Political risk

Political risk is a type of risk faced by investors, corporations, and governments. It is a risk that can be understood and managed with proper aforethought and investment.

Broadly, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisions—or “any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives.” [Eurasia Group and PricewaterhouseCoopers, “Integrating Political Risk Into Enterprise Risk Management”, http://www.pwc.com/Extweb/onlineforms.nsf/docid/F44B471C9D848314852570FF0069BBCA?opendocument] . Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection).” [Kennedy, C. (1988): Political Risk Management: A Portfolio Planning Model, Business Horizons, Vol. 31, p.21] Portfolio investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk.

A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the most authoritarian. Long-term assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world. [Ian Bremmer, “How to Calculate Political Risk,” Inc. Magazine, April 2007, p. 101]

Understanding risk as part probability and part impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns.

There are both macro- and micro-level political risks. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, it would be incorrect to equate macro-level political risk analysis with country risk as country risk only looks at national-level risks and also includes financial and economic risks. Micro-level risks focus on sector, firm, or project specific risk. [Ephraim Clark, “Valuing political risk”, Journal of International Money, and Finance, Vol. 16, No. 3, 1997, 484-485; Stefan H. Robock, "Political Risk: Identification and Assessment." Columbia Journal of World Business, July-August 1971, pp. 6-20; and Stephen J. Kobrin “Political Risk: A Review and Reconsideration”, Journal of International Business Studies, Vol. 10, No. 1 (Spring - Summer, 1979), pp. 67-80. ]

Macro-Level Political Risk

Macro-level political risk looks at non-project specific risks. A common misconception is that macro-level political risk only looks at country-level political risk; however, the coupling of local, national, and regional political events often means that events at the local level may have follow-on effects for stakeholders on a macro-level. Other types of risk include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose both portfolio investment and foreign direct investment risks that can change the overall suitability of a destination for investment. Moreover, these events pose risks that can alter the way a foreign government must conduct its affairs as well.

Research has shown that macro-level indicators can be quantified and modeled like other types of risk. For example, Eurasia Group produces a political risk index which incorporates four distinct categories of sub-risk into a calculation of macro-level political stability. This Global Political Risk Index can be found in publications like The Economist. [Rolling with the Punches,” Economist, October 1, 2007 http://www.economist.com/displaystory.cfm?story_id=9890890 (accessed 05/06/2008)] Other companies which offer publications on macro-level political risk include Business Monitor International, Economist Intelligence Unit, and Political Risk Services.

Micro-Level Political Risk

Micro-level political risks are project-specific risks. An examination of these types of political risks might look at how the local political climate in a given region may impact a business endeavor. This type of risk includes project-specific government review (such as the Committee on Foreign Investment in the US (CFIUS) process in the United States), the selection of dangerous local partners with political power, and expropriation/nationalization of projects and assets.

To extend the CFIUS example above, imagine a Chinese company wished to purchase a US weapons component producer. A micro-level political risk report might include a full analysis of the CFIUS regulatory climate as it directly relates to project components and structuring, as well as analysis of congressional climate and public opinion in the US toward such a deal. This type of analysis can prove crucial in the decision-making process of a company assessing whether to pursue such a deal. For instance, Dubai Ports World suffered significant public relations damage from its attempt to purchase the US port operations of P&O, which might have been avoided with more clear understanding of the US climate at the time.

Political risk is also relevant for government project decision-making, whereby government initiatives (be they diplomatic or military or other) may be complicated as a result of political risk. Whereas political risk for business may involve understanding the host government and how its actions and attitudes can impact a business initiative, government political risk analysis requires a keen understanding of politics and policy that includes both the client government as well as the host government of the activity.

Political Risk Mitigation

Companies may have a Chief Risk Officer who is charged with managing political risk or, in many cases, this job falls to the Chief Financial Officer.

At the macro-level, political risk mitigation largely involves understanding political uncertainties of the operating environment and the risks faced by all business operations in individual countries. Such information can come in the form of customized analysis or in-depth subject matter reporting; information that can enable an investor or firm to calibrate their risk appetite. Mitigation tactics involve both macro- and micro-level strategies. A recent article on the subject suggested that political risk mitigation should not simply revolve around the decision to enter or avoid a given country’s marketplace, but should rather center on the pragmatic usage of contingency planning, intellectual property safeguards, risk diversification, and sound exit planning to guard against uncertainty. [Ian Bremmer and Fareed Zakaria, “Hedging Political Risk in China,” Harvard Business Review 84, no. 11 (2006)]

At the micro-level, political risk insurance and hedges play a larger role. MIGA and OPIC provide project-specific political risk insurance. This type of insurance usually outlines specific triggers, such as expropriation or breach of contract by a local party, which entitle the insured entity to a pay-out after relinquishing control of the insured project to the insurer. Political risk insurance, however, often involves premiums which must factor in considerable uncertainty and the threat that arbitrary decisions will affect the value of insured property. Policies therefore can often be very expensive. Businesses can also purchase hedges, which could be derivative instruments, which allow them to reduce risk by selecting a level of return based on a given set of outcomes.

Political risk mitigation takes place before, during, and after an investment. Prior to investment, businesses can perform due diligence related to local partners and carefully word and structure their contracts. While a project is on-going, the investor may benefit from building local political leverage through community activities. After a risk has been realized, its effects may be mitigated through post-hoc litigation and retaliation, as well as the implementation of a previously developed contingency plan, or exit from the market.

References

Extended Bibliography

1. Ian Bremmer, “Managing Risk in an Unstable World”, Harvard Business Review, June 2005

2. Ephraim Clark & Radu Tunaru, The Evolution of International Political Risk 1956-2001, http://econpapers.repec.org/paper/mmfmmfc05/37.htm

3. Eurasia Group and PricewaterhouseCoopers, “Integrating Political Risk Into Enterprise Risk Management”, http://www.pwc.com/Extweb/onlineforms.nsf/docid/F44B471C9D848314852570FF0069BBCA?opendocument

4. Llewellyn D. Howell, “The Handbook of Country and Political Risk Analysis”, Third Edition, PRS Group, 2002

5. Nathan Jensen “Measuring Risk: Political Risk Insurance Premiums and Domestic Political Institutions”, Washington University, http://www.sscnet.ucla.edu/polisci/cpworkshop/papers/Jensen.pdf

6. Martin Lindeberg and Staffan Mörndal, “Managing Political Risk—A Contextual Approach”, http://www.diva-portal.org/diva/getDocument?urn_nbn_se_liu_diva-1029-1__fulltext.pdf

7. Theodore H. Moran ed., International Political Risk Management: Exploring New Frontiers (IBRD: Washington, 2001, pg. 213-214)Jeffrey D. Simon, “A Theoretical Perspective on Political Risk”, Journal of International Business Studies, Vol. 15, No. 3. (Winter, 1984), pp. 123-143.

8. Guy Leopold Kamga Wafo, “Political Risk and Foreign Direct Investment”, Faculty of Economics and Statistics, University of Konstanz, 1998, http://www.ub.uni-konstanz.de/kops/volltexte/1999/161/

Footnotes