POLITICAL RISK MANAGEMENT

1. Explain the meaning of country risk and its relevance in the internationalenvironment.
2. Discuss the concept of political risk and its significance for firms operating in an
international environment.
3. Assess the main factors affecting the level of political risk in a country.
4. Explain the main approaches that can be adopted by multinationals in both themeasurement
and management of political risks.

Organisations do not operate in a vacuum and their operations are affected by many external factors
which may not be within their control. Political risk is one such factor which is particularly relevant
for multinationals given that they operate in an international environment. Over the past decade, the
types and magnitudes of political risks faced by multinationals have increased considerably,
government intervention in the form of tax laws, currency controls, expropriation, among others can
impact significantly on the firm’s operations. While most of the time the impact of political
interference is negative, it can also, sometimes, provide opportunities. Thus, global firms should
undertake a formal political risk assessment so as to determine the investment climate in foreign
countries. This helps not only to identify risky countries so as to avoid committing resources in these
places but also helps monitoring countries in which the firm is already operating.

COUNTRY RISK ANALYSIS (includes political, economic & social)

Country risk can be defined as the risk of losses due to country
specific economic, political or social factors or simply because of
company specific characteristics. Another risk is sovereign risk which can be viewed
as the risk of losses on private claims and direct investment. This type of risk is more relevant for
financial institutions such as banks, but multinationals are mainly concerned with country and
political risk. This can be defined as the risk of unwanted consequences due to
political activity of the host country’s government and political
events.
Country risks can be classified as macro risks or micro risks.

Macro Risks
Macro risks can be viewed as the risks affecting all multinationals operating in a
particular country and the major risks include:
Forced Disinvestment:
Host governments can force firms to disinvest through takeovers, nationalization, confiscation, or
expropriation.
Common in industries like oil exploration and production industries.
Legal under international law if compensation is provided.
Compensation might not meet company expectations.
Motivations for Forced Disinvestment:
Government's belief in better resource utilization.
Improvement of government image.
Desire for control due to strategic or developmental reasons.
Types of Disinvestment:
Takeovers or nationalization: Compensation in exchange for management withdrawal.
Confiscation or expropriation: Minimal or no compensation due to political or philosophical shifts.
Legal title or income streams can be expropriated.
Unwelcomed Regulation:
Regulations on taxes, reinvestments, profit repatriation, management, limitations on employment etc.
Aims to reduce multinational profitability.
Initially encourages multinationals, then enforces unfavorable regulations.
Interference with Operations:
Host government actions to affect multinational efficiency.
Reasons include local development impact or political interests.
Methods include negative comments, limited support, trade union encouragement.
Social Strife:
Breakdown of government machinery due to factors like racial tensions, labor strikes, natural calamities.
Leads to economic disturbances and political risk increase.
Impacts multinational performance.

Micro Risks
This type of risk is specific to each firm and consequently affects each firm in a
different way.
Goal Conflicts:
Conflicts between host government objectives and multinational objectives.
Disagreements in key areas: sector control, ownership sharing, export market control.
Governments aim for full employment, price stability, growth, and balance of payments stability.
Policies may clash with multinational goals.
Monetary Policy Conflict:
Government uses monetary policies to control finance availability and cost.
Multinational bypasses with parent company funds.
Alters competitive position by accessing cheaper credit.
Fiscal Policy Dilemma:
Government attracts foreign investment with tax breaks and subsidies.
Dependency on incentives can hinder independent growth.
Removal of incentives (tax concessions) can impact multinational's development.
Trade Policy Discrepancy:
Host government uses tariffs and non-tariffs (protectionism) to protect local industries e.g. taxes.
Conflicts with multinational's financial performance.
Balance of Payments Impact:
Multinational repatriation of earnings strains balance of payments – capital outflow.
Governments may regulate multinational operations for stability.
Local Protection and Employment:
Government restricts multinationals to shield industries or employment – keep unemployment low.
Agreements ensure local employment or manufacturing.
Conflicts with multinational objectives.
Corruption and Bureaucratic Delays:
Corruption requires commissions for approvals – heavy bribes.
Bureaucratic delays without corruption.
Both impact multinational operations financially and operationally.

POLITICAL RISK MEASUREMENT

Political risks are becoming more significant for global firms. However, there is little
consensus on the questions of what constitutes this risk and how to measure the level of
political risk. Various forecasting models have been developed whereby country risk indices
are used to measure the level of political risk.
Two basic approaches can be adopted. Firstly, there is the country-specific
approach which relies mainly on a country risk analysis. Alternatively, a more micro
approach can be adoptedby using a firm-specific perspective.

Political Stability
 Government tenure (length of time in power) indicates political stability; frequent changes suggest
instability.
 International conflicts hinder investment due to unfavorable conditions.
 Assessing stability is crucial for safe and reliable multinational investments.

Economic Factors
 Economic indicators (inflation, balance of payments, GDP, growth rate) reflect political risk.
 Stronger economic conditions lead to safer and more profitable investments.

Subjective Factors
 Qualitative factors, not easily quantifiable, play a role in assessing political risk.
 Consider factors like attitude towards private ownership, incentives for foreign investors.
 Capital flight reflects political risk; it's the export of savings due to capital safety concerns.
 Higher capital flight suggests greater political risk and lack of citizen trust in the government.
 Measuring capital flight is challenging due to its complexity.
 The Firm-Specific Perspective

Although there exist many indices that try to combine political, social and economic factors
so as to assess the level of political risk, it should be noted that their use is problematic. This
is because political risk may not affect all firms in the same way.
But these indices assume that all firms in a given country are exposed to the same degree of
political risk. Research has shown that companies may be affected differently because of
differences in their size, industry, level of integration, ownership
structure among others. Hence, instead of applying a general index of political risk, the
firm can take a micro approach by assessing its own susceptibility to political risks.

Nature of sector or Industry:

 Sector or industry influences political risk impact.
 Industries with more regulation and societal importance face greater scrutiny.
 Government might control pricing or quantity to safeguard consumers' interests.
Level of Operation:
 Complex, globally integrated operations deter government takeover and regulation.
Technology Sophistication:
 Advanced technology hinders government regulation or takeover – they don’t know how to.
Competition Level:
 High competition reduces government interference; market forces determine demand and price.
 Low competition prompts regulation to prevent monopoly power and consumer exploitation.
Form of Ownership:
 Local ownership is favorable; foreign-owned subsidiaries face more regulations and
nationalization risk – depends on the country.
Management Nationality:
 Foreign management increases political risk; local management reduces it.

POLITICAL RISK MANAGEMENT

One basic approach that can be adopted by global organisations in political risk management
is to firstly identify and address the level of political risks based
on various factors. This is followed by the development of appropriate
policies in advance in order to minimise the impact of political risk. Finally, in
case the government goes for expropriation or nationalisation of the firm’s operations or
assets, the firm should implement measures so as to maximise
compensation.
 The process of political risk includes the measurement or assessment and

management ofrisk. In other words, the firm must firstly evaluate the degree of risk under the
given situation and then determine how to deal with the risk. It is useful at this stage to
compare the level of risk and the associated return.
High risk compensated by high return is worthwhile whereas in the absence of adequate

return it may not be wise to accept risky investments.

The diagram below illustrates the main steps in the political risk management process.

It should be noted that the political risk management process is a continuous one as political
situation and other factors do not remain constant. Because of ongoing changes in economic,
political and social factors, the firm must be proactive in adapting its measures to such
changes.
APPROACHES TO POLITICAL RISK MANAGEMENT

The multinational can either adopt a defensive approach or integrative approach.

The first approach involves the protection against host government actions and
most of the policies are adopted through the functional management areas as shown in the
diagram. The integrative approach, on the other hand, serves the purpose of making the
organisation appear local by integrating the firm with the host economy.
 Defensive approach Integrative approach (All local)

Financial Strategies Financial Strategies

- Maximise debt finance, minimise - Raise equity from host govt

local retained earnings - involve local creditors
- Enter into joint venture with locals - Ensure that internal pricing is fair

Management Policies
- Minimise role of host nationals at Management Policies
strategic points - Employ high percentage of locals
- Train and educate local staff so as - Establish commitment among local
to inculcate loyalty employees

Logistics
- Crucial segments of the business to be Operations Management
located outside but near the country - Maximise localisation in terms of
- balance production among several sourcing, employment and R&D
locations - Use local sub-contractors, distributors
and transport systems
Marketing Management
- Control markets Marketing Management
- Maintain a strong single global - Share markets with domestic players
trademark - Appoint local distributors and use
- Maintain control over distribution local network
network
Government Relations
Government Relations - Provide public services
- Company must know its strengths - Develop and maintain channels of
and weaknesses and try to communication with political members
negotiatewith the government

PRE-INVESTMENT POLICIES – pencore ale dans pays la

Once the political risk has been ascertained, the international firm can adopt thefollowing policies
in order to limit the impact of the risk.

Avoidance Strategy: (easiest way)

Company avoids investing in high political risk countries.
Not a complete solution, as all foreign investments have some level of political risk.
Could result in missing profitable opportunities.
Focus should be on managing acceptable risk and required returns.
Insurance Strategy:
Insuring against political risk.
Allows company to focus on business operations.
Covers foreign assets, not business risk.
Doesn't fully protect against nationalization or expropriation.
Provides partial protection from political risk.
Negotiation Strategy:
Agreements with host country's government before investment.
Defines rights and responsibilities for both parties – transparency & full disclosure.
Obsolete due to potential changes in government stance.
Investment Structuring Strategy:
Modify operational and financial policies to deter government interference costs.
Align project value with firm's control to discourage takeover.
Examples include centralizing R&D in home country and controlling transportation.

OPERATING POLICIES – déjà dans pays la

The global firm can make use of a number of policies so as to minimise political risk, as discussed.
Planned Divestment:
 Multinational firm plans divestment by gradually selling foreign investment ownership to local
investors. – sell part ownership
 Done to reduce political risk; equity interest sold if risk becomes too high.
 Transaction challenges due to lack of collaboration; government may not honor purchase
commitment.
Maximisation of Short-Term Profits:
 Focus on maximizing short-term profits without considering long-term consequences.
 Tactics: raising prices, lowering quality, cutting capital and R&D expenses.
 Indirect form of disinvestment; attracts host government's attention.
 Short-term success, but doesn't ensure company's long-term survival.
Local Stakeholders Strategy:
 Involves engaging local stakeholders for effective strategy e.g. banks
 Stakeholders: existing consumers, local suppliers, local investors.
 More local involvement – lowers risk of expropriation by host government.

POLICIES AFTER EXPROPRIATION – kabza kar liya

Sometimes, despite all policies and approaches designed to prevent nationalisation or expropriation, the
multinational might finally be taken over by the host government. In the event of expropriation, the firm can
try to negotiate with the government by, for instance, pointing out that the firm would have
continued to bring future economic benefits and helpthe local government. If negotiation does not
work, it can seek legal help by entering a case either in the host country or its own home
country. In other situations, some multinationals simply surrender and accept whatever
compensation the host government decided to give to them.
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