By Dugan, William E. | Risk Management, September 1999 | Go to article overview


Dugan, William E., Risk Management


In its initial foray into international operations, MilWood Products Inc. embarked on subsidiary operations in Latin America. The decision was based on the progression of the company's thirty years of growth. Headquartered in the upper Midwest, MilWood had secured the lion's share of the fabricated wood products market in North America. A diversified network of production centers enabled the company to bring its product to market in a more timely fashion than the competition, and regional distribution outlets were able to fill contractor orders in days rather than weeks. Growing demand for their products throughout South America prompted the company's decision to explore subsidiary operations in the region.

MilWood executives participated in fact-finding missions to various countries, initiated market research and feasibility studies, examined transport networks and researched the availability of a skilled workforce. Working through the Ex-Ira Bank, they also addressed host country fiscal and monetary policy risk, exchange rate systems and regulatory policy. The MilWood team then met with foreign government officials and discussed collective bargaining agreements with local labor leaders. Satisfied with their findings, company executives made the decision to invest in a production and distribution facility designed to meet projected regional demand over the next decade.

Despite initial success, however, MilWood Products S.A. failed to achieve the envisioned return on investment. The problem was not related to the management structure of the foreign operation nor inaccurate projections of demand. Instead, in its initial risk assessment, the company failed to anticipate the host country's legislative agenda. The broader political and economic conditions that had been so attractive to MilWood--the government's emphasis on privatization and liberalization (deregulation), property rights of foreign investors and a stable exchange rate system--generated political demands from competing interests.

Within eighteen months of MilWood's foreign start-up, the labor code of the host country was revised. The old code dated to the 1930s, reflecting the political and economic conditions of that period; the revised legislation was defined by the global climate of the new millennium. The emphasis on controlling labor through co-optive and repressive means was replaced by broader worker rights and a decreased role for government.

Whereas the subsequently altered labor-management relations ultimately contributed to slight increases in MilWood's production costs, the company's transportation costs doubled. The old labor code reflected the government's response to violent rail union activity in the 1930s; it provided for tight control of these organizations, including a restrictive wage regime. The revised code removed these restrictions, allowing market forces to determine wage and price structures in the transportation industry--both increased. The outcome was a shrinking bottom line for MilWood Products S.A.

While the MilWood scenario is hypothetical, it is based on a composite of cases and events that captures the essence of political risk assessment. In this case, it seemed that company executives had thoroughly analyzed the business risks associated with overseas investment. These decision makers, however, had little knowledge of the host country's labor history. Furthermore, they failed to project the macro level impact of the government's development program (privatization and liberalization) on diverse sectors of society. Given these limitations, MilWood executives could not have anticipated the increased cost of operation resulting from the transformation of the broader political landscape.

Foreign direct investment, particularly in the economies of the developing world, offers a wealth of opportunity. The risks associated with operations in unfamiliar and potentially hostile environments, however, are also greater. …

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