What is Political risk?

Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action. Political risk can be understood and managed with reasoned foresight and investment.

Political risk is a probability of loss due to political instability in the buyer’s country that may result in cancellation of a license or otherwise affect the buyer’s ability to make payments. Political risks are insurable risks, and overlap with the political component of force majeure risks.

The term political risk has had many different meanings over time. Broadly speaking, however, 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.

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). 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.

Political risk is the risk an investment’s returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers or military control. Political risk is also known as “geopolitical risk,” and becomes more of a factor as the time horizon of an investment gets longer.

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.

Understanding risk partly as probability and partly as 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.

Political risk can affect the operations and profitability of a business as directly and quickly as any financial, physical, or market risk factor. The impact of political risk is considered to be long-term because the risk rises over time, given the greater potential for events and changes over time. Although political risk is extremely difficult to quantify, companies and investors must examine and understand the potential for political risks by closely examining the location’s history, political institutions, and political forces at work in the region.

Political risk can lead to:

• Confiscation, expropriation or nationalization of assets;
• Export/import embargoes or cancellation of export/import licenses;
• Physical damage to assets from political violence;
• Termination of or default on contracts;
• Non-payment or moratorium due to exchange transfer and currency inconvertibility;
• Non delivery/shipment of goods;
• Calling of on-demand bid or contract bonds and guarantees for unfair or political reasons;
• Forced abandonment or divestiture;
• Non-payment by government and/or government owned entities of trade related debt to financial institutions.

Macro-level political risk

Macro-level political risk looks at non-project specific risks. Macro political risks affect all participants in a given country. 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. Macro political risks also affect the organizations operating in the nations and the result of macro level political risks are like confiscation, causing the seize of the businesses’ property.

Research has shown that macro-level indicators can be quantified and modelled 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. Other companies which offer publications on macro-level political risk include Economist Intelligence Unit, DaMina Advisors and The PRS Group, Inc. DaMina Advisors is focused on frontier markets such as Africa.

Micro-level political risk

Micro-level political risks are project-specific risks. In addition to the macro political risks, companies have to pay attention to the industry and relative contribution of their firms to the local economy. An examination of these types of political risks might look at how the local political climate in a given region may affect a business endeavor. Micropolitical risks are more in the favour of local businesses rather than international organizations operating in the nation. This type of risk process includes the project-specific government review Committee on Foreign Investment in the United States (CFIUS), 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 U.S. 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 United States 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 U.S. 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 affect 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.

Managing Political risk

Although there are a number of ways to protect a company against political risks, proper planning and due diligence are most important. Too many businesses begin operations in an unfamiliar country without having taken the time and devoted the resources necessary to ensure a better-than-average chance of success. Developing solid relations with relevant governing authorities is the preferred approach, but this may not always be possible or even desirable.

Another important component of creating a political-risk-friendly investment environment is to establish a good relationship with a workforce. Too often, foreign businesses are perceived as having uncaring managers who do not appreciate their workers. This can have dire consequences. One of the best ways to protect your assets is to generate a loyal workforce. Management can be replaced much more easily than can a workforce, and it is becoming more common for host governments to remove corporate managers and replace them with other experienced managers that will operate in accordance with government objectives.

Companies should consider the following to better manage political risk:

• Insurance as one option;
• Avoid political risk with control procedures;
• Deal with risks on an ongoing basis;
• Understand macro and a micro political risk environment;
• Diversify Political risks.

Political risk analysis

Political risk analysis, in risk management, is the analysis of the probability that political decisions, events, or conditions will significantly affect the profitability of a business or the expected value of a given business decision. A wide spectrum of political risks may affect business, and political risk analysts use both qualitative and quantitative methodologies to analyze and assess such risks.

Although political risk analysis has a long history, a series of international crises in the 1970s prompted its development into an institutionalized business practice. They included the 1973 oil embargo by OPEC (the Organization of the Petroleum Exporting Countries) and the Nicaraguan and Iranian revolutions of 1978–79. Academic research on political risk analysis also emerged in earnest in the 1970s and ’80s.

Political risk analysts identify political risks and their variables, assess their significance and the relationships between them, and make recommendations regarding the management and mitigation of political risks. Social science research and nonacademic interpretations of current affairs influence all three phases—namely, the analysis, assessment, and management of political risk.

Although political risk analysis could apply to the domestic activities of a business, in practice it usually comes into play when a business is considering activities in other countries. In the academic literature, the focus is generally placed on foreign direct investment (FDI) rather than on relatively passive portfolio investment. The exposure of assets or personnel in FDI reinforces the relevance of political risk analysis. However, political risk can also affect the expected profits and market stakes of exporters, contractors, and licensors.

Sources of Political risk

Several sometimes overlapping government functions can have an impact on business. In many industrialized countries, government’s role as a regulator is especially extensive, resulting in legislation related to the environment, health and safety, employment, trade unions, and consumers. A government can also serve as a restrictor of business activity (tariffs and trade quotas), a redistributor of business income (taxation and social welfare policies), a customer (procurement), and a sponsor (subsidies and other corporate welfare).

Some scholars have argued that political risk analysis displays an inherent bias, according to which any government intervention in the economy is negative. It is in any case meaningful to locate the particular relationships between multinational business and national governments or other political actors when assessing the actual political risk. The particular cultural and historical context may also influence political risk—for example, in cases in which energy or mineral companies are associated with earlier colonial projects in Africa or the Middle East.

The most familiar relationship between business and political authorities is a cooperative arrangement, in which negotiations are ongoing and a normal part of operations. A second kind of relationship is collaborative, consisting of privately owned companies with a strong governmental presence or joint ventures between private businesses and public-sector companies.

An authoritative relationship exists when a multinational corporation and a government are at loggerheads. In most cases, a government can impose new rules, which may result in divestment by the company. Two other relationships are far less frequent. A home government may use a multinational company to promote its political objectives. Alternatively, in the case of subversion, a multinational company may actively work to undermine a host government, sometimes with the covert encouragement of the company’s home government. In the latter two cases, the conduct of business can also constitute a source of political risk.

Risks to business in a country may ensue not only from actions by the government in that country but also from actions by governments in other countries. Opposition groups and other domestic stakeholders and the particular political circumstances in a country may also become linked to political risk. In some countries, owing to the power or authority of informal networks linked to the government, such groups, rather than the government itself, may be the main source of political risk to a particular business.

Types of Political risk

Political risk may vary at different business levels—that is, for all foreign business actors, for a particular industry or company, or for a particular project. Political risk also depends on the type of investment, its methods of financing, its location, and the time frame involved. Political risk may affect several aspects of a business, including personnel, assets, contracts, operations, transfers, and company goals.

Risks to personnel and operations may include intimidation, kidnapping, sabotage, and terrorism, especially if the risks arise from political concerns. However, some risks may ensue from nonpolitical actors and constitute a general security risk only, requiring a distinct set of preventive measures and responses. Asset risks may include general nationalization and specific expropriation, restrictions on ownership, and an insistence on locally owned shareholdings or local directorships. Contractual risks may include changes in contractual conditions due to legislative or bureaucratic action and the violation or termination of contracts due to violence or political change, including revolution, civil war, secession, interstate war, coup d’état, or peaceful succession.

Risks to operations constitute a broad category and include all host country regulations that affect business operations. They may include labour relations, taxation, restrictions on labour or technology transfers, and local product content regulations. Some other examples are quotas and tariffs, environmental and consumer protection, antitrust and merger laws, discrimination in awarding contracts, and bureaucratic nepotism. Transfer risks could include exchange controls, profit repatriation, and restrictions on royalty payments. Local variations of these risks are possible in countries where the regional authority of an area is at loggerheads with the central government or where a local power broker is the actual authority on the ground.

Methodology of analysis

Some multinational corporations have in-house analysts, while others at least partially outsource the task of analysis to specialist providers. A company’s need for political risk analysis may differ at different times. The perceived need for political risk analysis tends to be greater near a decision to enter or avoid a particular country’s marketplace, but different forms of political risk analysis are also used as a regular form of early warning, to periodically review in-country operations, or sporadically in response to new uncertainties or setbacks.

Analysts use both quantitative and qualitative models for analysis, and there is no consensus on the methodology. A model is an extended representation that is used to better understand, adapt to, manage, and control identified political risk factors. The number and nature of variables, their combinations, and the weights assigned to them by the model builders are based on the interpretative frameworks used by political risk analysts.

Quantitative assessment models purport to assess various indices, such as political stability, based on nominal, ordinal, or interval variables. Some models have been designed for particular sectors—for example, the financial or energy sector—and most models also include an element of qualitative judgment.

The main qualitative techniques are judgmental forecasting—for example, the so-called Delphi method, which is the accumulation of expert opinion under controlled conditions. Informal brainstorming between experts is also used, especially when time is of the essence. A more systematic model may be used to identify key assumptions and key drivers and then to construct several alternative futures within different time frames and to estimate the likelihood of different outcomes and their impact on particular business concerns. Political risk analysis aims to provide insight into areas of the political process in which a business needs to intervene if it wants to change the business environment, mitigate its potential risks, or maximize its opportunities.