Economic Risk Assessment of Democratic Republic of Congo Finance Essay

This report provides an assessment of the Political and the Economic Risk of DRC for FDI by Rio Tinto and whether it will have the access to the funds to finance its direct investment in the DRC and what are the available sources to finance that project and different risks associated with them. While discussing the issues relating the political risks and other macroeconomic indicators related to the DRC. The report also addresses the issue of repatriation of dividends to the UK and risks associated with the cancellation of the mining contract. The methods used for the economic risk assessment are the comparisons of the macroeconomic ratios i.e. GDP, the comparison of CFC and GBP to determine the foreign exchange risk and its effects. The sources of finance were determined through the current strategies and sources that are used by the Rio Tinto itself. The taxation issues were discussed in accordance with the current UK and DRC's taxation laws. The results of data that has been used show that the DRC has a high political and economic risk irrespective of the fact the economy of DRC has grown in the last few years and political process has also been stabilizing. Rio Tinto have the required sources of finance available in form of Joint Ventures like it recently did with the Chinalco and in the case given the Angang Steel Company, Bridge Financing and DFI which provide funds to the companies investing in the developing countries. The repatriation of profits to UK shareholders can also be managed. And the risk associated with the cancelation of license can be mitigated by either transferring the risk by getting Political Risk Insurance or by reducing it through joint ventures.

Introduction

Democratic Republic of Congo is a country situated in the Central Africa. It was colonized by Belgium till 1960, when it gained the independence from them. Though the country got independence, the USA and Belgium helped the COAS Mobuto. It was that time that led the country into three decades of unstable, undemocratic period of Mobuto, resulting into the many adverse effects of the dictatorship in the country.

During this period injustice, mismanagement of the issues and corruption was at its peak. These were the reasons that stopped the country which was enriched with the natural resources to grow and benefit from its natural resources, which plays a vital role in the economy of the country. In 1980 the mining industry accounted for almost 75% of the total exports and 25% of the country's GDP.

Economic Risk Assessment of DRC

Political Risk: The political conflicts have been the main hurdle in the development of the DRC. The main cause of political instability in the DRC has been the presence of armed rebellions in the Far East part of the country. But due to agreement between DRC and Rwanda, the support of UN and developed countries the political environment is getting stable and its contributing a lot to the economy regardless of the political risk of DRC is still termed as high.

Economic Environment of the DRC has been improving since the democratic process has started in the country. Macroeconomically DRC has grown in the past year that resulted in a stable foreign exchange rate that has also affected the inflation rate in the positive way. The debt situation has also improved due to the debt relief by the IMF and World Bank. The GDP of the country has been improving, the below graph shows how it transformed into 5.4% from -6.9% from 2000 till 2010. The GDP growth fell in 2009 that was because of the economic recession that affected the whole world. Since the mining industry comprises major chunk of the DRC's GDP, therefore revival of mining industry in the 2010 has directly impacted the GDP of the DRC. The mining industry comprises almost 30% of the GDP. The projections of IMF further show that the GDP will grow till almost 7%, which is a positive sign for the investors. GDP per capita (PPP) has also from $314.42 (2008) to 319.59(2009). The exports are also projected to grow in the 2010 and the imports are growing more in comparison to the exports hence resulting in increased negative balance of trade but investors know that the increase in imports is due to the import of the machinery required in the mining industry and to develop the infrastructure of the country. The negative balance of trade will increase the economic burden on the country but the FDI mainly by the mining companies like Rio Tinto will help the DRC to improve its current account and foreign reserves. The negative point here is that DRC still wants to borrow more money from IMF and different countries to fund its budget. IMF has agreed to provide $10 billion to DRC in return on the reconsideration of the earlier contract with the China worth $9 billion.

Figures Source: World Bank and IMF

Foreign Exchange Risk is high as CFC is continuously depreciating against the GBP in the long run, which is a negative indicator to the Rio Tinto because the country in which the Rio Tinto repatriate is UK where GBP is used . The foreign exchange risk can be mitigated by the Rio Tinto through the forward contracts or hedging it through different ways.

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The first issue regarding the shipment is that the China is far away from the if sent through sea to the China, it will have to pass through the Somalian water that has been full of danger because of the Somalian Pirates, though this risk has been mitigated by the few of the best navies in the world like BRN and the PN. The other issue is that it will have to pass through Pakistan since most of the Chinese imports and exports are currently passed through the Pakistani Ports. And since Pakistan is politically instable therefore there is lot of risk involved. The shipment will also carry a high shipment costs due to the long route. This risk can be mitigated through International Insurance of the shipments because this is the best and more effective way to mitigating the risks involved in the shipment of iron ore to the China from DRC.

Sources of Finances

Mining companies like Rio Tinto in UK have many options for financing their projects. But in order to get the investment the projects has to be independently reviewed. Financing for mining projects is often different from the financing of other types of the projects, for this kind of project the investors will focus mainly on the technical and economical data of the project and country respectively therefore the reputation of the people engaged is very important. Sources of finance that are available to the Rio Tinto are

UK Commercial Banks as a Bridge financer: Rio Tinto has A3 (Stable) Long Term Rating (Source: Moodys's Investor Services) but still since the political and economical risk of the Mining Sector in DRC is high and also the involvement of the Exchange Rate Risk the Commercial Banks may not be willing to lend the long term loans to Rio Tinto to finance their projects irrespective of their reputation and credit rating. Therefore Rio Tinto should look for the like bridge financing that usually are short term loans that are paid one off at the end of the term and are useful to finance the initial stages of the iron ore mining project which are more risky. It will provide Rio Tinto to get rid of the project if unsuccessful at the initial stages repaying the short term loan. But before opting this option Rio Tinto should also consider that same level of security May be asked by the financers as long term lenders may be asking as the risk profile of DRC is high.

Dividends Cut: The dividend cut is a cost free funding source. Rio Tinto even if only pay the half of the dividend it paid to its equity shareholders in 2009 i.e. £550 million, it will be enough to finance the mining project in DRC. The main risk associated with this source if finance is that the shareholders may get a negative impression due to non payment or low dividends because Rio Tinto has already paid £552 million which is 60% less than the 2008's dividends, even though the reason of drop in the amount of dividends was a clear indication of the effects of the recession on the Rio Tinto which has also led the drop in profits as well. The shareholders still may get a negative impression on the shareholders and potential investors in the Rio Tinto. That may be the reason that Rio Tinto is planning to give same amount of dividend they gave in 2008 to the shareholders just to give the positive message to the shareholders.

Joint Ventures with the Companies is an agreement where two or more business agree to cooperate and help each other on a certain project by either combining their resources or exchanging one resource with the other to get benefit out of it. It will not require any kind of changes in structure of the companies; it will only be a relationship of cooperation with each other where each one is responsible for its own profit share and risks. It also gives an immediate cashflows to the company. Rio Tinto has previously tried this with the company called Chinalco which led to cashflows of £12.5 billion and the current requirement of £250 million. And even recently the Rio Tinto is looking forward to more joint ventures with the companies in the China. The joint ventures also have risks that the different cultures and management style may result in poor coordination. And even the balance of expertise may not be achieved in the joint ventures and the objectives of the venture may be vague but in Rio Tinto joint venture with Chinalco seems to be well planned and handled and that shows their professionalism and long term view.

Development Financial Institutions are the alternative financial institutions that are mostly funded by the developed countries to help the under developed and developing nations by initiating the investment by the different multinational companies in the country by giving them loans and grants. So in return the economy of those countries are improved and investment by the companies in that countries' infrastructure and fulfilling different CSRs. For example in the case of Rio Tinto the £250 million is not a big amount for the development financial institutions like ADB, which can give the loan to Rio Tinto at rate lower than the market rate to improve the mining sector and mining legislation since Rio Tinto is one of the largest mining company in the world, so it has strong CSR values and may also influence the government of Congo. The risk in this source is that DFIs usually impose certain covenants on Rio Tinto which may __ them to perform their operations independently and implement their plans as they had planned and if the covenants imposed are not met than there may be adverse implications of that.

Repatriation of Profits to UK Shareholders

Rio Tinto Group is a dual listed company which is trading on both the UK's LSE and ASE. Therefore the Rio Tinto is wishing to repatriate all of its annual profits to the shareholders in UK. There are number of issues which has to be addressed if they want to do this, some of those issues include the foreign exchange risk issues, CSR and the taxations issues are involved.

Taxation Issues: The Mining Code of DRC the mining companies to pay the Professional Tax on their earnings i.e. their profits at a rate of 30% instead of the Corporate Tax Rate of 40%. The Professional Tax is charged on the same profit that is calculated by other Companies following the IFRSs and IASs or the local accounting laws. Since UK neither has any Double Tax Treaty signed with the DRC nor the Rio Tinto has registered their mining operations in DRC as a company, therefore the HMRC will ask the Rio Tinto to pay the UK Corporation Tax at a full rate of 28%. And the repatriation of the dividends will be treated as Overseas Income and not as the dividends due to the point discussed above. Though the Rio Tinto can get the DTR on the tax paid i.e. lower of tax payable in UK or paid in the DRC. Another issue here is of the withholding tax because the DRC's Mining Code will deem the repatriation if the profits as dividends paid to the UK Shareholders of Rio Tinto and the withholding tax rate of the DRC is 10%, which will further reduce the amount repatriated to UK shareholders. Another corporate taxation issue here is that the Government of DRC is trying to get more and more tax revenue through its mining industry through curtailing different kind of benefit given to the sector under the Mining Code, even though the strong reaction from the industry has been given against the actions,. But still there is a possibility of the increase in the tax liabilities to the DRC Government which will ultimately reduce the profits repatriated to the UK shareholders.

Foreign Exchange Risk: This is the key issue involved here because the foreign exchange rate determines how much dividends the shareholders of Rio Tinto will get in the UK, after the issues of tax has been determined and resolved. There is a key concern here for the Rio Tinto because the currency of DRC CFC is devaluing against the GBP.

CSR and Local Environment Issues: The Rio Tinto is one of the largest mining companies in the world that has high values of CSR. CSR is just not all about Rio Tinto spending their money out from their profits in DRC or certain place where they are operating it is something more than that it is about how the Rio Tinto will contribute to the economy of the DRC which is in the developing stage, since Rio Tinto will export the iron ore to their joint venture partner Angang Steel Company, this will contribute to the GDP of DRC due to the increase in exports will have a positive impact on the balance of trade of DRC. Rio Tinto contributed almost $45,000 million in 2009 to the economies in which they are operating. The negative impact of the repatriation of profits to the UK will be the flight of foreign exchange to the UK in terms of GBP hence affecting the foreign exchange reserves of the DRC. Since the Rio Tinto is intending to repatriate the profits to the government and people of DRC may look negatively thinking that their country's resources were only used to make profits for the people of the UK and they get nothing from these kind of contracts. Rio Tinto should invest a small amount in the infrastructure of the DRC making people feel that something is been done for them in return of the usage of their resources and this infrastructure will not only benefit the DRC but also the Rio Tinto providing them better roads for example for the transportation of their iron ore to their Chinese partner.

Risk Cancellation of Licence by DRC Government.

DRC's parliament is responsible to regulate the mining industry through the legislative process. The Mining Code 2003 is the framework through which the industry is regulated. Constitutionally the title and ownership of the mines and land that has minerals belong to the state of DRC. Though DRC Government may allow different national or foreign entities to explore and mine the fields and land to extract the minerals through a license. As the CEO of Rio Tinto has assured they will get the license of extracting the iron ore in the similar way. There is another risk that is hanging on the Rio Tinto regarding their project in DRC is that the Government of the DRC may cancel the license of Rio Tinto. The main issue here is that since Rio Tinto is one of the key players in the mining industry all over the world it may use its reputation power to resist any tax increase on the mining industry. Earlier this year on the pressure of IMF and western countries the President of DRC Mr Kabila was forced to revise the contract terms of Tenke contract with the China. Even in 2007 a panel was appointed by the Government to review the 61 mining contracts that were considered for either cancellation or revised. And it was not the first time. So this may also happen to the Rio Tinto resulting in either loss of license or assets being confiscated by the DRC.

So the possible strategies for the Rio Tinto would be either TARA:

Transfer strategy means that Rio Tinto will accept the risk of either licence been cancelled or asset confiscation and Rio Tinto will than try to transfer this risk to the third parties like the Insurance Companies that provide PRI to the companies investing in the developing countries or either get the guarantees from the DFIs. Though this will have a cost to the Rio Tinto financially in the Political Risk Insurance and non financial in the DFIs case but it will give a sigh of relief to the Rio Tinto about their FDI in the DRC to extract iron ore.

Avoid means that Rio Tinto doesn't face the risk of licence cancellation by simply avoiding the FDI in DRC. That means that the Rio Tinto should not invest in the DRC at all, which doesn't seems to be right because Rio Tinto Group can clearly either reduce or transfer the risk even after looking the financial statements of Rio it is clear that they can afford the investment as well. And also the project can get the Rio Tinto shareholders lot of return on their investment in the long term.

Reduce: Rio Tinto can even reduce the risk of the licence cancellation by entering into a joint venture with any company which is what Rio Tinto will more likely do. As in the case Rio Tinto has already entered into the joint venture with the Angang Steel Company, this clearly means that Rio Tinto has already shared its risk with them but the percentage of risk been shared is dependent upon the joint venture contract of the companies. This is more likely solution for Rio Tinto.

Accept: Another option for Rio Tinto is to face the risk of licence cancellation and doing nothing about it. This option is least used strategy in the contracts like Rio Tinto is entering into because an investment of this amount £250 million is not that small.

Conclusion:

DRC is a developing country with high economic and political risk, though the overall economic condition of the country is still not good but the political environment has stabilized a bit and economy of DRC has grown in the last few years which is giving a positive indication to the foreign companies which are willing to invest in the country's mining industry. Rio Tinto is a one of the largest mining and CSR group which can help the local people and economy and helping government by giving high revenue in relation to their mining contract while fulfilling the interest of their own shareholders. The investment might not produce any profits in the short term but Rio Tinto have the available resources to go with the project though the risk is high will compensates the high returns in the long term fulfilling the interest of the Rio Tinto's shareholders.

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