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Political Risk

The Role of ADB and Multilateral Development Banks in Addressing Political Risk in Asia

Daniel Wagner | October 1, 2003

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In our post-September 11 world, it is difficult to tell the difference between "perceived" and "real" political risk, and investors are wary. 1 There is no doubt that these shifting perceptions of risk have impacted the underwriting orientation of political risk insurance providers. Development banks can provide support and access to trade finance.

Heightened global political risk—brought about by a combination of global terrorism, the economic meltdown in Argentina, and the crisis in corporate governance—has transformed the international business landscape in a dramatic way over the past 2 years. In a general sense, all political risk insurance (PRI) providers find themselves affected by the new realities of the post-September 11 world—whether they have Argentine claims to deal with, whether a major portion of their business used to be project finance-driven and now, suddenly, is not, or whether they have to rely on a drastically reduced supply of reinsurance to insure their own exposures.

International businesses find themselves operating in a world where all of the assumptions they have used in the past for engaging in cross-border trade and investment have been turned on their head. It now takes an extra degree of accurate information, combined with personal experience and good instincts, to be able to tell fact from fiction. The ability to distinguish between "perceived" political risk and the "reality" of political risk has changed. In many cases, it has changed to such a degree that it is hard to tell the difference between the two.

For example, an uninformed observer might conclude that the political risks associated with doing business in much of Asia are high. So high, that he might conclude he would be better off not investing in Asia. That observer may not really know much about a particular country, but instead, might rely on a literal interpretation of press reports, or preconceived notions of what it must be like to conduct business in a given country in the region. Even today, after all that has happened since September 11, that observer would, more often than not, have been wrong in this assessment.

Many foreigners who have lived and worked in most Asian countries for any length of time will tell you that many press reports on the region describe an environment that is exaggerated and sensational. What is closer to the truth is that while political risks associated with conducting business in Asia certainly exist, they are no more pronounced than the political risks associated with doing business in many other parts of the world. Any political risk insurer is likely to tell you that what matters most about a transaction is not the country in which it is based, but rather, the quality of a given proposal, the experience of the sponsors, the content of a given contract, and the developmental benefits associated with the project. There can be, and often are, very good deals being done in countries that many people would otherwise think are untouchable.

Further to my point, a recent poll appearing in The Economist magazine listed the top 5 countries at perceived risk of terrorism. They were, in order from first to fifth, Colombia, Israel, Pakistan, the United States, and the Philippines. According to that listing, the United States is at greater risk of being attacked by terrorists than the Philippines. If you were to ask an American whether he thinks the USA is at greater risk of terrorist attack than the Philippines, he would probably say "No." If you were to ask a Filipino the same question, he might very well say Yes." Perceived risk is a function of individual perception, which is in turn based on a person's own view of the world. There will be no unanimity on this point. And yet, people's perception of risk affects so many things. If we invest, how we invest, where we invest, and with whom?

There is no doubt that these shifting perceptions of risk have impacted the underwriting orientation of PRI providers. They, too, must weigh all of the information at their disposal and arrive at a conclusion that will permit them to make a determination about which transactions merit to support. The net result of all that has happened since September 11 is that most PRI providers have adopted a more conservative approach to underwriting—whether driven by claims and reinsurance guidelines or by a natural inclination to take a more critical look at the risks being underwritten.

Ultimately, of course, this "conservatism" will prove to be a good thing from a risk management perspective. That PRI providers are taking an even more critical view of the political risks they are insuring will help "the industry" recover from what has to be viewed as a severe challenge. This approach will no doubt result in fewer claims and improved performance, which should lead to stronger reinsurance support in the medium-to-long term. The challenge, which is already manifesting itself, is how to arrive at a meeting of the minds between providers of PRI and end users.

What has happened is that the conservative underwriting approach being adopted by the PRI providers is being met with a similarly conservative approach to lending being made by international financial institutions, whose credit committees are simultaneously demanding greater levels of protection against political and credit risks. At the same time, most private PRI providers are constrained in what they can and cannot do based on their underwriting guidelines and reinsurance treaties. Clearly, there is going to have to be some compromise by both sides if deals are going to get done in the future. The question is: who is going to budge?

ADB's Role

The Asian Development Bank (ADB) is committed to playing a catalytic role. At a time when so many private PRI providers have had their capacity, tenors, and ratings cut, sometimes severely, the ADB's capabilities in terms of lending and providing creative credit enhancement tools such as PRI, remain unchanged. The ADB remains triple-A rated, and its ability to provide loans and guaranties is unhindered.

One of the ADB's missions is to fill the gap created by the "normal" operation of the capital markets. One objective is to push the envelope and support transactions in countries that other bankers and insurers are reluctant to support. These challenging environments from among the 62-nation family of ADB member countries are where the ADB prefer to do business. At no time has this been more important than right now.

Ultimately it will be up to Multilateral Development Banks (MDBs), like the ADB, to craft new solutions to some of the "structural" problems confronting the international banking and trading system. Indeed, that is an important function of such institutions. Fostering regional cooperation is perhaps one of the most important roles institutions can play.

For example, the ADB is currently promoting the ASEAN + 3 Bond Initiative, whose objective is to develop efficient local bond markets in Asia that will enable the private and public sectors to raise and invest long-term capital without currency and maturity risks. This initiative will facilitate access to the market by a wider variety of issuers while creating an environment conducive to developing local bond markets. ADB has also recently created a terrorism insurance facility for Pakistan—a country where few foreign insurers are prepared to provide such coverage.

Often, ADB involvement adds an impetus to expand the range of activities a PRI provider may become comfortable in supporting. Its Guarantor-of-Record program, wherein ADB lends its good name and ultimately, its paper, to lead PRI placements, has proven to be a popular tool to expand the range and scope of private and public sector PRI participation.

The Role of MDBs

During past periods of financial crisis, some critics have argued that the guarantee, loan, and investment tools utilized by MDBs to keep international trade finance available to importers and exporters in crisis-affected countries have focused too much on providing conventional hard currency loans to host governments to help restore foreign exchange reserves and international confidence. This, it is argued, enables continued servicing of existing foreign exchange debt owed to public sector financial institutions and private sector banks—including some that were either over exposed to the crisis affected country, or undercapitalized.

In response, some MDBs have recently by-passed host governments and experimented with lines of credit issued directly to local banks to ensure access to foreign exchange, and thus liquidity. MDBs have also issued guarantees supporting local bank obligations to pay under documentary credits and risk sharing arrangements that allow local banks to provide more domestic trade and other finance to a wider variety of borrowers than their capital base would otherwise allow.

In the future, MDBs can play a better, more effective role in supporting access to trade finance during periods of crisis, by:

  1. Improving these tools, so that they can be quickly and economically introduced in a number of markets, well before a crisis starts;
  2. Focusing on filling market gaps that might appear, so that private-to-private cross-border, "country," and "bank" limits can stay open and domestic intermediation can continue; and
  3. Using the least amount of intervention possible, giving priority to tools that help private-to-private flows first, leaving the public-to-public foreign exchange loan "sledge hammer" as a last resort.

Looking Forward

It seems to me that at this time, when the banking and insurance markets are coping with the realities of the post-September 11 world we are living in, development banks have a unique role to play, particularly with "difficult to place" transactions. As political risk continues to impact how—or if—cross-border business is conducted, the importance of PRI will surely grow. The question becomes, how can PRI providers create new products that will satisfy an increasingly sophisticated end-user, and how can direct underwriters meet these needs while operating within the constraints set by reinsurers and their board of directors?

As we know, insurance is, by its very nature, a product that grows and twists and turns with market demand. I have little doubt that PRI providers will find a way to meet the challenges posed by the post-September 11 world. In the meantime, we will all continue to watch in amazement at the many profound changes that we have yet to experience as the 21st century unfolds.


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1 The views expressed herein are the author's and do not reflect the opinions of Asian Development Bank or any other organization.