A Short Guide to Political Risk

Robert McKellar

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351961639
• Edition: 1
• Topic: Economics
• Subtopic: Political Economy
• Index: Economics

In a competitive and increasingly internationalised business world, many companies rely on the high risk/reward ratio of operating in unstable areas. Those companies willing to engage in emerging or developing countries can often be exposed to a politically volatile environment over which they have little control. Political risk, therefore, is one of the most hazardous challenges that an international business can face. In A Short Guide to Political Risk you will find a business-centric introduction to political risk that will familiarise international managers with the concept and accelerate the learning curve towards proficient and coherent political risk management. Robert McKellar explores: the key political risks that companies have faced in the recent past, and current trends in the evolution of the political risk landscape; the concept of political risk and its constituent elements; models and approaches for assessing political risk; the principal options for managing political risk, and suggestions for organisational structures to ensure a coherent and consistent approach; as well as wider issues that a company needs to consider in developing its own attitude and philosophy on political risk. A Short Guide to Political Risk is an essential introductory guide for risk managers and for all senior managers concerned with their organisation's global performance and reputation.

1 Introduction

Overview

International businesses face unique challenges. Most readers can relate from personal experience. When at home, we take most things for granted: we know how the transport system works; what prices and levels of service to expect when we go shopping or out for dinner; reasonable taxation rates and how much fudging we might get away with; which neighbourhoods to avoid at night; what kinds of behaviour will cause insult or charm; and the limits of the law’s tolerance for our more eccentric behaviour. When we travel abroad for a vacation or business trip, even to countries with a broadly similar culture, this baseline knowledge needs to be partially abandoned and re-learned in the local context. We need to quickly adapt to new terrain, laws, and culture, and if we do not, then we become the hazard-prone traveller likely to have a very unpleasant, costly trip and come back more xenophobic than ever.

If we multiply the number of variables and the degree of complexity by several orders of magnitude, we begin to approximate the challenges facing large-scale foreign business operations.

Unlike their more home-bound counterparts, international businesses, those which have engaged in overseas environments in search of new markets, labour, and supplies, face an array of unique challenges. Different local and international regulations need to be taken into account; the social and environmental impact of any operation aside from only (and even then) trading will need to be considered; duty of care becomes more acute given that many staff are far from home at the company’s behest; intercultural gaps and misalignments need to be bridged; the limitation or eccentricities of local infrastructure need to be factored into operational plans; health and safety standards need to be adjusted for a new climate; and HQ needs to manage the ‘global–local’ balance, or risk having an overseas office take on its own identity and strategy.

These are challenges that still confound even the most experienced international players, but even these questions presuppose a level of stability in the operating environment: The familiar ‘rules of the game’ still apply, however hard the game might be. There is another variable that affects international business operations, and which is more exogenous, less controllable by conventional business practices, and potentially more hazardous: political risk, the subject of this guide.

Definition of Political Risk

Political risk can be defined as potential harm to a business operation arising from political behaviour. The next two chapters will explore the issue at a historical and then theoretical level, but we can briefly deconstruct this definition for some conceptual clarity. We will address risk, harm, and political behaviour in turn.

Risk can be defined as potential harm, or hazard. More precisely, ‘a risk’ refers to a potential event or condition which, if realised, would cause harm or damage to a business. Risk is usually measured in terms of the probability of realisation, and the degree of harm, or impact, which would be incurred if a risk manifested. The intersection of these two independent variables yields the overall severity of a risk.

Three common errors in the interpretation of risk help to define the concept. One is forgetting that the two measures of risk (probability and impact) are independent. If something bad happens the effect might be disastrous, but if the chance of it happening is negligible then overall severity is limited. Conversely, just because something is nearly inevitable, it does not make it a severe risk unless the impact incurred would be relatively serious.

The second error is to equate uncertainty with a low probability. For example, if we have almost no idea about whether or not a risk will manifest, the best reflection is a probability of 50 per cent. This seems like a high score for something uncertain, but indeed it is the only accurate depiction of complete uncertainty: ‘It could go either way.’ Western intelligence services, as well as commercial risk consultancies, have long struggled with the question of whether or not to assign numerical probabilities to risk, but given differences in personal and linguistic/cultural interpretation of probability indications, a numerical assessment in conjunction with a descriptive indication is the safest bet.

Finally, there is considerable confusion about the difference between ‘risk’ and ‘a risk’. Risk is negative potentiality, or the hazard incurred by being in a particular situation. A risk, as defined above, is a specific potential event or condition, such as a kidnapping or a scandal. We will be applying both usages. Risk as a concept is not the target of this guide, but it is useful to be aware of its implications, and some of the logical challenges it can pose.

Any business operation is ultimately aimed at achieving a specific profit; harm can therefore be defined as inadequate profit or loss. But focusing only on profit loses sight of potential harm to less tangible but equally critical factors of international success. For example, realised political risk can damage a company’s reputation and thereby reduce a firm’s moral influence with key stakeholders in a project. Another example is damage to the morale of key employees: Not only will performance on the ground suffer, but some international personnel might be reluctant to take overseas assignments in the future, thereby hindering a firm’s capability to grasp overseas opportunities in the interests of long-term growth. Harm in our context, then, can be defined more broadly as damage to a business’ capacity to succeed in overseas operations, whether in specific overseas projects or globally.

Finally we come to political behaviour. Politics refers to activity aimed at deciding how a society should be organised: who gets what and how; who decides on laws; and which prevailing ideals should be the moral basis for the social organisation (that is, a self-structured federation of groups who see themselves as part of a greater community, such as a nation-state). Politics occurs at a variety of levels. We most commonly associate such activity with states, but politics can also be global, regional or local. Another useful concept is political power: the ability to influence the social organisation. Governments often have official power, that is, the legal right to create and enforce laws governing society, but power can also derive from public mobilisation, economic bargaining strength, or raw coercion (as Mao wrote, ‘Power comes from the barrel of a gun.’)

Political behaviour is activity aimed at influencing politics, that is, maintaining or solidifying the status quo in terms of the social organisation; changing the status quo to align the social order with different interests or ideals; or influencing official power to further specific non-political economic or social interests (for example increased trade or labour flexibility). Such behaviour is undertaken by governments (or ‘regimes’ as might be more appropriate where official power rests more with specific individuals than institutions), but it is also undertaken by social activist and interest groups, insurgent and terrorist groups, transnational organisations such as the United Nations (UN) or the Organisation for Economic Cooperation and Development (OECD), and even the media when it has a particular political viewpoint. Indeed nearly any type of organisation, from a multinational company to an organised crime syndicate, can become a political actor if it actively seeks to influence politics. We must be careful, however, not to see everything as political. Ultimately the political arena is concerned with the social organisation and its underlying ideals.

We will apply these conceptual guidelines to help maintain focus, but there will be some inevitable stretching of these boundaries as we enter areas where politics and other spheres of life, and risk, begin to blur.

Relevance of Political Risk

The relevance of political risk derives in part from the fact that it arises from the interaction of two very different domains. First, a business exists to create profit for itself and its stakeholders, and business managers and investors across all sectors share a very specific language and mindset oriented around these objectives. Market share, growth, margin, and return on investment predominate in business thinking. A political actor, on the other hand, is concerned with the social organisation and its underlying ideals. The common language of political actors consists of authority, ideology, political culture and identity, the social ‘good’, and the levers of power to influence these. This distinction alone makes political risk a unique challenge to businesses, who need to understand at least the basics of a very different language and mindset in order to address it.

Second, the political realm is pervasive. Nowhere are we unaffected by the laws of the state, and indeed business occurs in a framework ultimately set by political authority and social consensus. In developed countries businesses can afford to take this framework for granted, since it changes very little over time. In many developing countries, however, the political domain is still evolving towards an equilibrium, and the framework in which business operates regularly shifts. Businesses need to adapt to a changing and often volatile political landscape, or they will find themselves at odds with the very ground on which they stand.

A third point of relevance is that the stakes are far higher in politics than business. If a business fails or disappears, it will not affect the lives of an entire society or nation. People seldom put their lives on the line to defend market share, but people routinely take extreme risks in seeking political objectives and death is often an occupational hazard for a committed ideologue. When an international business enters a politically volatile environment, they are exposed to often intense rivalries over which they have little control, and their interests will mean little to those engaged in the pursuit of their own political vision. Therefore political risk is arguably one of the most hazardous challenges that an international business can face.

Political risk, then, is relevant because it is challenging for businesses to understand, it is inescapable when dealing with developing countries (or emerging markets), and it is uniquely hazardous. All of these indicate the necessity of understanding it and developing competencies to manage it.

However, there is another reason why political risk is relevant. Some of the highest growth opportunities lie in developing countries, and globalisation is enabling and indeed compelling international businesses to seek these opportunities in order to maintain growth and competitive advantage. Yet political risk is endemic in such regions. There is a strong risk–reward equation in emerging markets. For those who can understand and manage the risks, the rewards will accrue. Political risk management, then, is a key factor for success in emerging markets, and a key enabler of international growth. Those who learn this competency sooner than others will gain strategic advantage, while for others political risk will remain a barrier to entry; they will watch their more adept competitors reap the rewards of emerging market presence, while established markets become ever more competitive and saturated.

Objectives and Scope

The objectives of this guide are informed by a reading of the way in which even experienced international firms deal with political risk. Most companies regard their overseas operations in conventional business terms, and there seems to be an underlying assumption that the ‘rules of the game’ are more or less universal. Political variables are considered in standard Political, Economic, Social and Technological (PEST) assessments, but the political domain is generally not regarded as uniquely sensitive. In other cases, politics is often seen as analogous to the weather – it is an exogenous variable and its impact is largely beyond control. As with the weather, we can insure against the loss it could cause or we can avoid it, but actively managing it seems to be beyond the competencies that we normally associate with business.

Even when political risk is acknowledged as important and manageable, business managers are seldom trained in how to integrate it into strategic or operational decisions or how to apply corporate resources to mitigate it. Most managers learn by trial and error, and develop crude rules of thumb to guide them, often based on previous and perhaps inapplicable or unsuccessful experiences. Additionally, political risk management might be occurring in pockets within a firm or operation, but often in silos of activity which can easily end up working at cross-purposes.

Given the potential impact of the political environment in which international business operates, and the opportunities inherent in sound political risk management, an ad hoc and incoherent approach is far from optimal.

The aim here is to help provide a business-centric introduction to political risk, to familiarise international managers with the concept and to accelerate the learning curve towards proficient and coherent political risk management. At an introductory level, the book will address:

• the key political risks that companies have faced in the recent past, and current and future trends in the evolution of the political risk landscape (Chapter 2);
• the concept of political risk and its constituent elements at the analytical level (Chapter 3);
• models and approaches for assessing political risk in a specific global or operational context (Chapter 4);
• the principal options for managing political risk, and suggestions for organisational structures that could be developed to ensure a coherent and consistent approach (Chapter 5) and
• some of the wider issues that a company needs to consider in developing its own attitude and philosophy on political risk (Chapter 6).

As an introductory guide, the scope of the book is necessarily constrained:

• Political risk is most prevalent in emerging markets, as are the highest growth opportunities, therefore emerging markets are the principal geographic focus here.
• The focus favours operational and strategic issues, and less financial ones. The bulk of the current literature on political risk already tends to cover in detail project financing and insurance, and the risks best addressed by these measures.
• The focus is on political risk, not emerging market risk generally. There are others types of issues associated with entering emerging markets, such as health, crime, cultural and infrastructure risks, but we attempt to constrain ourselves to the political issues (there is some inevitable overlap with these other areas, especially crime).
• The book is necessarily an introduction. It is intended to illustrate the broad outlines of this complex issue and to provide a baseline knowledge of the subject to aid in further investigation; furthermore, there are diverse interpretations on political risk and this guide will inevitably have its own – further and diverse reading is recommended for a more detailed and holistic perspective.

2 Political Risk: Continuity and Change

Overview

The objective of this chapter is to introduce some of the main political risks that international firms have faced, and to suggest how the global political landscape of business is evolving.

Political risk has been a significant factor in international business since the end of World War Two. Some challenges have been nearly continuous throughout this period, and can be regarded in some respects as ‘background noise’ at the global level, even if the political landscape might shift dramatically in specific ...