates (WEFA). Big 6 accounting firms and major commercial and investment banks also have developed large economics departments in recent years.

Political Risk Specialists

Political risk analysis first flowered in the United States during the late 1970's in response to the Iranian revolution. American businesses lost billions due to that debacle. One of the best known political risk consultants is Kissenger Associates. It was founded by former Secretary of State Henry Kissenger, and has been called the "white-shoe" firm of political-risk analysis. Other firms include Multinational Strategies, Political Risk Services of Syracuse, a unit of International Business Communications; Probe International of Stamford Connecticut; London-based Business Risk International Inc. (part of the Economist Group holding company which also owns The Economist magazine); and SPC International, the consulting arm of the Systems Planning Corporation headquartered in Arlington Virginia. Some political analysts also provide economic and market analysis as well as elements of management consulting. Several major corporations have divisions or individuals responsible for political risk assessment.

Political risk analysts take into account government structures, the interests of elites, ethnic and religious groupings, population flows, economics, and history. They generally have a network of experts to call upon for specialized knowledge. Political Risk Services systematically consults more than 250 specialists.

The industry is divided into two groups--the traditionalists and the quantifiers. Political Risk Services uses a computer model to quantify risk factors. The model identifies the three most likely political scenarios for more than 80 countries. For example, in 1990 the firm forecast a 45% chance of a center-right coalition, a 40% chance of a center-left coalition, and a 15% chance of a military takeover for Brazil. The model also identifies such risk factors as turmoil, investment conditions, trade barriers and economic policy. The Economist Intelligence Unit reported the following credit risk rankings based on economic and political factors during the first quarter of 1994:

Iraq	100
Russia	95
Nigeria	78
Poland	55

Fees for political risk analysis can range from less than $500 to well into six figures. The Council for International Business Risk Management, based in Dallas, is the trade organization for this profession.

Academic Politico-Economic Studies

Many of the tools for quantitative risk evaluation were developed in academia. These tools can help investors decide what to focus upon in evaluating political and economic risks. The studies can ultimately help to quantify the risks and can be systematically incorporated into portfolio allocation and econometric models. Several different types of studies can be used by advisors and investors to evaluate political risk. These studies show that many specific socio-political variables appear to systematically influence economic events, and should be monitored. We will discuss below studies that have quantified socio-political effects upon the economy.

The raw data for these analyses can be found in publications by the World Bank, the IMF, the UN, the ILO, GATT, and the OECD; a variety of historical statistics collections produced by Brian R. Mitchell (1973, 1982, and 1988), The World Handbook of Political and Social Indicators (Bruce M. Russett, Lance Taylor, et. al), A Cross Polity Survey by Arthur Banks (1971), and Comparative World Data by Muller and Borrschier (1988). Additional data and leads can be found in the studies themselves, particularly those of Adelman and Morris (1965, 1972, and 1988), Gupta (1991), and Scully (1992)). Political and economic measurements are also available from the Interuniversity Consortium for Political and Social Research. Extreme care should be exercised in comparing economic data across nations. Use of current exchange rates to compare GNP's is not generally appropriate. The Penn World Tables, published originally in the Quarterly Journal of Economics in 1991, and periodically updated, are considered the most authoritative source of comparative data.

From 1960 to the present, Irma Adelman and Cynthia Taft Morris have produced the most comprehensive and sophisticated studies measuring the interaction of socio-political and economic variables. Primarily through factor analysis of large data sets across countries and through time Adelman and Morris (1965, 1972) found significant interactions. In one factor loading involving data from 74 Less Developed Countries in the early 1960's, they concluded that 70 percent of the intercountry variation in per capita GNP was associated with four common factors extracted from 24 sociopolitical variables.

In a study of 23 countries on six continents between 1850 and 1914 Adelman and Morris (1988) conclude that no single theory of causation can account for the many directions economic development took between 1850 and 1914. The data reveal that institutions--for example foreign dependence relationships, market systems, political power structures and land tenure arrangements--were the most important influences shaping domestic development, but no particular set of institutions was a prerequisite for success. They conclude that the neoclassical theory that resources, technology and comparative advantage determine development patterns does not adequately explain variations either across or within countries. However, among countries with fairly similar institutions growth of per capita GNP, rapid export increases, and rates of industrialization were closely associated with expanding economic opportunities and supplies of inputs.

Several other researchers have conducted significant, but less comprehensive, quantitative studies of socio-political and economic interactions throughout the world. Many of these studies have analyzed the effects of political instability upon growth. For example, Barro (1991) found that growth is positively related to measures of political stability, and inversely related to a proxy for market distortions and the share of government consumption in GDP. A one standard error increase in the magnitude of his measure of market distortions is associated with a reduction in the per capita growth rate of four tenths of a percentage point.

In The Economics of Political Violence Gupta (1990) created an index of political instability for 104 noncommunist countries between 1948 and 1982. He found that political instability will reduce the rate of growth in per capita income by approximately six tenths of one percent. Alesina and Perotti (1992) concluded that income inequality increases socio-political instability which, in turn, decreases investment. The findings, obtained for a sample of 72 countries, were quite robust. A one percent increase in an index of socio-political instability decreased investment by 2.89 percent. Scholine and Timmerman (1988) of the University of Hamburg, using both principal components and regression analysis, concluded that political instability significantly depresses GDP growth, and that increases in government regulation cut real capital formation in a 70 country 137 variable model. Venieris and Gupta (1983) reported that socio-political instability significantly reduced both the percentage of GDP devoted to investment and GNP growth. They also predict instability through a complex functional relationship.

Adelman and Hihn (1984) estimated a mathematical model of political change that offered predictions of political developments. They determined that polarization is difficult to avoid if a country is going to develop. However, polarization is neither a necessary nor a sufficient condition for the emergence of political instability. Furthermore, the possibility of instability can be greatly reduced if governments make a conscious effort to pursue a development process that leads to greater social mobility and is combined with greater political participation.

Several other researchers have analyzed the effects of other political variables upon economic growth, investments, and profits. Faini, Annex, and Taylor (1984) reported that a 10% increase in defense spending reduces annual growth by .13% through a sample of 69 countries between 1952 and 1970 and a time series analysis of India between 1950 and 1972. David Landau (1986) found that Government consumption expenditure reduces economic growth significantly, while government capital expenditures do nothing to increase growth. Scully (1992) concluded that the average economy where freedom is restricted (as measured by political openness, precedence of individual rights over state rights, prevalence of private property, and market allocation of resources) are less than half as efficient in converting resources to gross domestic product as free societies. Katherine Freeman (1976, 1985), building upon the theoretical and empirical work of David McLelland, reported that coefficients for "achievement motivation" in a simple production function were significant. Freeman (1984) also found that GNP, achievement motivation, the percentage of the population aged 65 or older, and the existence of democracy explained per capita government welfare expenditures.

The more subtle social, political and economic interactions in industrialized countries have also been subjected to quantitative interdisciplinary models. The "revealed preferences" of government policy literature, examines the influence of short-term cyclical economic fluctuations upon general government expenditure and various policy parameters. Pissardes found that, as expected, a rise of 1% in unemployment was associated with cuts of .6337 percent in the bank rate, and .4401% in the tax rate, while an increase in the price level produced a rise in the bank and tax rates. Havrilevsky concluded that monetary authorities significantly increased reserves when unemployment rose or inflation fell.

There is also a literature which examines the determinants of government spending, which in turn, influences the economy. Tussing and Henning (1974) found support for the influence of "Baumol's Disease," which explains the growth of public expenditures by price effects arising from a systematic public-private productivity-growth differential. Their study cast doubt upon the Peacock-Wiseman "displacement effect," which holds that public expenditures grow more rapidly after wars and other "social upheavals" because these events shift taxpayers' notions of maximum tolerable levels of taxation. Delorme and Andre (1978) find little evidence of either effect in France between 1872 and 1971. Chester (1977) reported that government spending was a function of per capita GDP, Union Density and the proportion of Catholics in the population. Cameron (1987) found evidence that international factors, primarily the openness of the domestic economy to international competition, provides the best explanation of growth in government expenditures. Political factors such as the degree of electoral competition and/or the parties that hold power also help explain this variations in public spending. Economic and fiscal explanations did not seem to play a major role in determining expenditures.

"Politico-econometric models" enhance reaction functions by specifying equations for voting behavior. Politico-econometricians then examine the mutual interaction of voting with economic policies, and economic outcomes. Bruno Frey and Freiderich Schneider have been in the forefront of politico-economic research. Frey (1978a, 1978b, 1979, 1984a and 1984b), and Frey and Schneider (1978a, 1978b and 1988), have constructed "politico-econometric" models of Britain, Germany, Switzerland, and the U.S. Frey found that left wing governments significantly raised government expenditures in Britain between 1962 and 1974, and in Germany between 1951 and 1975. Ray Fair (1978) has appended political equations to his large econometric model of the U.S. Douglas Hibbs (1981, 1987A, and 1987B), a political scientist has also created successful political-econometric models. He found (Hibbs, 1981) that political economic models traced past development better than purely economic models, that left wing governments tended to increase government expenditures and taxes when they enjoyed a "popularity surplus", while right wing governments decreased expenditures and taxes. All governments tend to undertake expansionary policies when they have popularity deficits, according to Hibbs.

Political business cycle models formulated and estimated by William Nordhaus (1974) and others find theoretically and empirically that governments tend to boost spending before elections. Nordhaus measured political business cycles by examining changes in unemployment rates and found very marked cycles in Germany, New Zealand, and the United States, modest indications of an alternating sequence in France and Sweden, but no evidence for these cycles in Australia, Canada, Japan and the UK. between 1954 and 1972. MacRae (1977) confirmed behavior consistent with political business cycles at times between 1957 and 1972. McCallum (1982), however, found evidence contrary to the political business cycle hypothesis. Findlay (1990) ran quarterly regressions that provided support for the existence of a political business cycle during Republican Administrations between 1951 and 1987.

In The Rise and Decline of Nations, Mancur Olson (1982) draws upon an impressive array of evidence to show that through time political stability allows "distributional coalitions" to form and gain strength. These coalitions depress growth through collusion and special legislation. Several empirical studies by Olson and others have found evidence for the importance of distributional coalitions. A recent book by Jonathan Rauch, Demosclerosis, describes the operation of Olson's theory in Washington today.

One arena for this legislation that has drawn the attention of many economists is trade policy. Tariffs can change the economics of investment. Many investments are undertaken to circumvent or forestall restrictions. Baack and Ray, (1973, 1983), Baldwin (1982, 1986, 1989), Bhagwati (1982), Brock and Magee (1978, 1984, 1989), Canto (1983-4, 1986), Canto, Kimball, Adish and Vishwa (1986), Caves (1976), Cheh (1974), Cline (1980), Conybeare (1983), Fieleke (1976), Friedman (1978), Gallarotti (1985), Gilpin (1987), Grassman (1980), Helleiner (1977), Henriques and Sadorsky (1994), Hillman (1982, 1988a, 1988b, and 1989), Hillman and Ursprung (1988), Krueger, (1974, 1978), Lavergne (1983), Magee, Brock, and Young (1989), Mayer (1984), Mayer, Wolfgang, and Riezman (1985), Michaely (1977), Pincus (1975), Rausser and Freebairn (1974), Ray (1974, 1981a, 1981b, and 1987), Ray and Marvel (1984), Richardson (1989), Riedel (1977), Saunders (1980), Stern (1987), Takacs (1981), Tosini and Tower (1987), and Walley (1985), and others have quantified politico-economic interactions with respect to trade policy.

Elsewhere, Acks (1994), I have shown through a cross section model across countries and a time series model of Britain from 1865 through 1980 that when economic models of growth and choice omit political, social, historical, and psychological factors they are subject to significant levels of specification error. When socio-political variables are included without incorporating mutual interactions, serious levels of simultaneity bias arise. If investors base their decisions on purely economic models they will produce suboptimal results.

The cross section model currently contains five endogenous variables, two of which (GNP Growth and Investment) can be classified as "economic", and three (Educational Investments, Political Stability, and Liberty) as "sociopolitical".

The model produced the following results: (t statistics are in parentheses)

DLRGDP = + 2.34 + .53DLK + .33DLL + .12ALH - .25LGDP65PW (1)

(7.25) (11.01) (2.07) (1.85) (6.76)

- .03POLSTB -.03CIVLIB

(2.31) (1.40)

where DLRGDP = Change in the log of real GDP

DLK = Change in the log of Capital Stock

DLL = Change in the log of the Labor Force

ALH = Average level of education of Labor Force

LGDP65PW = Log of GDP per worker

POLSTB = Index of Political Instability

CIVLIB = Index of Civil Liberties (inverse)

and t statistics are in parentheses

IK85 = + .0826 - 1.22E^-12K85 + .0020H85 + 2.056E^-08L85 (2)

(9.27) (0.34) (1.45) (0.25)

- 0.0039POLSTB - .0007GVPGNP86 + .0003MONPGD86

(2.03) (2.68) (2.64)

where IK85 = Investment Rate (per $ of Capital Stock) 1985

K85 = Capital Stock 1985

H85 = Human Capital Stock 1985

DLL = Labor Force 1985

POLSTB = Index of Political Instability

GVPGNP86 = Government sector share of GNP 1986

MONPGD86 = Ratio of Money Supply to GDP 1986

ALH = - 0.44 - .19LGDPAVPW - .02LIB1 + .04RELCON66 + .10WESTRN66 (3)

(0.81) (3.34) (4.07) (1.65) (2.66)

where ALH = Average Level of Human Capital 1965, 1985

LGDPAVPW = Log of average level of GDP per worker 1965,1985

LIB1 = Index of Liberty

RELCON66 = Index of Religious Conservatism

WESTRN66 = Index of Westernization of Attitudes

POLSTB = - 1.78 - .90DLRGDP - .85ALH + 4.753E^-09RGDP65B (4)

(1.49) (1.97) (2.11) (1.87)

- 1.24E^-18RGDP65B² - 1.18CIVLIB - .11CIVLIB²

(1.09) (2.35) (1.68)

where POLSTB = Index of Political Instability

DLRGDP = Change in the log of real GDP

ALH = Average Level of Human Capital 1965, 1985

RGDP65B = Real GDP 1965

RGDP65B² = Real GDP 1965 Squared

CIVLIB = Index of Civil Liberties (inverse)

CIVLIB² = Index of Civil Liberties (inverse) squared

CIVLIB = + 6.80 + .14POLSTB - 2.18ALH - 1.05E^-09RGDP65B (5)

(21.90) (1.98) (10.49) (2.11)

where CIVLIB = Index of Civil Liberties (inverse)

POLSTB = Index of Political Instability

ALH = Average Level of Human Capital 1965, 1985

RGDP65B = Real GDP 1965

H85 = + 1.09 - .91LH65 + .53LGDP65PW - .06LIB1 + .29WESTRN66 (6)

(0.61) (4.36) (2.70) (3.56) (2.23)

+ 0.006DURP6585

(0.32)

where H85 = Level of Human Capital 1985

LH65 = Log of Level of Human Capital 1965

LGDP65PW = Log of GDP (1965 prices) per worker

LIB1 = Index of Liberty

WESTRN66 = Index of Westernization of Attitudes

DURP6585 = Change in percentage of the population urbanized

1965 - 1985

The regressions show that westernization of attitudes and religious conservatism significantly affected education, and that education, in turn significantly affected output. Political instability also affects growth. In addition, political stability significantly influence investment and Liberty, which, in turn play a role in determining growth.

An econometric model of the U.K., parts of which are presented below, found that the government in power and strike activity significantly influenced growth. Thus

D(LGDPFCEX) = - 0.10 + 0.52D(LALHRW) + 0.57D(LKSTNTO) + 0.04LEDULTS (7)

(2.79) (3.48) (10.67) (3.02)

- .10WAR2

(5.56)

where D(LGDPFCEX) = Change in log of nominal GDP

D(LALHRW) = Change in the log of All hours worker

D(LKSTNTO) = Change in the log of the Nominal Capital Stock

LEDULTS = Index of stock of education of Labor Force

WAR2 = Dummy variable for World Wars I and II

and t statistics are in parentheses

LINVKSTK = - 0.61 + 0.78LINVKSTK(-1) + 0.49D(LGDPF900) (8)

(4.28) (15.24) (2.13)

- 0.04D(LCONSL,2) + 0.02GOLAMLIM - 0.01STDYSSTK

(0.42) (2.03) (1.90)

- 0.05IRE - 0.16WAR2

(1.95) (3.15)

where LINVSTK = Investment Rate (per $ of Capital Stock)

D(LGDPF900) = Change in Real GDP

D(LCONSL,2) = Change in Long Term Interest (Consol) Rate over Last 2 years

GOLAMLIM = Dummy Variable = 1 if government conservative

-1 if liberal or labor

STDYSSTK = Strikes days lost in past 5 years

IRE = Dummy Variable = 1 if Southern Ireland part of U.K.,

0 otherwise

WAR2 = Dummy variable for World Wars I and II

In conclusion, several socio-political variables appear to systematically influence economic events and should be monitored by investors.

V. LESSONS FROM INVESTMENT HISTORY

Regardless of which information sources are utilized investors would do well to follow a few simple rules. First learn a region's history, culture, and politics as well as its economy. Second, be aware that social, political, and economic change is often discontinuous, subject to huge instantaneous changes as in the case of Iran and Eastern Europe.

Third, economic and political events in democracies tend to be cyclical. Recessions or depressions alternate with prosperous times, and left wing governments alternate with conservative right-wing rulers. Although conservative ideologies and governments have dominated Britain, the U.S., and Germany since 1980, one day pressures to redistribute wealth, and for an activist government will revive.

Fourth, financial and economic systems tend to be subject to "Manias, Panics, and Crashes" in the words of Charles Kindleberger (1989). The "South Sea Bubble" of 1720, the Panic of 1873, and leveraged purchases of stock before the Great Depression, provide a small sample of the continuous excesses described by Kindleberger and others. During the South Sea Bubble, a Dutch Banker said that "Exchange Alley" in London resembled "nothing so much as if all the Lunatics had escaped out of the Madhouse at once." Land speculation in America and Dutch overexpansion of credit through investment in British government debt and in other instruments produced a crisis in 1763. Of the Panic in 1837 which took place in Britain and the United States, President Andrew Jackson wrote "in both countries have we witness the same redundancy of paper money and other facilities of credit, the same spirit of speculation, the same partial success, the same difficulties and reverses, and, at length, the same overwhelming catastrophe." The fuel for the Panic of 1837 was provided by wildcat banking, silver imports, and new joint stock banks. The Depression of 1873 began when weaknesses in the market for rail securities, decreasing capital imports, and falling stock prices prevented farmers from obtaining seasonal loans for their crops. The experience of 1873 was repeated in 1884 and 1893. The collapse of speculative activity in the copper market caused a severe run on banks in 1907, leading ultimately to the creation of the Federal Reserve. The financial debacle in the 1930's is remembered better than past events because many who lived through it are still alive, and those born afterwards grew up with stories of the hardships. This list of financial distress can be multiplied many fold. Richard Thaler, an economist at Cornell University and other psychological economists points out that people tend to give too much emphasis to recent data, and not enough to long-run averages or statistical odds.

As recently as the late 1980's and early 1990's many argued that the financial system appeared to be headed for collapse. The New York stock market crashed in October 1987, and was followed by most markets throughout the world. Banks loaned more than 300% of their capital to Less Developed Countries--with little regard for the borrowers' ability or willingness to pay. Speculative lending by S&L's will cost taxpayer's more than $200 billion. The General Accounting Office indicated that the U.S. guaranteed an additional $100 billion worth of loans that will not be repaid. Major banks reported losses in the billions due largely to excessive lending to real estate developers and Less Developed Countries. The consumers behind on their loans soared. In 1987 and 1988 banks lent more than $150 billion for leveraged buyouts. Ten banks accounted for $27 billion in loans. At each of these banks, the stock of buyout loans reached at least 39% of equity, and at two of these institutions exceeded 100% of equity. In June 1988 corporate debt stood at $1.78 trillion, up from $1 trillion in 1982, while cash flow rose quite modestly. Interest absorbed 34% of corporate pretax earnings--up from 22% in January 1983. In the first quarter of 1990, junk bond yields averaged 14.5%--seven percentage points above the safety benchmark (the Three Month Treasury Bill), or more than twice the difference in January 1989). The lowest rated junk bonds in the Merrill Lynch High Yield Index had a total return of minus 13.6 percent, as prices fell 27%. Prices of Campeau Corporation bonds plunged to 10% of their original purchase price. Major corporations filed for bankruptcy filings including several airlines, Revco, Integrated Resources, Southmark, Braniff, Resorts International, Hillsboro, Macy's, and the Campeau Corporation.

The point is that financial systems are subject to significant instability. High returns do not imply strong results in the future. China recently suspended new issues and has taken other steps to curb speculation, and many foreign markets are considered to be overvalued. Major financial corporations lost huge sums of many on trading activities during the second quarter of 1994. The growth of risky derivatives and unregulated mutual funds troubles many analysts. Unfortunately both positive and negative memories regarding the other side of cycles tend to be short.

Fifth, conflict over the distribution of income appears to be inevitable. It is a fundamental driving force of political and economic outcomes. Capitalism tends to make the distribution unequal, and thus is subject to conflict. It is capable of creating massive unemployment, which is a breeding ground for social unrest. Communism may be dead, but the lessons of Karl Marx can be ignored only at great peril. Talk of an end to history is absurd.

VI. CONCLUSION

Numerous risks confront international real estate investors, which are not faced domestically. In projecting after tax returns to projects, socio-political risks must be considered. Some socio-political risks can result in confiscation or destruction of property, while others are more subtle and could produce slight decreases in returns. Four types of risks are faced by international real estate investors--1) Political, 2) Socio-cultural, 3) Economic, and 4) International. In order to mitigate risks, investors should consider insurance. They should also educate themselves regarding a region's history, culture, and politics as well as its economy, and be aware that social, political, and economic change is often sudden and generally cyclical. The knowledge gained can avert disasters, and allow skillful investors to reap huge windfalls.

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