What is Political Risk?
The term “political risk” refers to the type of risk that corporations, investors, and governments face due to various political events, decisions or conditions that eventually result in a significant impact on the profitability of the businesses. Political risk also adversely im act the expected value of any particular economic activity. However, if understood properly then these risks can be managed with reasonable foresight and well-planned investment.
Explanation of Political Risk
The political risks can potentially drag down the investment returns of businesses or even result in complete loss of the capital employed in the businesses. It is not an easy task to quantify risks as in most cases there will be limited case studies or sample sizes needed to comprehensively understand the issue of an individual nation. As such, various international agencies or other similar government bodies offer insurances against some of these political risks.
How to Manage Political Risk?
In order to manage any political risk, it is very important to understand the underlying risks and then decide whether the risks are worth taking or not. Usually, corporations or investors retain a certain portion of the risks and hedge the remaining in order to maintain a diversified portfolio so that their overall investments are not affected by any specific political event. The investors manage the risks by hedging their investments against issues that may take place in the future. For instance, if the investors can sense political unrest in Nigeria then they might decide to purchase put options for the equity investment there. A well-planned hedging strategy can reduce the quantum of losses significantly either by limiting the loss or creating gains elsewhere to compensate for the fall to some extent.
Examples of Political Risk
Now, let us look at some of the real-life examples and how they were skillfully managed by the companies.
In the year 2004, various environmental groups within Brazil gathered to stage large scale protests against the consortium of foreign companies, headed by the US-owned Alcoa, who were planning to set-up a hydroelectric power plant in Brazil. In order to control the protests, the consortium decided to invest more money to compensate the people who were getting relocated and to mitigate the expected environmental damages.
The local people in the oil-rich region of Niger Delta (Nigeria) often launch attacks on the company compounds. They frequently abduct the foreign oil workers and then demand that a larger portion of the oil revenue generated from the region should be spent on that very region. In order to manage the risks, the oil companies operating in this region usually hire security firms to protect workers as well as spend on local welfare, such as building schools & hospitals and creation of jobs for locals.
Types of Political Risk
This can be classified into major types – macro-level risk and micro-level risk.
Macro-Level Risk: These risks have an effect on all the participants in a given nation. Some of the common types of macro-level risks include regulatory changes, currency actions, endemic corruption, sovereign credit default, declaration of war, and changes in the composition of the ruling party. These events hinder portfolio investments as well as foreign direct investment risks, which can potentially change the business suitability of any given region.
Micro-Level Risk: Besides macro-level risks, the companies also need to pay attention to the risks at the industry-level and evaluate their contributions to the local economy. Typically, the micro-level risks arise when the local governments are more in the favor of the local businesses than that of the international organizations that operate there. Some of the common types of micro-level risks include project-specific government stance, nationalization of projects, and assets.
Sources of Political Risk
In most industrialized nations, the government primarily acts as a regulator and facilitator for issues related to the environment, employment health & safety, consumers, etc. But in some cases, the government restrict business activities through the imposition of higher tariffs, trade quotas, higher corporate taxes, etc. Some scholars believe that government intervention of any kind is one of the major sources of political risk as it often results in a negative impact on the economy. Further, opposition political parties along with other domestic stakeholders can also be linked to various risks.
Causes of Political Risk
Although there can be several causes for political risk, some of the main indicators that corporations and investors to look out for are as follows:
- A new trade agreement that affects the overall nation
- The steep increase in the unemployment rate resulting in civil unrest
- Rise of a new political party or an existing party gaining more power
Political Risk Factors
Some of the major factors contributing are as follows:
- Ideology: Any change in the ideology of the ruling party results in a significant political and economic change in that country.
- Nationalism: It is an idiosyncrasy that is primarily witnessed among the local participants of the developing nations and as times it gives way to political unrest.
- Stability: The political stability of any nation is largely dependent on cultural diversity (in terms of language, race, and religion) and its acceptance among the people of the nation.
- International Relations: The sweetness in the relationship between different countries can be instrumental or detrimental for ease of doing business in a given country.
Importance of Political Risk
Typically, political risk directly impact the operations of the businesses and in turn their profitability. Moreover, the effect of political risk is usually long-term in nature and it increases over a period of time. As such, businesses and investors should evaluate and understand the potential of the political risks by scrutinizing national history, political establishments, and various political forces operating in the region.
So, it can be seen that political risk is an important aspect of international businesses. Although many companies face the brunt of political risk, some businesses get unique benefits out of it if the ruling government intend to improve the country’s economic situation through infrastructure building and job creation.
This is a guide to Political Risk. Here we also discuss the introduction and how to manage political risk? along with types and examples. You may also have a look at the following articles to learn more –