Political risk is a type of
riskRisk is a concept that denotes the precise probability of specific eventualities. Technically, the notion of risk is independent from the notion of value and, as such, eventualities may have both beneficial and adverse consequences...
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.” .
Political risk is a type of
riskRisk is a concept that denotes the precise probability of specific eventualities. Technically, the notion of risk is independent from the notion of value and, as such, eventualities may have both beneficial and adverse consequences...
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.” . 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 (
terrorismTerrorism is the systematic use of terror especially as a means of coercion.At present, there is no internationally agreed definition of 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.
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 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.
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.
Research has shown that macro-level indicators can be quantified and modeled like other types of risk. For example,
Eurasia Group-Overview:Eurasia Group has offices in New York, Washington, London, and Tokyo; with about 100 full-time employees. The company also employs a network of 480 experts in 65 countries in Asia, Latin America, Europe & Eurasia, and Middle East & Africa--a profile The Economist magazine calls "an...
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 EconomistThe Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in an office in the City of Westminster, London. Continuous publication began under founder James Wilson in September 1843. While The Economist calls itself a...
. Other companies which offer publications on macro-level political risk include Business Monitor International,
Exclusive AnalysisExclusive Analysis is a specialist intelligence company that forecasts political and violent risks, drawing on a privileged global source network to provide objective, actionable, commercially relevant and forward-looking analysis for its clients....
,
Economist Intelligence UnitThe Economist Intelligence Unit is part of the Economist Group.It is a research and advisory company providing country, industry and management analysis worldwide and incorporates the former Business International Corporation, a U.S. company acquired by the parent organization in 1986...
, and Political Risk Services.
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 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 StatesThe United States of America is a federal constitutional republic comprising fifty states and a federal district...
), 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 WorldDP World is a subsidiary of Dubai World, a holding company owned by the government of Dubai in the United Arab Emirates.In March 2006, it purchased the Peninsular and Oriental Steam Navigation Company of the United Kingdom, which was then the fourth largest ports operator in the world, for £3.9...
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 OfficerThe chief risk officer or chief risk management officer of a corporation is the executive accountable for enabling the efficient and effective governance of significant risks, and related opportunities, to a business and its various segments. Risks are commonly categorized as strategic,...
who is charged with managing political risk or, in many cases, this job falls to the
Chief Financial OfficerThe chief financial officer is a corporate officer primarily responsible for managing the financial risks of the corporation. This officer is also responsible for financial planning and record-keeping, as well as financial reporting to higher management. In some sectors the CFO is also...
.
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.
At the micro-level, political risk insurance and hedges play a larger role. MIGA and OPIC, both public sector insurers, provide project-specific political risk insurance while private market insurers can provide cover for projects as well as a portfolio of investments. 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 insurancePolitical risk insurance is a type of insurance that can be taken out by businesses, of any size, against political risk—the risk that revolution or other political conditions will result in a loss....
, 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 be expensive and are manuscripted after extensive negotiations. An experienced and specialist broker can assess the availability of appropriate cover from private and public insurers and then, based on their experience and expertise, negotiate appropriate policies. 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.