How important is managing political risk in the international business context?
ABSTRACT
How important is managing political risk in the international business context? Due to the global context in which business is conducted today, political risk along with financial and economical risk is relevant in any decision making of starting a business or investing overseas. However I will focus mainly in political risk by identifying the ideas and major key points that literature has. Next I will analyse and compare the key issues found in the literature according to the idea of managing political risk and finally I will concluded by explaining the diverse forms of managing political risk according to the type of investment or entrepreneurship.
INTRODUCTION
Political Risk is undoubtedly one of the key factors analyse by any company when starting business or investing overseas and jointly with economic and financial risk it creates what is known as country risk. "Country risk analysis rests on the fundamental premise that growing imbalances in economic, social, or political factors increase the risk of a shortfall in the expected return on an investment. Imbalances in a specific risk factor map to one or more risk categories." (Meldrum, 2000.) One of the risk categories is: political risk that "refers to the possibility that political decisions or events in a country will affect the business climate in such a way that investors will lose money or not make as much money as they expected when the investment was made." (Howell. 1992)
Managing political risk and all the factors that can 'affect the business climate' (Howell, 1994); is one the key factors that must face managers when predicting or trying to anticipate political risk in any country. Due to the nature of the investment, political risk analysis considers several factors and conducts the analysis depending on the main objective or goal of the entrepreneurship. In the study literature we will find some similarities and differences that will help us understand the concept of managing political risk.
LITERATURE REVIEW and PERSONAL CRITIQUE
Understanding Political Risk is something that due to the importance of emerging markets in the world and the allure of globalisation has made the analysis and assessment of country risk a critical component of valuation in recent years.
In the 1960's and later in the 1970's the world and its way of governance were changing from colonial systems to democratic and independent establishments; the appearances of innovative ways of governance were new in the international context. The permanent clash of western ideals, the post-war era (WWI and WWII), the constant shadow of a cold war, and the turmoils of new economic forces that started to guide country decisions; show that political risk management to investors was underlying and should be taken seriously. A chain of events such as expropriation, confiscation and nationalisation became major concerns to investing companies in developing countries around the world.
"We have moved from a system where western powers, though often democratic at home, were authoritarian and hierarchical in their systems of rule as applied in the developing world. While some new states adopted this style of governance, others chose to depart from it explicitly. To escape from that rigid and elite-centric system, newly independent countries often fell back on support from other governments in the Communist and Socialist worlds. Relying on the ideology of those systems, these new governments often developed political processes that, in representing entire populations, propagated a system in which property governments for the population held ownership, especially of major industries. In order to get from the colonial to the socialist structure, these governments often expropriated and directly interfered with businesses operating within their borders". (Howell, 1994)
Later between the 1980's and 1990's with the decay of the Soviet Union and communism, the consolidation of the European Union, and the hegemony of western ideals such as privatisation and liberalisation represented by the United States, a new globalise economy started and despite the less involvement of the government in the economic forces, the relation between politics and business has created a high impact that must not be underestimated.
According to the literature, by political issues that can involve risk we can understand: "Political means having to do with: a) the governance system of a
country (political structure); b) the nature of particular governors (authority); c) the response of the population to the government (legitimacy); and d) the nature of the society being governed (culture, social phenomena)." (Howell, 1994). There are different ways of analysing the assessment of the mentioned factors by Howell, other authors, companies, private institutions and government organisations. However analysts have found it is not always easy to measure political risk and standardised it. Different interpretations of the context analysis of a country arise and derived on many conclusions. Duncan Meldrum describes that difficulty within interpretations of political risk, "Unfortunately, no comprehensive country risk theory exists to guide the mapping process. In practice, most country-risk services create risk measures using an eclectic mix of economic or socio-political indicators based on selection criteria arising from their analysts' experiences and judgment. The services usually combine a variety of factors representing actual and potential imbalances into a comprehensive risk assessment that applies to a broad investment category" (Meldrum, 2000). Perhaps one of the most commented articles on this matter, on how to measure and what factors must be included when analysing political risk appeared in The Economist 1986 'Countries in Trouble' in which they considered the following variables as key factors when determining the political situation of a country for investors, they also gave to them a maximum negative numerical value.
Key Points
Negative Points
)
Bad Neighbouring
3
2)
Authoritarianism
7
3)
Staleness
5
4)
Illegitimacy
9
5)
Generals in Power
6
6)
Strife/Warfare
20
7)
Urbanisation
3
8)
Islamic Fundamentalism
4
9)
Corruption
6
0)
Ethnic Confrontation
4
TOTAL POINTS
67
(The Economist)
The 10 points that The Economist brought to analyse political risk have been related and compared with other studies ...
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Key Points
Negative Points
)
Bad Neighbouring
3
2)
Authoritarianism
7
3)
Staleness
5
4)
Illegitimacy
9
5)
Generals in Power
6
6)
Strife/Warfare
20
7)
Urbanisation
3
8)
Islamic Fundamentalism
4
9)
Corruption
6
0)
Ethnic Confrontation
4
TOTAL POINTS
67
(The Economist)
The 10 points that The Economist brought to analyse political risk have been related and compared with other studies of government and independent that started their own analysis and studies; firms such as Bank of America World Information Services, Business Environment Risk Intelligence (BERI), Control Risks Information Services (CRIS), Economist Intelligence Unit, Euromoney, Standard & Poor's Rating Group, Political Risk Services' Coplin-O'Leary Rating System (PRS), and Moody's Investor Services.
Political Risk Services' Coplin-O'Leary Rating System (PRS), and Business Environment Risk Intelligence (BERI) created other measuring systems that cover other factors than the ones described in The Economist, however we must clearly understand The Economist was among the first to review a measuring system and others followed their guidelines. When having a look to each of the 10 points review by The Economist we must try to understand the context and what each one of them means.
The Economist Model
) Bad Neighbouring: It implies that despite domestic efforts to build a well structure and independent internal policy, the country is submerged into a region or area that undeniably will interact and external decisions from its neighbours will be influential. "Location or Neighbourhood Risk includes spill over effects caused by problems in a region, in a country's trading partner, or in countries with similar perceived characteristics" (Meldrum, 2000).
2) Authoritarianism: It could also be totalitarian regimes, and is a very important key point when understanding political risk. The counterpart of any authoritarian regime is a democracy, where a majority elects governing leaders. By this I am trying to also relate point number 4) which is Illegitimacy in which a vast majority of the population accepts the state, on the other hand, the government positions could be democratically elected or could be authoritarian and at the same time they can be legitimate or illegitimate. Controversial? Indeed. When analysing political risk, possible investors can see authoritarianism as a positive fact towards their investment as they would find alliances from the government, but at the same time it is also an uncertainty as any latent risk would be. I must be clear on this, I am not taking a position of considering authoritarianism as an option, and I must say I am against it, however the business morale always finds alliances on all types of systems without taking consideration what kind of establishment it is, and not all the time thy consider it as a risk.
3) Staleness, by this I understand that a government can get out of date, in other words, their governing period may be very long and its commitment for developing programs may possibly decay. This definitely creates an unstable climate when power changes from hands or during a transition period.
5) Generals in Power, again it can be considered a double morale controversy, however I am not going to run into discussing it, instead I will stick to what common sense can understand and has proven that military officers who reach the power in most of the cases not by elections, and their period while governing is considered as a dictatorship depending on the means they use to reach the power. Its legitimacy is not conceived by a vast majority and therefore is also a key issue when discussing political risk.
6) Strife and Warfare. War is undoubtedly what causes a great impact in political risk analysis and I would describe it as the ultimate or final expression of many negative problems within a country. By this, it is comprehensible that war causes instability and any attempt of investment is subject to the conflict, how long will it last, its origins etc., and for sure it will bring completely uncertainty.
7) Urbanisation is one of the aspects that I would understand as the concentration of people in cities, and by that, all the kind of problems that appear by a rapid and uncontrolled urbanisation. Indeed it can be a controversial factor when analysing political risk, but it sure can be explain in a different context because underneath the title of urbanisation what they are try to explain is a whole different problem derived from the concentration of people and that can obey, or would fit more to a social issue which within the patterns of political risk can be considered a problematic factor.
8) Islamic Fundamentalism: the way I understand Islamic Fundamentalism under political risk analysis is that they are considered to be an important matter based on the way they can affect internal affairs of a country. However, this must be looked under the perspective that any religion that enables its followers to act under a fanatic premise in internal affairs can be considered as a threat due to the way its participation may possibly affect any political and state decision. In other words it is not only Islam, it could be any religion depending on their degree of interaction with government and politics.
9) Corruption, the way I understand it, it is something that can be present in all types of organisations. Decisions are always influenced on the search of the proper scheme, but since political decisions are no longer political, but more business or money decisions, or made of link of multiple factors that will incline any decision towards the economic benefit of the involved parties, corruption can be considered as major problem and its degree varies depending of maturity of and commitment of nations.
0) Ethnic Confrontation; I understand by ethnic confrontation within political risk analysis a confrontation between races in which culture and religion are also involved that can threaten and create an unstable climate for investors.
In response to the Key Points exposed by The Economist we have the Coplin- O'Leary model used by Political Risk Services and the BERI Model from Business Environmental Risk Information that can give a more detailed review on how to measure political risk through other and sometimes similar factors. First of all they all approached the analysis of the factors from a social and political perspective even though the Coplin-O'Leary Rating System, Political Risk Services (PRS) focuses on 'projections of most likely regime, level of turmoil, transfer risk (currency convertibility), investment risk (restrictions on equity ownership), and export risk (risk to exporters to the country)' (Coplin-O'Leary) and examines direct government and economic functions which makes a difference with The Economist and BERI models. Taking The Economist model we can see that within the factors of the other models they are some similarities that can be understood and follow the same pattern of the ones exposed by The Economist.
Key Points
Positive Points
)
Internal Causes
Fractionalisation of the political spectrum and the power of these factions
Fractionalisation by language, ethnic and/or religious groups and the power of these factions
Restrictive (coercive) measures
required to retain power
Mentality, including xenophobia, nationalism, corruption, nepotism, willingness to compromise
Social conditions including population
density and wealth distribution
Organization and strength of forces for a radical left government
7
7
7
7
7
7
2)
External Causes
Dependence on and/or importance to
a hostile major power
Negative influences of regional
political forces
Societal conflict involving demonstrations, strikes, and street violence
Instability as perceived by non-constitutional changes, assassinations, and guerrilla wars
7
7
7
7
TOTAL POINTS
70
Business Environmental Risk Information (BERI) Model
With the BERI model the similarities and differences with one presented by The Economist.
* Fractionalisation by language, ethnic and/or religious groups and the power of these factions, when compared with The Economist; it is parallel with Ethnic Confrontation.
* Fractionalisation of the political spectrum and the power of these factions, there would not be any variable in The Economist that represents "It represents divisions among political perspectives in the society."(Howell 1994)
* Restrictive (coercive) measures required to retain power, is Authoritarianism in The Economist.
* Mentality, including xenophobia, nationalism, corruption, nepotism, willingness to compromise, it is factors that intends to cover some but not all of the variable that can be found in The Economist model.
* Social conditions including population density and wealth distribution, Urbanisation from The Economist model also tries to explain the concentration of people in cities.
* Organization and strength of forces for a radical left government, obeys to the still left movements enforced by guerrillas that want to reach the power.
* Dependence on and/or importance to a hostile major power, Bad Neighbouring from The Economist, although I explained it as seen as region or area problem.
* Negative influences of regional political forces Bad Neighbouring from The Economist fits more to this variable from the BERI Model.
* The Economist Strife/Warfare can encompass societal conflict involving demonstrations, strikes, and street violence.
* Instability as perceived by non-constitutional changes, assassinations, and guerrilla wars does not have a common variable in The Economist model but can also be encompassed Strife/Warfare.
On the other hand, with the Coplin-O'Leary Rating System, Political Risk Services (PRS) we can clearly see the way they have put themselves to analyse a direct impact on government decisions or legislation that can affect foreign direct investment FDI. Even though, as mentioned previously within the context of political risk analysis all implicitly consider the social aspect as one of the key issue to be analyse, the Coplin-O'Leary goes beyond this, by reviewing what might be considered as internal laws, its possible changes and consequences for FDI. It focuses on government action and differentiates its analysis depending on the sector. For Direct Investment Risk it considers labour cost expansion, exchange controls, repatriation restrictions and policy, taxation discrimination, equity restrictions and political turmoil. In Financial Service Risk, it reviews exchange controls, monetary expansion, and borrowing liability. For the Export Sector Risk, it considers political turmoil, exchange controls, tariffs, non-tariffs, and international borrowings.
Key Points
Positive Points
)
Political Turmoil Probability
0
2)
Equity Restrictions
0
3)
Personnel/Procurement Interference
0
4)
Taxation Discrimination
0
5)
Repatriation Restrictions
0
6)
Exchange Control
0
7)
Tariff Imposition
0
8)
Non-Tariff Barrier Imposition
0
9)
Payment Delays
0
0)
Fiscal Monetary Expansion
0
1)
Labour Cost Expansion
0
2)
International Borrowing Liability
0
TOTAL POINTS
20
Coplin-O'Leary Rating System, Political Risk Services (PRS)
When comparing all three models we see that they all review and consider several and in some cases different and/or similar political risk factors, they also give the tools to cover the most accurate prediction and possible scenarios, however not all analysis are 100% reliable, but they will indeed give the information for a making decisions on how to manage political risk. "That is, political risk analysis does not result in a prediction. It has as its product a forecast. The difference is that there are elements to the analytical process that prevent the projection of specific events. The projection is that given a history, usually or "there is a high probability that" history will repeat itself. Or given a set of circumstances, an outcome has a high probability of following." (Howell, 1994)
CONCLUSION
"The relatively small number of expropriations in the past 20 years or so might suggest that political risk is a thing of the past. Some would argue, in fact, that the trend towards globalization has made it extremely unlikely that a host government in a developing country would expropriate a foreign investor's assets. After all, the argument goes; these governments lack the resources (both capital and know-how) necessary to achieve the kind of sustainable growth that the developed world has long enjoyed". (Wilkin, Minor, 2001) Organizations through out the world face the uncertainty of how to manage political risk, what was consider as threat thirty years ago, is no longer. A new approach has been made, and globalisation indeed has to do with the political risk analysis of the past years. The variables consider by The Economist in 1986, the Coplin-O'Leary Rating System, Political Risk Services (PRS), and the Business Environmental Risk Information (BERI) Model are all valuable and serious attempts to measure political risk; however the context in which they were developed must be adjusted to the new exposures of globalisation. Investors and entrepreneurships don't want to loose money, businesses are every day more global, and political risk is facing an analysis under a financial perspective. Companies that need to manage political risk are considering all the possible variables and once they have reach an evaluation decisions are being taken. It is well known that the higher the risk, the higher the returns, however you must be prepared and that is what managing risk is all about. Overseas Private Investment Corporation (OPIC) and Multilateral Investment Guarantee Agency are two of the many organisations and insurance agencies that protect and cover related risk claims. "Political risk insurance encompasses a very broad family of related insurance products designed to insure against government acts (or failures to act) that affect a company's normal business operations adversely. Policies are often written to address specific concerns of investors or lenders". (Wilkin, Minor, 2001) However in order to manage political risk there are also some considerations that companies must have jointly with an insurance policy that with will enable the company or the organization to build a better way of constructing a solid structure to prevent uncertainty and risk.
. Contractual undertakings with government: Contracts not always prevent related government decisions, so therefore companies must always look to have flexible contracts or a compensation scheme that benefits both parties involved in order to prevent a lose.
2. Involve local private or public interests: When doing business a joint venture with local interests of the host country will definitely help to prevent any possible hostility since local interests are involved.
3. Community Relations: Informing and letting know the community of social benefits and welfare derived from foreign investment can be the best ally for companies, a social commitment developing roads, schools, medical centres etc, give a positive image of foreign company.
Not all companies face the same political risk and uncertainty has to be measured depending on the sector, decisions on how to manage political risk may vary from country to country and the model or the variables that you consider when evaluating must try to cover all possible scenarios. Contracts, Insurance Policies and the strategies used in Foreign Direct Investment are decisions that managers must considered when trying to mitigate political risk. On a more globalise and open economy world, companies and countries can handle these risks, through risk identification and assessment, and by employing sophisticated risk mitigation and risk transfer techniques, that can be helpful for all parties involved. Developing Countries are still the ones that can offer a major political and establishment instability; however, developed countries can also be a threat to investors where strong protecting policies and any alteration of the status quo can divert investment.
Political Risk is not only a matter of developing countries; it is something that must be analysed and considered on a global context without distinction and its measuring variables must reflect the reality of the moment with all its threats and implications.
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ELECTRONIC REFERENCES
Overseas Private Investment Corporation (OPIC) http://www.opic.gov/
Multilateral Investment Guarantee Agency (MIGA) WORLD BANK http://www.miga.org/
TBS 984 International Business