Measuring Political Risk

Risks to Foreign Investment

Charlotte H. Brink

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351918978
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

Offering a fresh, transparent approach encompassing new material, this invigorating volume measures political risk - for instance the risk that foreign investment might face in any country. It also demonstrates how progress or regress made in good governance initiatives as conditionalities to aid can be assessed. Governments can monitor their own policy environment(s), and take remedial action if necessary. The methodology allows for measurement of previously un-quantified 'soft' factors that add to the risks foreign investors might face, demonstrating why these factors are of importance to both risk assertive and risk averse investors. Features include: - 103 contextualized, measurable risk factors and their 411 risk factor indicators. - Guidelines to using these factors in order to perform generic macro analyses, or micro, client/project/industry-specific analyses. - Explanation of the methodology with which to comprehensively measure the probability of risk occurring in any macro or micro investment climate.

Chapter 1
Introducing Political Risk

Introduction

Political risk and the analysis thereof remains a highly fascinating and extremely interesting phenomenon, and keeping up with the ever-expanding nature thereof is indeed a challenge.

This introductory chapter attempts to offer at least some clarity on questions relating to political risk analysis. One of these relates to developing the theoretical and practical ideas and motivations that prompted this book. Apart from placing the topic of the book in context, this chapter also aims to explain why the topic was decided upon, what the importance and uses of this book on political risk can be, as well as its relevance.

The term investment implies an expected return. This differentiates the action of making a!n investment from giving a gift. Yet a return on an investment is difficult to guarantee, if at all. This implies that an investor runs the risk of not receiving expected returns, making fewer gains on the investment, or losing the investment entirely. The cause of such losses is almost always beyond the control of those making decisions regarding investment. Although a more detailed conceptual clarification follows in the second chapter, for a foreign investor a working definition of political risk analysis broadly encompasses the analysis of the probability that factors caused or influenced by the (in)action or reactions of stakeholders within a political system to events outside or within a country, will affect investment and business climates in such a way that investors will lose money or not make as much money as they expected when the initial decision to investment was made.¹ These factors can be of internal (from inside the host country) or external origin, and can pose macro (generic) and/or micro (specific) risks.

Foreign investment projects are subject to the sovereignty of the host country in which they are active. Such projects can enjoy strong and enforceable protection mechanisms under laws regarding ownership, stable investment codes, tax incentives, guarantees against expropriation, and the guaranteed unrestricted remittance of profits. However, under the very same sovereignty, a foreign investment can be “taken hostage” or “held for ransom” by a looming threat of government reneging on negotiated and seemingly secure contracts, concessions or licenses. The same laws that protect abiding foreign investors as guests in a host country can in fact constrain profitability and operationability.

Sovereign laws of a host country are either perceived as being on the side of foreign investors, or not. Strategizing around foreign expansion endeavours often deal with questions about whether positioning and roles within a host country can be negotiated; whether the presence of foreign investors are resented, barely tolerated, or hard-earned. The dependence of a host country on foreign investment can be a double-edged sword. Non-essential investments, for instance those outside the provision of public services, should be ready to manage their positions in a host country with great flexibility and adaptability without becoming so attractive as to warrant nationalization.

Such positioning is surpassing the goals of economic and financial gain, as organizations are increasingly confronted with political and social factors as well. A host government might welcome foreign investment – but do the governed? Triple bottom lining involves investment decision making based not only on financial responsibility, but also on socially and environmentally accountable business practice. Yet political risk can cause the most prudent triple bottom liners to flatline. Compliance, socially responsible investments, social impact reporting, environmental responsibility, and economic responsibility to the organization as such as well as to the host country, combined with managing the political risk an organization might face, comprise the business environments in which foreign investment competes for profitability and often the mere maintenance of a market presence.

Some Background to Political Risk Analysis

The measurement and observation of political risk depends to a great extent on subjective human judgment which is in some instances a handicap for political risk analysis. The use of a model for political risk analysis and management aims to “balance” user subjectivity with a model that can reflect researched information in order to attempt a more objective probable estimation of risk. As further events take place and the latest information becomes available, and as past experience becomes relevant, these estimates can be adjusted.

The system of analysis proposed in this book is not an inanimate object – apart from 103 political risk factors and their 411 indicators, it also absorbs the experience and knowledge of its users – people and stakeholders who react and respond to events, and whose views may change, including those of the political risk analyst.

In an attempt to quantify traditionally subjective political, economic and social phenomena in Chapter 5, quantified data presented as weighted factor indicators of risk can be calculated by relaying information into a model designed to reflect the outcome of an operationalized analysis. This model aims to assist during the decision making process surrounding foreign investment, where human rationality is limited when operating in conditions of considerable uncertainty (Simon, 1972).²

One phenomenon still keeping foreign investors away from African countries, sadly, from those endeavouring to make investment incentives and opportunities attractive is not even risk as such, but rather uncertainty. One way of solving the problem of not knowing what is “out there”, is by knowing what is. Strangely enough, there is more comfort in knowing what the risks are than not knowing or being uncertain. These threats can then be observed and measured. One is then able to manage risks and plan in the event of them occurring, recognize and anticipate threats.

It is this uncertainty that the model in this book attempts to clarify and alleviate somewhat, as it focuses on developing procedures that may not only enable foreign investors and/or governments to make better decisions, but to manage the implementation of these decisions (Brewer, 1985; Crain and Tollison, 1990; Goldstein, Reinhart and Kaminsky, 2000; Makridakis, Wheelwright and Hyndman, 1998).³

Before applying a particular method or model of political risk analysis, it is important to ask about its underlying theory. Political risk analysis and management is mostly grounded in “problem solving theory” (Pidd, 1996). In designing a model for political risk analysis, the relationship(s) between “hard” economic and “soft” socio-political variables should be grounded not only in “tangible” economics, but in social science knowledge and research as well. Risk models should be adaptable and flexible so that they can be reconstructed to suit industry and investor specific micro circumstances. The use of a particular method of analysis greatly influences the investment decision, as well as the reliability and validity of the eventual product of a political risk analysis.

Political risk analysis first became a recognizable field of interest and practice during the mid-1970s, and an initial density in the literature points toward the aftermath of the 1973 oil-crisis. The multi-disciplined⁴ research environment of political risk analysis seemed to have lost its momentum toward the end of the Cold War.⁵ This does not imply that there is no longer a demand for political risk analyses – quite the contrary. There is certainly a need for new research and novel approaches to the field of political risk analysis and the management of such risks. The environment in which political risk analysis occurs has also become more complex. The global balance of power is constantly shifting; multipolarity has replaced bipolarity; new regional groupings have cemented political and economic ideals; and deeply embedded conflicts flare-up repeatedly. Amidst all of this, international trade and its regulating regimes can testify to the more complex structure in which political risk analysis operates. Fortunately, social science methods become increasingly sophisticated, enabling better projections on the basis of available information, while computers have facilitated the accelerated processing of such information and technology, enabling one to gather the latest information via various electronic resources.⁶

There is a need to fill the gap in contemporary political risk analysis research with a model that better represents reality. Causal relationships and analytical procedures are affected by socio-cultural, political and economic phenomena, and should be incorporated into a frame of reference with which to assess political risk.

There has always been a relationship between politics and business, and respect for this relationship enables a better understanding of the risks involved in a particular project. This relationship also forms the dynamic backdrop against which international business is conducted every day. Misunderstanding its delicate nature may result in inapplicable and useless risk analyses. The political risk analyst should be able to advise clients on certain investment opportunities and strategies, and be ready with answers regarding complex decision making environments. Certainly, risks should not only be avoided at all times. By determining the nature and extent of the risks involved, risks can actually be exploited and even possibly profited from depending on the degree to which an investor is either risk averse or risk assertive.

Evidential realities of political risks as contributors to business or investment risk are found in the practice of political risk insurance coverage that is extended to foreign operations by international private banks and political risk insurance companies. Necessary coverage can be calculated by making use of quantitative political risk analysis during the capital budgeting process. Political risk insurance is used as a political risk management strategy where an unfamiliar environment requires attention and assessment before an investment is made. An analytical framework is thus called for which is manifested in a quantitative model for political risk analysis.

As mentioned previously, political risk factors can be of internal (from inside the host country) or external origin, and can pose macro (generic) and/or micro (specific) risks. Political risk analysis should incorporate country risk (explained in Chapter 2) and include indicators of the economic and financial characteristics of a political system. Of course, both the unique and the comparable societal and environmental characteristics of a certain system should also be taken into account before one embarks upon a political risk analysis.

Political risk analysis enables, to some degree at least, a way of recognizing or anticipating political risk, after which a means of managing these risks can be suggested. In this book, this is done by means of identifying risk factors and their indicators, and by determining the relationship(s) between these factors. By identifying, operationalizing and organizing such risk factors, a model can be designed for the practice and operationalization of political risk analysis. In these instances, further criteria should also be accounted for. Such criteria include the types of investments involved, the character of specific industries, the infrastructural environment, and as well as a time frame – how long an investor should wait before commencing operations, or for how long an investment should be made. The management of these identified risks can be conducted in a generic fashion, or whittled down into combinations to suit specific investments or operations.

This book concentrates on political risks that foreign business, be it direct foreign investment, import and/or export operations, private banks, international donors, NGOs, bilateral sovereign loans, joint ventures, or agents operating in host countries might face. In the light of such diverse uses for political risk analysis, a few can be mentioned at this stage. Political risk analyses can be used to anticipate potential for the imposition of new investment codes, political upheaval that may lead to forced divestiture, or even the breakdown of administrative processes in a country. Comprehensive, valid and trustworthy analyses, comparisons and summaries are useful for assessing the political environments within which various financial decisions for foreign investment must take place. Strategic planning; preliminary viability studies and research; as well as risk management involves identifying trends, and the ways in which the foreign investor can take advantage of those trends profitably (Brod, 1992; Tarzi, 1992).

The Research Problem

Skepticism concerning the operationalization and quantification of non-economic variables, a preference for in-depth single country analyses,⁷ and the lack of clearly defined boundaries for political risk analysis precisely because of its multi-disciplinary nature has resulted in the lack of a systemic approach in the field. This skepticism is based on a belief that political risk is too formless and subjective a concept to be exposed to systematic quantitative analysis (Simon, 1984).⁸

There are some very important questions that should guide studies into the conceptualization, measurement and analysis of political risk. These relate to the notion of political risk itself being made more precise, and revisiting some current methods of risk analysis. It is also worth remedying empirical defects that may arise when measuring “soft” variables traditionally regarded as typical of social science – an area infamous for problems with quantitative measurement.

The primary proposition of this book is that a mathematical quantitative model can measure qualitative givens and present calculated results of a political risk analysis. Some questions that are central to this book will be explored further and expanded upon as the discussions progress, and briefly involve:

• How the notion of political risk can be made more precise.
• Why some present methods of risk analysis are insufficient.
• Empirical problems that may arise in the measurement of “soft” variables or risk factor indicators.
• Methodological problems that may arise and how the model for political risk analysis proposed in this book can be constructed in such a way that the concepts and variables that follow can be adequately operationalized.
• What the importance is of, and problems faced during the sourcing of information for risk analysis and management.⁹
• How the management of political risk can be conducted under decreased uncertainty.

Just as there is a need to enable both country specific and comparative analyses, it must also be shown that combinations of so-called “soft” political, social and even environmental factors can be empirically observed, measured and translated into numerical terms and equations, and be represented in a compounded result as a calculated risk. The generic model proposed in this book will prove not only useful for political risk analysis as such, but also useful in designing strategies for the management of political risk. The necessity to consider so-called “soft” variables in decision management processes is reflected in the idea to include information that could be regarded as “soft” (such things as people’s attitudes, roles and assumptions) as well as “hard” or technical data (such as numerical data) (Pidd, 1996).

This book’s practical objective is to present a model that can accentuate both isolated events as well as illustrate and map trends. The model can be manipulated to reflect a worst-case scenario, depending on the values fed into the equations. This can be done by choosing to weigh risk factor indicators in an unfavourable way if so required (where each risk factor has its own set of indicators that may or may not point toward the presence of the particular risk factor) thus reflecting the outcomes and consequences of certain decisions. The weight carried by the various risk factor indicators can also be manipulated – should a client wish that socio-economic factors weigh more t...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Table of Contents
• Dedication
• List of Figures and Tables
• Preface
• 1 Introducing Political Risk
• 2 Thinking About Political Risk: A Conceptualization
• 3 Thoughts and Examples on Modelling Political Risk Analysis
• 4 Political Risk Factors and their Indicators
• 5 Presenting a Model for Political Risk Analysis
• 6 Managing Political Risk
• 7 Summary and Concluding Remarks
• Bibliography
• Index