Interest Rate Differentials and Political Risk

Abstract

Political risk is customarily associated with the expropriation of local branches of foreign firms by the host-country governments, usually with inadequate compensation, mostly within developing countries. Consequently, many firms prefer to borrow locally to finance their foreign subsidiaries to minimise their exposure to losses from expropriation; they anticipate that if a subsidiary is expropriated, its new owners would be obliged to repay its debts, and the parent firm would be free of any remaining financial obligation. A second, less dramatic concern with political risk involves changes in exchange controls — firms are concerned about host-country constraints on the payment of dividends and the repayment of capital;¹ they want to ‘get their money out’ as soon as possible.