Political risk management

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,
labor, 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. According to agency theory, corporate decisions are
more likely to reflect the best interests of executives (rather than the best interests of
shareholders) when managers’ interests are less aligned with those of stockholders. Thus,
corporate risk management decisions will reflect an executive’s personal sensitivity to
political risk in firms in which executives indicate that they are less concerned about the
interest of stockholders and in firms managed by younger executives who put their own
career concerns ahead of the interests of shareholders

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 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.

Micro 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

The political risk management policies should be integrated with the current risk management
structure because political risk is often intertwined with other risks such as regulatory or
social risks. The principles of this approach to managing political risk are:

1. Political risk management starts at the top - Top level management should understand
that political risk affects every aspect of their organization. The responsibility for monitoring
political risk should be assigned at both the board and management level. The company’s risk
tolerance level should be communicated across the organization.
Managing political risk directly impacts performance – There are also many other ways
that monitoring political risks can help the organization. For example, it can allow the
company to anticipate leadership changes, influence policy, and participate in social change
as well as monitor the impact of regulatory, social, and economic change. These risks are
especially important for companies with a large capital asset base or those in heavily
regulated industries. For other industry sectors the political risk could have a greater impact
on their supply chain, reputation, and market.

Evaluating political risk optimizes decision making – Management should view political
risks and the other risks that affect it in terms of a portfolio. This method of examining risk
will allow management to see how the risks interact with each other and that political risk can
be both internal and external to the organization. The portfolio view can also help companies
view their political risks globally and determine if risks in different countries offset each
other. This method of diversification can allow managers to see how political risks shift
across the globe and allow them to take advantage of opportunities.

Political risk assessment is today a task of paramount importance for the international
investor. While in the past political risk was often conceptualised in terms of hostile action by
host countries' governments, with the quick pace of globalization its nature and sources
have considerably changed, raising the interest of scholars belonging to different fields, from
international economics to international relations, from empirical political science to
psychology and decision theory. In an era in which global equilibriums have changed and
once clear-cut distinctions such as “developing” vs. “developed” countries have become
blurred, intelligence and risk management have become a major source of concern. The
issue of the relationship between politics and the activity of international investors has
become even more burning in light of the on-going economic and financial crisis, a
crisis whose causes are – at least partially – ascribable to questionable policy choices.

 impact of political risk in business

Business performance is the effort expended by a business firm in achieving its objectives of
customer satisfaction, employee satisfaction, societal satisfaction, and ultimately profitability.
Several studies such as Richard, Devinney, George and Johnson (2009), and Ibeto (2011), have
shown that the effort expended by multinational business managers in achieving their goal in Nigeria
has not been very successful. Richards et al (2009), maintain that the successful performance of
multinational companies depends to a great extent on the political environment of the host country.
According to these scholars, political environment refers to forces and issues emanating from the
political decisions of government, which are capable of altering the expected outcome and value of a
given economic action, by changing the probability of achieving business objectives. Ibeto (2011)
described the political environment as factors arising from changes in government policies and
programmes, which influence the ability of economic entities in achieving their goal.
The multinational business managers in Nigeria operates in a dynamic political environment
characterized by risks of multiple taxation, currency devaluation, inflation, repatriation,
expropriation, confiscation, campaigns against foreign goods, mandatory labour benefit legislation,
kidnapping, terrorism, and civil wars (Griffen, 2005). Actions taken by government such as
regulatory, legal framework, and political changes may decrease business income and acts as
barriers to foreign investment. Although it has been established that the political environment has a
link with business performance, there seems to be inadequate literature and empirical evidence in
Nigeria that relate the political environment to the performance of multinational companies. An
attempt to investigate this relationship and expand the frontier of knowledge in this area of study
led to the hypothesis that political environment has no significant relationship with business
performance of multinational companies in Nigeria

Not only that the political environment poses direct risks to firms, but politics is also component of
other external risks. Ibeto (2011) posit that regulatory changes have the potential to promote or
inhibit market competition, social risks often have political bases and responses, and political
mismanagement can turn natural or human-made events into catastrophes. Moreover, the political
environment is often perceived to be outside of management’s control, making it difficult to define,
predict, and align with objectives. Given the complexity of these issues, it is no wonder that
corporations often fail to address issues of political environment in a systematic way. Multinational
companies are grappling with political issues that sometimes surprise even the most experienced
(Auster & Choo, 1993). For multinational companies, political risk emanating from the political
environment refers to the risk that a host country will make political decisions that will prove to have
adverse effects on the multinational's profits and/or goals. Adverse political actions can range from
very detrimental, such as widespread destruction due to revolution, to those of a more financial
nature, such as the creation of laws that prevent the movement of capital (Griffen, 2005). Generally,
there are two types of political risk, risk and micro risk. Macro risk refers to adverse actions that will
affect all foreign firms, such as expropriation or insurrection, whereas micro risk refers to adverse
actions that will only affect a certain industrial sector or business, such as corruption and prejudicial
actions against companies from foreign countries. Regardless of the type of political risk that a
multinational corporation faces, companies usually will end up losing a lot of money if they are
unprepared for these adverse situations. For example, after Fidel Castro's government took control
of Cuba in 1959, hundreds of millions of dollars ‘worth of American-owned assets and companies
were expropriated. Unfortunately, most, if not all, of these American companies had no recourse for
getting the money back (Andoh, 2007)
According to Walter (2014), the implication of political environment to a business is that the
risk emanating from it 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. More so, there are political risks or events arising from
nongovernmental actions, factors that are outside the government responsibility. There are
wars, revolution, coup d'etat, terrorism, strikes, extortion, and kidnappings (Andoh, 2007).
They all derived from some unstable social situation, with population frustration and
intolerance. All these risks can generate violence, directed towards firms' property and
employees. There may also be the case of externally induced financial constraints and
externally imposed limits on imports or exports, especially in case of embargoes or any
economic sanctions against the host country. Political risks induced by the government
constitute some laws directed against foreign firms. Some government-induced risks are very
drastic. There are expropriation, confiscation and domestication (Auster & Choo, 1993).
According payment of compensation to the owners. In other terms, it is involuntary transfer
of property, with compensation, from a privately owned firm to a host country government.
Expropriation may generate some funds for the owners. However,procedures to get paid from
the government are sometimes protracted and the final amount remains low. Furthermore, if
no compensation is paid, conflicts may erupt between the host country and the country of the
expropriated firm. For instance, the relations between U.S. and Cuba acknowledge such
situation, since Cuba does not offer compensation to U.S. firms that have their assets sized.
Also, expropriation can refrain other companies from investing in the concerned country
(Auster & Choo,1993). Confiscation is another type of ownership risk similar to
expropriation, except compensation. It is involuntary transfer of property, no compensation,
from a privately owned firm to a host country government (Limna, 2012). In confiscation,
firms do not receive any funds from government and therefore, it represents a more risky
situation for foreign firms. Some industries are more vulnerable to confiscation than others
because of their importance to the host countries and their lack of ability to shift operations.
Sectors such as mining, energy, public utilities, and banking have been targets of such
government actions. Domestication offers to governments a subtle control over the foreign
investments. Limna (2012) stated that domestication involves a partial ownership transfer and
companies are urged to prioritize local production and to retain a large share of the profit
within the country. Domestication can negatively impact the international business manager’s
activities, as well as that of the entire firm. For example, if foreign companies are forced to
hire nationals as managers, poor cooperation and communication can result. If domestication
was imposed within a short time span, poorly trained and inexperienced local managers
would head the firm operations with possible loss of profits. Other government actions-
related risks are less dangerous but more common such as boycott and sabotage (Griffen,
2005). When facing shortage of foreign currency, government, sometimes, attempts to
control the movement of capital in and out of the country. Often, exchange controls are levied
selectively against certain products or companies. Exchange controls limit importation of
goods so that firms might be confronted with difficulties in their regular transactions. Severe
restrictions on import can be a motive for foreign corporation to shut down. There may also
be a raise in tax rate applied to foreign investors in order to control them and their capital. g
to Limna (2012), expropriation is the seizure of foreign assets by a government with

Business performance is a measure of how a manager efficiently and effectively utilizes the
resources of the firm to accomplish its goals as well as satisfying all the stakeholders (Jones &
George, 2009). It is the real output measured against the intended or expected output. It is viewed
as a term that is made up of three major areas of firm outcomes and these three areas are: financial
performance that is made up of profits, return on assets (ROA), return on investment (ROI); product
market performance such as sales revenue and market share; and shareholders return such as total
shareholder return (TSR) and economic value added (EVA). According to Selden and Sowa (2004)
business performance is what is designed to assume that a firm accomplishes certain goals that are
both specified intrinsically and implicitly. Perrow (1961) distinguishes between two kinds of
organisational goals, official goals which are the general purposes of the organisation’s founders and
leaders, while the operative goals designates the end sought through the actual operating policies,
the modifications and subversions of these ends by personnel in decision making positions and by
the forces of pressure from the external environment. However, Kast & Rosenzwig (1985) argued
that performance is a function of ability, effort and opportunity. Ability is dependent upon
knowledge and skills and technological capabilities that provide an indication of range of possible
performance. Effort is a function of needs, goal- expectation and rewards and it depends on the
degree to which individuals and/or groups are motivated to aspirant effort. Opportunity must be
provided by the managers for individual’s ability and effort to be used in ways that will result in the
achievement of goals. In a nutshell, business performance is an approach used in assessing the
progress made toward goals, identifying and adjusting factors that limit the progress of the firm in a
competitive environment.
 managing political risk

) Avoiding Investment:

The simplest way to manage political risks is to avoid investing in a country ranked high on
such risks. Where investment has already been made, plants may be wound up or transferred
to some other country which is considered to be relatively safe.

Investment

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This may be a poor choice as the opportunity to do business in a country will be lost.

2) Adaptation:

Another way of managing political risk is adaptation. Adaptation means incorporating risk
into business strategies. MNCs incorporate risk by means of the following three strategies:
local equity and debt, development assistance, and insurance.

i) Local Equity and Debt:

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This involves financing subsidiaries with the help of local firms, trade unions, financial
institutions, and government. As partners in local businesses, these groups ensure that
political developments do not disturb operations. Localization entails modifying operations,
product mix, or any such activity to suit local tastes and culture. When McDonald’s
commenced franchisee operations in India, it ensured that sandwiches did not contain any
beef.

ii) Developmental Assistance:

Offering development assistance allows an international business to assist the host country in
improving its quality of life. Since the firm and the nation become partners, both stand to
gain. In Myanmar, for instance, the US oil company Unocal and France’s Total have invested
billions of dollars to develop natural gas fields and also spent $6 million on local education,
medical care, and other improvements.

iii) Insurance:

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This is the last means of adaptation. Companies buy insurance against the potential effects of
political risk. Some policies protect companies when host governments restrict the
convertibility of their currency into parent country currency. Others insure against losses
created by violent events, including war and terrorism.

3) Threat:

Political risk can also be managed by trying to prove to the host country that it cannot do
without the activities of the firm. This may be done by trying to control raw materials,
technology, and distribution channels in the host country. The firm may threaten the host
country that the supply of materials, products, or technology would be stopped if its
functioning is disrupted.

4) Lobbying:

Influencing local politics through lobbying is another way of managing political risks.
Lobbying is the policy of hiring people to represent a firm’s business interests as also its
views on local political matters. Lobbyists meet with local public officials and try to
influence their position on issues relevant to the firm. Their ultimate goal is getting
favourable legislation passed and unfavourable ones rejected.

5) Terrorism Consultants:

To manage terrorism risk, MNCs hire consultants in counterterrorism to train employees to

cope with the threat of terrorism.

6) Invaluable Status:

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Achieving a status of indispensability is an effective strategy for firms that have exclusive
access to high technology or specific products. Such companies keep research and
development out of the reach of their politically vulnerable subsidiaries and, at the same time,
enhance their bargaining power with host governments by emphasizing their contributions to
the economy.

When Texas Instruments wanted to open an operation in Japan more than a decade ago, the
company was able to resist pressures to take on a local partner because of its unique advanced
technology. This situation occurred at a time when many other foreign companies were
forced to accept local partners. The appearance of being irreplaceable obviously helps reduce
political risk.

7) Vertical Integration:

Companies that maintain specialized plants, each dependent on the others in various
countries, are expected to incur fewer political risks than firms with fully integrated and
independent plants in each country. A firm practicing this form of distributed sourcing can
offer economies of scale to a local operation. This strategy can become crucial for success in
many industries.

If a host government were to take over such a plant, its output level would be spread over too
many units, products, or components, thus, rendering the local company uncompetitive
because of a cost disadvantage. Further risk can be reduced by having at 0 least two units
engage in the same operation, thus, preventing the company itself from becoming hostage to
over- specialization. Unless multiple sourcing exists, a company could be shut down almost
completely if only one of its plants were affected negatively.

8) Local Borrowing:
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One of the reasons why Cabot Corporation prefers local partners is that, it can then borrow
locally instead of adding an additional level of risk with the investment funds being in a
currency which is different from the currency of all the sales and costs of the venture.
Financing local operations from indigenous banks and maintaining a high level of local
accounts payable maximize the negative effect on the local economy if adverse political
actions were taken.

Typically, host governments do not expropriate themselves, and they are reluctant to cause
problems for their local financial institutions. Local borrowing is not always possible,
however, because of restrictions placed on foreign companies, which otherwise crowd local
companies out of the credit markets.

9) Minimizing Fixed Investments:

Political risk, of course, is always related to the amount of capital at risk. Given equal
political risk, an alternative with comparably lower exposed capital amounts is preferable. A
company can decide to lease facilities instead of buying them, or it can rely more on outside
suppliers, provided they exist. In any case, companies should keep exposed assets to a
minimum to limit the damage posed by political risk.

10) Political Risk Insurance:

As a final recourse, global companies can purchase insurance to cover their political risk.
With the political developments in Iran and Nicaragua and the assassinations of President
Park of Korea and President Sadat of Egypt all taking place between 1979 and 1981, many
companies began to change their attitudes on risk insurance. Political risk insurance can
offset large potential losses. For example, as a result of the UN Security Council’s worldwide
embargo on Iraq until it withdrew from Kuwait, companies collected $100-$200 million from
private insurers and billions from government-owned insurers