Political Risk.

Political Risk
It is the risk that political decisions or events in a country negatively affect the profitability or sustainability of an investment. Political risk is the chance that political decisions, events or conditions in a country will affect the business environment in ways that may adversely affect the business of MNEs.

• Political risk matters most to any MNE in the world.
• When companies choose among the 200 countries, they consider political risk to be very important.
• The lower the political risk, the better the business opportunity and in turn higher the country attractiveness.

Causes of Political Risk

1. Govt. Actions.
2. Civil Strife/Unrest/Disorder.
3. International War.
4. Harmful actions against people.
5. Change in political ideology

1. Govt Actions

Govt. action can change the country's attractiveness. Governments can put restrictions to the sectors in which business can be done.

Govt puts many acts to impose restrictions on the sectors like FERA and MRTP Act.

FERA Act (Foreign Exchange Regulation Act)-1973

An act to consolidate and amend the law regulating certain payments, dealings in foreign exchange and securities, transactions indirectly affecting foreign exchange and the import and export of currency, for the conservation of the foreign exchange resources of the country and the proper utilisation theory in the interests of the economic development of the country.

MRTP (Monopolistic and Restrictive Trade Practices Act)-1969

MRTP was enacted

• To ensure that the operation of the economic system does not result in the concentration of economic power in hands of few.
• To provide for the control of monopolies.
• To prohibit monopolistic and restrictive trade.

2. Civil Strife/Unrest/Disorder

• It Could be due to economic unrest.
• People unrest can also happen because people are unhappy with the present govt.
• It affects company’s operations and profits.
• It can lead to damage of company’s property.
• Eg: French Revolution

3. International War

• Damages or destroys the company’s local assets.
• Eg. When Iraq invaded Kuwait, there were many MNEs by virtue of management contracts. Many Indian companies were also operating.
• MNEs are bound to leave the country during war.

4. Harmful actions against people

• Injurious actions that target the local staff of the company; often involves kidnapping, extortion and terrorism.
• Generally seen in lesser developed countries.

5. Change in Political Ideology

• Political ideology can change with the change in political government.
• Every government has a different perception about the MNEs.
• In case of Monarchy, like saudi arabia,when a new prince comes in , chances are there will be changes in political environement.

Impact of Political Risk

1. Expropriation or Nationalization.
2. Disruption of property.
3. Unilateral breach of contract.
4. Restrictions on repatriation of profit.
5. Differing points of view.
6. Discriminatory taxation policies.

1. Expropriation or Nationalization

• A govt or political faction unilaterally takes ownership of the company’s local assets. Compensation to the company, if at all forthcoming is generally a trivial percent of the asset’s value. This event was common in the 1960s and 1970, but is rare today. However in any event the losses are immense.
• Sometimes the company’s assets are taken over by the host country with or without adequate compensation. It is generally a hostile takeover, a mandate and not a choice which is given to the company. It generally happens in developing countries for natural resources like oil, diamond when the host country feels that there is no value addition.
• Eg. Cuba, Chile, Venezuela, Uganda, Zambia, Uthopia, Iran

2. Disruption of property

• Kidnapping, thefts occur.
• Strikes happen resulting loss of profit (opportunity loss) in addition to property getting damaged.

3. Unilateral breach of contract

• Decision of a government to repudiate the original contract that it had negotiated with the foreign company. The revision penalizes the firm and rewards the nation by reallocating the profits of the local operations.
• In addition this extends to government approval of a local company’s choice to breach its contracts with its foreign partner.
• In some countries the new govt might not honour the previous management contracts / leases.

4. Restrictions on repatriation of profit

The govt arbitrarily set limits on the gross amount of profits a foreign company can remit from its local operation.

5.Differing points of view

Differing interpretation of labour rights and environmental obligations create backlash problems in the foreign company’s home market.

6. Discriminatory taxation policies

A foreign company bears a higher tax burden than the local firm, or in some cases, the more favoured foreign company, due to its nationality.

How to access political risk

Managers use 3 approaches to predict political risk :

1. Analyzing past trends.
2. Taking expert opinion.
3. Examining the social and economic conditions that might lead to such political risk

1. Analyzing past trends

Companies cannot help but get influenced by past patterns of political risk. Management can make predictions based on past patterns. Predicting risk using past trends holds many dangers. However political situations may change rapidly for better or worse as far as foreign companies are concerned.
Examples :

• FDI into US fell sharply after 2001 terrorist attack in NY because foreign firms saw the US as less safe than before.
• Expropriation of property occurred frequently in the 1970s and early 1980s, but it has been less important in recent years.
• In Pakistan, initially democracy ruled and then dictatorship where as in India it has always been democratic in spite of change in governments.

2. Expert Opinions

Companies may rely on experts’ opinion about a country’s political situation, with the purpose of ascertaining how influential people may sway future political events affecting business.

Companies read the statements made by political leaders both in and out of office to determine their philosophies on business in general, foreign input to business, the means of affecting economic changes and their feelings toward given foreign countries. Managers visit the country and listen to a cross section of opinions. Embassy officials and foreign and local business people are useful sources of opinions about the probability and direction of change.. Journalists, academicians, middle level local govt authorities and labor leaders usually reveal their own attitudes, which often reflect changing political conditions that may affect the business sector. Companies may determine opinions more systematically by relying on analysts with experience in a country. These analysts might rate a country on specific political conditions that could lead to problems for foreign businesses. A company also may rely on commercial risk assessment services, such as those published by Business International, Economist Intelligence Unit, Euro money.

In this method companies should examine views of govt decision makers and then get a cross-section of opinions and use expert analysts.

3. Economic and Social Perspective (Semantec Technique)

There are two economic parameters i.e. aspiration level and achievement level. Aspiration level of people spreads with education, TV, Internet where as the achievement level increases with income level. Differences in aspiration level and achievement level leads to frustration. If disparity between the two is very high year after year, then the frustration level increases. Higher the frustration level, higher the political risk in terms of unrest.Companies may examine country’s social and economic conditions that could lead to the peoples’ level of aspirations and the country’s level of welfare and expectations. If there is a great deal of frustration in a country, groups may disrupt business by calling general strikes and destroying property and supply lines.

Types of Political Risk

There are four types of political risk

1. Systemic.
2. Procedural
3. Distributive
4. Catastrophic

1. Systemic Political Risk

These kinds of risks are inherent in system. Domestic and International companies face political risks created by shifts in public policy or change in political ideology. These regulations alter the business system for all companies, so not necessarily meant for only foreign companies. Then again, a government may target its public policy initiatives toward a specific economic sector that it believes foreign companies unduly dominate. Systemic changes do not necessarily create political risks that reduce potential profits.
Eg. In 1990, newly elected Argentina govt. began a radical program of deregulation and privatization of the state centred economy.

2. Procedural political risk

Companies procure from best sources from different countries to have comparative advantage. Globally competent supply chain is required from most competitive/best sources. The three main objectives of supply chain are

• Lowest cost.
• Shortest time.
• Quality and reliability.

Normally supply chain is never short term until there is a war situation. As we get raw materials from across the world, it has to cross borders, so the company faces different levels of risk. Some countries are more corrupt and the company faces many hurdles. The risks are higher in less developed countries. Every day people, products and funds move to different locations in the global market. Each move creates a procedural transaction between units, whether within a company or country. Political actions sometimes create frictions that interfere with these transactions. Government corruption, labour disputes and a partisan judicial system can significantly raise the cost of getting things done. Corruption among custom officials can push a foreign firm to agree to pay for special assistance, if it wants to clear goods through customs.

3. Distributive Political Risk

MNE and host country cannot do without each other. MNE is doing a business in host country and thus generating employment. But if the host country feels that the MNE is capable of doing much more than at present and mostly much of it is going currently to other countries then host country wants to have a larger share from the MNEs economic gain for its own people and their economic growth. Thus taxation changes can come in.
Many countries see foreign investors as agents of prosperity. As foreign investors achieve greater success, some countries question the distributive justice of the rewards, wondering whether they are getting their fair share. Countries then aim to claim a greater share of rewards but in ways that do not provoke the company to leave. They do so by revising their tax codes, regulatory structure and monetary policy to capture greater benefits from foreign companies.
Eg. US has highest degree of political risk in world of cigarette companies on matters of taxation, regulation, business practice and liability.

4. Catastrophic Political Risk

These types of risks arise from flash points like ethnic discord, civil disorder or war. Those random political developments adversely affect the operations of all companies in a country. While uncommon, their impact disrupts the business environment for all firms.

Role of Government

• Interest Articulation: Understand the interests of all stakeholders.
• Interest Aggregation: Putting it all together in the form of budget. Prior to budget government talks in a structured form to various groups.
• Policy Making : Legislature.
• Implementation+Adjudication :
• Should look forward for the economic cooperation of other countries.
• Should look for groups which the country joins. A company which has more membership internationally, is more transparent and predictable about its policies.
• should look for the proper functioning of foreign companies, local companies and small scale industries.

A country’s political environment has enormous implications to managers and companies. A political system is the complete set of institutions, political organizations, interest groups, the relationships between those institutions and the political norms and rules that govern their functions. The purpose of a political system must agree, is that it integrates different groups into a functioning, self sustaining and self governing society. Ultimate test of a political system is its ability to unite a society in the face of divisive pressures of competing ideas and outlooks.