Investors have begun to move slowly into the regions of new opportunity, while trying to keep a close eye on the political situations in these states, wary of processes that seem alien and events that seem unpredictable. But how does an investor "keep a close eye" on a political situation? What elements of the very complex and unfamiliar political situation require attention and assessment before the new investor risks personnel and critical amounts of capital? An analytical structure is needed to sort among the multitude of factors that contribute to the puzzles and riddles that often seem the best characterizations of politics and society in the new world of business opportunity. Such structures are provided for observers in the field referred to as 'political risk analysis.'

Political risk analysis is a practice that has been utilized by merchants and traders for hundreds, if not thousands, of years and is an ancient craft. Very simply, 'political risk' refers to the possibility that political decisions or events in a country will affect the business climate in such a way that investors will lose money or not make as much money as they expected when the investment was made. Some approaches to political risk analysis describe this as being an effort to project "harm" to the investor by political forces or resulting from political decisions. Analysis of history or current events leads to a projection of circumstances under which harm occurs. The purpose of making such a projection is to prepare the investor for dealing with such risks.

In providing political risk analysis, the elements of that phrase require attention. In this field we are examining political as distinct from economic risk. Political means having to do with: a) the governance system of a country (political structure); b) the nature of particular governors (authority); c) the response of the population to the government (legitimacy); and d) the nature of the society being governed (culture, social phenomena).

When politics is the subject, one is dealing with the behavior of people who run the government, with laws, rules, and guidelines they establish, with the reactions of the governed to that behavior and the rules, and with the ability of the political system (the government and the governed) to respond to demands and events in its domestic and international environments. These characteristics of society are tightly linked with business operations and corporate success.

Over the last thirty years, the nature of the relationship between the business world and the political and social worlds in which those businesses must operate has changed dramatically. In the 1960s and 1970s, much of the developing world was undergoing radical change, shifting from systems of colonial governance and control to independent and often innovative systems of governance. In the turmoil and uncertainty of the times, many took on an authoritarian character. Today, the last of the post-colonial dictators are falling and the world is increasingly governed by principles of what is known as 'political economy.'

We have moved from a system where western powers, though often democratic at home, were authoritarian and hierarchical in their systems of rule as applied in the developing world. While some new states adopted this style of governance, others chose to depart from it explicitly. To escape from that rigid and elite-centric system, newly independent countries often fell back on support from other governments in the Communist and Socialist worlds. Relying on the ideology of those systems, these new governments often developed political processes that, in representing entire populations, propagated a system in which property ownership, especially of major industries, was held by governments for the population. In order to get from the colonial to the socialist structure, these governments often expropriated and directly interfered with businesses operating within their borders.

Nationalization and expropriation became the greatest fears of foreign owners in the developing world during this era. Alliances with political parties or major personages and, eventually, political risk insurance became the means for protecting foreign owned businesses from the ravages of de-colonialization. In the 1980s, after the colonialism issue had faded into the shadow of the destruction of the Soviet and Communist empires, other elements of the relationship between politics and business have become more evident. Current forms of government involvement in business processes are more subtle but the impact of politics on business operations has, if anything, become even more potent.

The impact of politics on business operations has almost always been seen in the negative. Expropriation, inconvertibility of profits, war damage, damage from civil strife, and breach of contract for political reasons have been the consequences of political interference that have been insured by agencies such as the U.S. government's Overseas Private Investment Corporation (OPIC) and the Multilateral Investment Guarantee Agency (MIGA) of the World Bank. Obviously, there is a positive side to the relationship as well. The presence of a stable and structured legal system, for example, provides a set of expectations that foreign corporations find familiar and protective. But the startling challenge of expropriations and nationalizations in the 1950s and 1960s has left the field of political-business analysis focused on the side we now refer to as "risk."

Many forms of loss are covered by political risk insurance that may be obtained from public insurance companies like OPIC or MIGA or from private insurers like the American International Group (AIG) or Johnson & Higgins. But much of the harm that can be done is not coverable or is not covered by choice. In some instances, risk can be "managed" if it is anticipated. A major form of harm to international investors occurs through corruption, an affliction in the business world that is social in its origin but often politically condoned. For any firm, corruption costs are a direct loss. Particularly for American companies, which are under the jurisdiction of the Foreign Corrupt Practices Act, involvement in corruption can mean fines and prison terms in addition to the illegal payments made. In some societies bribes or "gifts" are expected at many levels of the transaction and can amount to as much as 3% of total costs. When the profit margin is hardly more than that, the costs to corruption may make the total difference as to whether the investment succeeds or not. In any case, it is not insurable.

Kidnapping for ransom by guerrilla or other political groups is another means by which the investor may lose money because of a political risk. If a manager or a family member is kidnapped, the cost of regaining that person may be in the millions of dollars. Other sources of loss in the political sector exist as well. The AIG list of political causes of contract repudiation is instructive. They include unilateral termination of a contract by a government, payment defaults, license cancellations, embargoes, war or civil war, default on an arbitration award, and government acts, laws, decrees, or regulations that result in breach or alteration of an agreement.

There are other politics-based losses that are commonly encountered. Property is confiscated in a manner that doesn't amount to expropriation. Investment property is damaged in politically motivated strikes. The government may interfere in the terms of a contract, such as in dictating ethnic quotas in hiring or forced procurement decisions. Limits may be placed on remittances by foreign nationals employed by the investor in the host country. There may be discriminatory taxation. The absence or loss of copyright protection is a particular problem. The potential for government or societal interference in business operations where harm could be done extends well beyond this list.

The ultimate concern in political risk analysis is that there will eventually be a loss or harm done to a business operating in a foreign environment, the source of which lies in political or social characteristics or phenomena. The investor's interest in political risk lies in forecasting that risk, so that it can be managed or avoided. Working backwards from the loss or harm, the analyst--whether corporate or academic--tries to anticipate the loss by envisioning the circumstances under which losses might occur. Those circumstances in turn are anticipated in an examination of societal attributes.

THE ANALYSIS OF RISK

The attributes to be examined fall into two categories. One is trends, the other is current but compared characteristics. In the case of trends, the matter is relatively simple, although perhaps somewhat deceptive. If there is a record of expropriation, the new investor obviously needs to be concerned. If the current government of a host country has previously nationalized foreign industry, potential investors obviously need to pay attention to the possibility that they, too, could be nationalized. Similarly, a history of civil strife and especially the occurrence of ongoing wars indicate a high likelihood that direct damage could occur to the investment or that contracts could be repudiated under war circumstances.

The second approach is to examine current societal attributes and the circumstances under which losses have occurred before, either in that same country or others like it. If high levels of ethnic tension are often followed by open ethnic conflict, for example, that civil strife could result in damage to businesses or in forced abandonment of the investment, as happened in 1994 in Algeria. Many of the forecasting methods, such as that presented by The Economist in 1986, rely on this approach.

In an article entitled "Countries in Trouble," The Economist provided sixteen variables which described current political, social, and economic circumstances wherein investors would face risks of the types of losses discussed above. A selected set of variables was chosen as representative in each of the three areas and they were weighted to result in a potential accumulation of 100 "risk" points for any of the fifty countries they analyzed.2 The Economist used proximity to a trouble spot or super power, extent of authoritarianism, degree of legitimacy of the government, staleness of the regime, involvement of the military, and extent of current war or civil strife as predictors of future harm to the foreign business. As social circumstances portending trouble, it chose rapid and concentrated urbanization, extent of corruption, degree of Islamic fundamentalism, and level of ethnic tension as critical predictors. Each, it was argued, foretold problems for the investor. Among these ten variables, only war was likely to cause direct losses. The other variables are simply precursors to war or other forms of damage.

In designing a model, the relationships between abstract concepts, such as authoritarianism, and acts of damage to the investor need to be grounded in social science knowledge and research. A variety of approaches have been put forth by corporate analysts and by political risk organizations in their efforts to describe the circumstances of incipient loss. Larger corporations such as oil companies or banks may have "in-house" advisory groups to examine the context in which the investment will occur. They may have their own models that encompass selected sets of variables and relationships among them that they have determined are appropriate forecasting tools for the types of decisions they will make with regard to investment. Chase Manhattan Bank, for example, has included the basis of political stability, social cohesiveness, corruption, and external factors such as war and vulnerability to fanaticism in its model. These firms, and especially smaller firms, may rely wholly or in part on political risk advisory services such as Political Risk Services, a division of International Business Communications, or the Business Environment Risk Intelligence (BERI) Index. The choice of the system of analysis can affect the investment decision dramatically.

THE NATURE OF "RISK"

In examining the models underlying various risk analyses, it is critical that the concept of "risk" be clearly understood. The term risk implies a probabilistic assessment. That is, political risk analysis does not result in a prediction. It has as its product a forecast. The difference is that there are elements to the analytical process that prevent the projection of specific events. The projection is that given a history, usually or "there is a high probability that" history will repeat itself. Or given a set of circumstances, an outcome has a high probability of following.

A number of elements of the analytical method and model prevent precise prediction. One is the model itself Modelers select different variables as representative of the situations that they believe will precede investor harm. Social systems are notably complex and some representative approximations of societal attributes are utilized in any model. The projection of outcomes from the situation becomes probabilistic because a) a complex set of circumstances is necessarily simplified and abbreviated in any model, and b) the selection of representative variables and their relationships may not be the optimal one.

A second and related element is the complexity of social phenomena. Even with the best of models, variables that are not included will still have some effect on the situation and will eliminate the possibility of perfect prediction. There is always the possibility, and perhaps high probability, that some unforeseen event outside the scope of the analysis will affect the government processes that result in losses. For example, a heavy rainstorm up river could result in flooding that, in turn, causes great damage to crops that is followed by food riots that bring the downfall of a democratic government and the installation of an authoritarian one that imposes strict controls on foreign business that deal in food products. While the probability of such events is low, they do occur and would not likely be included in even a good political risk model.

Another element that prevents prediction is partial information. Even if an optimal model is employed, the information that is incorporated as the basis of the assessment and forecast is inevitably incomplete and sometimes inaccurate. Whether there are direct observations of such phenomena as "press freedom," or media reports or authoritative testimony, there is no perfect description of such circumstances that can be introduced into the analysis.3 Variations in the data introduce some margin of error in the projection. This is unavoidable in social science analysis.

Human intervention also prevents prediction. Just as the person who is predicted to die in an automobile accident can stay away from automobiles for the rest of her life and thereby avoid the prediction circumstance, political risk analysis is provided with the specific intention that investors will somehow prevent the forecast from coming true. Unfortunately, many investors still don't pay attention to political risk forecast--as OPIC payments to its insured clients will show--or many proceed to take the risks because the opportunity is far greater than the risk. Many forecasted losses therefore do occur, but not all. The ones that are avoided result in a differentiation between forecast and outcome. Thus the forecast appears as a probability that is less than one hundred percent.

Many host country governments have argued that political risk forecasts are inaccurate because "ethnic tension" didn't turn into "civil strife" and subsequently war damage, for which an investor had been insured. This by no means is an indication that the risk was not there. It may have been avoided probabilistically, or it may have been manage--by the investor or the host government--such that the potential harm was avoided or eliminated.

MANAGING POLITICAL RISK

After receiving a risk assessment, investors presumably take some action as a result. They may proceed with the investment and ignore the risks or simply count them as risks as they do with economic risk. They may try to modify the arrangements or circumstances of their investment. For example, if one part of a country has civil strife and another does not, they may choose to operate in the less dangerous part of the country and leave the other until the situation changes. The investors may choose to go to an entirely different country. Some investors are now leaving China, for example, and choosing Vietnam instead to avoid social problems they have encountered.

Another approach to managing political risk is to negotiate a better deal with the host country government. If there is a high level of government interference in personnel decisions, for example, prior to the investment the investor can seek (and often obtain) a variation in convertibility limits or in tax levels in exchange for accommodating the government on the personnel issues. This can only be done, however, if the investor knows the social environment of the personnel issue and its implications for business operations. The risk assessment can be turned directly into an asset.

In some circumstances, the risk can be managed by direct action. In the case of kidnapping possibilities, for example, some firms have hired bodyguards or taken other protective measures to prevent situations from arising where a kidnapping could take place. Such measures entail some cost, of course, but would presumably be commensurate with minimizing the cost or harm to the investor.

Investors can develop alliances within the host country and even within the government that can elevate their position and help avoid the risk circumstance. This may be risky in itself if the faction or government they have aligned themselves with falls into disfavor. But it does constitute one method of active management of risk.

Perhaps the most common form of risk management is to obtain political risk insurance. Political risk insurance, as indicated above, is available in the public and private sectors and is widely held by international investors and businesses. That OPIC insurance was originally provided under the auspices of the U.S. Agency for International Development (AID) is an indication of the argument that risk should not lead to limitations on investment. Risk analysis offers advice to the investor on how to manage risk in a world full of political and social danger but also full of extraordinary opportunity, especially in the 1990s. OPIC's level premium rates for all countries covered are an indication that international investment is being encouraged, despite the difficulties to be faced, not discouraged. The prudent investor isn't avoiding risk but is simply taking advantage of available knowledge to deal with societies in the same manner that he would deal with economic or financial uncertainties. Political risk analysis and political risk management are therefore intricately and intimately intertwined.

In this volume, a variety of successful political and country risk forecasting systems are presented. These should be useful both to the experienced foreign investor and to the new investor seeking to determine how unfamiliar political systems and societies should be approached.

ENDNOTES

1. See "Countries in Trouble," The Economist, December 20, 1986, pp. 25-28.

2. For a full discussion of this approach, see Llewellyn D. Howell, Syed Rizvi, and Chris Cogswell, "Political Risk in Southeast Asia: A Perspective Through the Economist Model," Journal of Asian Business, Vol. 9, No. 2 (Spring 1993), pp. 19-36, and Llewellyn D. Howell, "Political Risk and Political Loss for Foreign Investment," The International Executive, Vol. 34, No. 6 (November/December 1992), pp. 485-498.

3. For a more extensive discussion of these problems, see Rudolf J. Rummel and David A. Heenan, "How Multinationals Analyze Political Risk," Harvard Business Review, Jan.-Feb. 1978, pp. 67-76.

From The Handbook of Country and Political Risk Analysis by Llewellyn D. Howell, Ph.D. Edited by William D. Coplin, Ph.D., & Michael K. O'Leary, Ph.D.
Copyright (c) 1994 by (c) IBC USA Licensing Inc., Reprinted by permission of IBC USA Licensing Inc.