Political Risk in a Changing World: Towards a New Definition

Gelis-Filho, Antonio

Fundação Getúlio Vargas – EAESP

São Paulo – Brazil

Antonio.gelis@fgv.br

Introduction

Considering how often the expression “political risk” (PR) is utilized both in academic

and non-academic sources of information, it is tempting to think that such concept is a

very well-defined one. Business and ordinary media often describe “political risk” as a

source of problems for transnational companies (TNC), and as something that – if it is

deemed to high - can inhibit foreign direct investment (FDI) in a country. Its precise

meaning, however, is far from established. Already in 1979, Stephen Kobrin noted that

“although the term „political risk‟ occurs frequently in the international business

literature, agreement about its meaning is limited to an implication of unwanted

consequences of political activity” (Kobrin, 1979, p. 67). Four years later, Fitzpatrick

(1983, p. 249), would affirm, in the same direction, that “although political risk is

mentioned often in the literature on international business, a consensus on the precise

meaning of the term has not yet been achieved”.

In this paper I analyze the current approaches to define the concept of PR and their

shortcomings and I also propose a new approach to understand the phenomenon. In

order to do that, I present a “trilateral model” of the concept, which describe political

risk as being a phenomenon that takes place in a dynamic and inherently unstable

relation among the organization that is the source of the foreign direct investment

(SFDI) together with its economic characteristics (economic sector where it operates,

ownership structure and financial health), the host country (HC) and the country of

origin (COI). By “source of foreign direct investment” (SDFI) I mean any organization

(international organizations, private equity and sovereign-wealth funds and most

commonly transnational companies) that can be involved in foreign direct investment.

I sustain here that “political risk” is better understood as a specific case of a broader

“institutional risk”, one that includes factors related both to a SFDI‟s COI and to the

countries where it operates.

Empirical Context

Political risk matters (v.g., Amariuta, Rutenberg & Staelin, R. 1979; Cosset & Suret,

1995; Hood & Nawaz, 2004). Accordingly to the OECD (1996, p.7), the concept of

foreign direct investment reflects the objective of obtaining a lasting interest by a

resident entity in one economy („„direct investor‟‟) in an entity resident in an economy

other than that of the investor („„direct investment enterprise‟‟). The concept is usually

related to transnational companies, but more recently other entities, like sovereign-

wealth funds have also become part of the FDI landscape (Johnson, 2007). State-owned

transnational companies have also become a major player, usually having an emerging

economy as country of origin (UNCTAD, 2011, p. 28-37).

The global peak for FDI flow happened in 2007, with US$ 1.971 trillion. In 2010, the

value was US$ 1.243 trillion (UNCTAD, 2012, current dollars). From much smaller

previous figures, “developing countries now attract two-fifths of global FDI and

originate close to one-fifth of overseas investment” (MIGA, 2011, p.10). Just to give an

example, “The BRICs saw their combined outward FDI flows skyrocket from $29.6

billion in 2005 to $144.3 billion in 2008 (MIGA, 2009, p.18).

Whatever the nature of the entity involved in FDI as a foreigner, it must deal with what

is called “liability of foreignness” (Bell, Filatotchev & Rasheed, 2012), defined by Peng

(2009, p. 11) as “the inherent disadvantage that foreign firms experience in host

countries because of their non-native status”. Among the precautions those entities can

take is political risk insurance (PRI). The most common events that are covered by PRI

are (MIGA, 2010, p.56-57) expropriation, currency inconvertibility, political violence

(war, terrorism and civil disturbance), breach of contract/arbitrage award default and

non-honoring of sovereign financial obligations. But PRI is not the most widespread

form of political risk mitigation, since the entities involved in FDI also “address

political risks through concluding joint ventures with domestic partners, exercising

caution by implementing investment plans gradually, and performing political risk

analysis and monitoring developments” (MIGA, 2011, p. 47).

The usefulness of the estimation of political risk, therefore, goes much beyond the

setting of insurance premiums. The measure utilized usually relate to one of the events

more commonly insured (for instance, sovereign debt default) or to a basket of factors,

in the middle of which one can find elements of political risk.. The Economist

Intelligence Unit, for instance, provides an assessment of risk based on factors like

“security risk”, “political stability risk”, “government effectiveness risk”, “legal &

regulatory risk”, “macroeconomic risk”, “foreign trade & payments risk”, “financial

risk”, “tax policy risk”, “labor market risk” and “infrastructure risk” (EIU, 2012).

Obviously, it is not clear from the categories that overlappings do not occur and even

which among the factors should be singled for estimating political risk. The root cause

of that kind of limitation lies in the lack of a clear and scientific definition of what is

political risk.

Political Risk: Critical Literature Review

In order to discuss the shortcomings of current definitions about political risk, I‟ll first

analyze the definition offered by Bouchet, Clark and Groslambert (2003), since it offers

a good example of both the strengths and the weaknesses of current definitions.

Bouchet, Clark and Groslambert define political risk as being a sub-category of “socio-

political risk”, which also includes social risk and government policy risk (2003, pp. 16-

19). Socio-political risk, in its turn, in their view is also a sub-category of a larger

“country-risk” group, which also include the risk of natural disasters and country-

specific economic risk.

Their classification presents some difficulties. By government policy risk they mean

“any unanticipated detrimental actions to foreign companies taken by local authorities”

(Bouchet, Clark and Groslambert, 2003, p.19). By political risk they understand “any

potential or actual change in the political system, civil or external war but also includes

any democratic evolution that may disrupt the foreign business” (Bouchet, Clark and

Groslambert, 2003, p.21). By social risk the authors understand “collective actions from

organizations such as trade unions, non-governmental organizations or more informal

sets of people that, peacefully or not, democratically or not, lobby the local authorities

and/or directly the foreign firms, in order to influence their policy and/or their actions”.

Bouchet, Clark and Groslambert classification presents some strong points. First, being

aimed at a essentially financial readership, it tries to break down the components of

“country risk”. It does so well enough by distinguishing among natural disasters,

economic risk and socio-political risk. The recent tsunami in Japan reminded us of

implications for investment of natural disasters-prone regions (Congressional Research

Service, 2011, pp.5-10). The classification also seems to be mutually exclusive and

exhaustive, even if the sharpness of the borders between “socio-political” and

“economic risk” could be questioned. The definitions of categories inside the “socio-

political risk” category, however, are far from clear. They seem to overlap and to stop

far short from offering a practical concept. For instance, why modifications made by the

government out of its own initiative (“government risk”) are categorized differently

from modifications made by that same government that were motivated from “lobby by

more informal sets of people”? For SFDIs, the consequences are very similar and there

is no reason to suppose that those factors do not mingle among themselves.

Another definition for political risk comes from Butler & Joaquin (1998, p. 599), to

whom PR is the risk that a sovereign host government will unexpectedly change the

"rules of the game" under which businesses operate. One problem with that definition is

related to the meaning of “unexpectedly”. Not mentioning the difficulties in defining the

meaning of “unexpectedly”, couldn‟t it be “unexpected” by lack of effort by the

surprised company in keeping track of political developments? Also, which are

precisely the “rules of the game”? Are they legal, customary or moral rules? Again a

definition of PR stops short of defining it.

Shapiro (1996, p. 747, apud Hood and Nawaz, 2004, p. 9) lists five main political

threats to corporations: expropriations, currency and trade controls, changes in tax and

labor laws, regulatory restrictions and requirements for additional local production. If

the author here has the merit of implicitly admitting the difficulties of defining PR,

instead presenting a list, the result is again a lack of definition, Moreover, the list has

overlaps (aren‟t “trade controls and changes in laws also regulatory restrictions?) and is

worried in presenting only the main political threats.

Simmons (1984), takes a step further by proposing a classification of political risk based

on four different interactions: direct-internal (host-government-to-MNE and host

society-to-MNE); direct-external (ex: International activist groups-to-MNE); indirect-

internal (ex: Host society-to-host society-to-MNE) and indirect-external (ex: Nation-

state-to-host government-to-MNE). His classification has some interesting aspects.

First, it shows that political risk is related to more than just factors internal to the host

country; second, it exposes the interactive nature of political risk, showing that political

risk is not something that “belong to the country”, but instead it is something that

belong in a set of complex relationships among factors; finally, it aims to offer a

comprehensive approach for practitioners. The result, however, present some problems.

First the author does not offer a proper definition of political risk, just taking it for

granted. Secondly, he seems to mix the concepts of “political risk” and of “political

event”, creating a classification based on the latter. Finally, instead of analyzing the

relationship among host-country, home-country, MNC and “international arena” and

“global arena” as a complex whole, he cedes to the temptation of breaking it in a myriad

of sub-relations that cannot be isolated except by oversimplifying his own reasoning.

The final outcome is a long list of political events that – again – can only be isolated

from each other by destroying the explanatory power of the model.

Similar shortcomings can be seen in Bunn and Mustafaoglu‟s (1978, pp. 1559-1559)

split between “political risk events” and “political risk factors”, out of which they derive

a very complex mathematical model.

The Multilateral Investment Guarantee Agency (MIGA), an organ of the World Bank

group, defines political risk as being “the probability of disruption of the operations of

MNEs by political forces or events, whether they occur in host countries, home country,

or result from changes in the international environment. In host countries, political risk

is largely determined by uncertainty over the actions of governments and political

institutions, but also of minority groups, such as separatist movements” (MIGA, 2009,

p.28). In other words, MIGA recognizes political risk in a broad sense (also including

operation at the home country) and political risk in a narrow sense (operations outside

home country).

The consideration of political risk in MIGA‟s definition as a phenomenon that embraces

also home operations has a logical appeal (companies operating at their home countries

can also face problems of a political nature) but is not really useful for the

understanding of political risk in international operation. When organizations operate

abroad, they face a whole new set of challenges, from cultural differences to

geopolitical rivalries between host and home countries, just to give two examples.

Moreover, the definition does not help to delimitate the scope of political risk, since it

define political risk as the possibility of disruption by political forces or events, in a

rather tautological way.

Hidden Assumptions behind the Static Concept of Political Risk

As explained above, the concept of political risk has been utilized in a very imprecise

way. In an effort to make it clearer, it is important to isolate some hidden assumption

behind the concept.

Those assumptions can be seen in the (mis)utilization of widespread indicator, often

utilized as an element of assessment for the “political risk” of a country. Most indicators

of political risk are taken as an inherent characteristic of the analyzed country. For those

that take the scores given by rating agencies, those figures summarize and at the same

time define what must be understood as political risk for that country. In such sense, the

concept of political risk works as a fixed characteristic, almost as a geographical

landmark. One such index that, in spite of not having being developed specifically for

estimating political risk is utilized frequently for such finality, is the corruption

perceptions index, developed by Transparency International (TI, 2012a).

Behind the utilization of an isolated measure of “political risk” for a whole country and

its economy as a whole, lie many hidden assumptions:

1. The Hidden Assumption of the Homogeneity of Political Risk through the Political;

Scene

2. The Hidden Assumption of the Homogeneity of Political Risk through Sectors;

3. The Hidden Assumption of the Homogeneity of Political Risk through the set of

SFDIs;

4. The Hidden Assumption of the Homogeneity of Political Risk through Countries of

Origin.

It is not reasonable, however, to consider political risk as being something that does not

depends on the heterogeneity of risk inside each one of those categories. It takes a

dynamic approach in order to avoid such mistake

Toward a Dynamic Concept of Political Risk

In order to present a definition of political risk that does not fall into the same traps of

definitions presented above, it is important, firstly, to make some points clear:

1. The concept of political risk here refers to activities of specific SFDIs, already

operating or considering operating in country (the “host country”) other than the

country (or set of country) where that SDFI is based and that can be called “home

country”;

2. Being a “risk”, political risk refers to a probability of occurrence of an uncertain

outcome, during a pre-specified period of time.

From “1” derives the fact that political risk, as defined here, refers specifically to trans-

border operations or plans of operation of a SFDI. In other words, political-risk is

something that makes sense only from a specific SFDI standpoint. Therefore, all

attempts to measure a country‟s political risk is deemed to failure: the concept is SFDI-

linked. What has a “political risk” is an operation of a specific SFDI in a specific

country, not that country per se.

From”2” derives two important aspects of defining political risk: (a) the need for

defining what is the undesirable outcome whose probability must be estimated and

factors involved on the occurrence or not of the undesired outcomes and (b) the need for

defining the factors involved on the occurrence or not of the undesired outcomes

The Undesirable Outcome in Political Risk

In order to create a meaningful definition of political risk as the probability of

occurrence of an undesirable outcome, it is obviously a first step to define what could

be that outcome. By analyzing the definitions previously described and the empirical

context of political risk, I define that outcome as being the perceived probability that a

SFDI operating out of its home country will have to deal with changes in the

institutional framework mediated by government hostile action, by failure of the

government to enforce existing protecting measures or facilitated by government

intentional inaction that will impact negatively on that company‟s access to productive

resources or that will impact on the control the company have on the destination of its

financial results. “Government”, here, refers not only to the executive power, but also to

the legal and political framework that guide its activities.

By defining the undesirable outcome that way, two common problems in defining

political risk are avoided: (1) the creation of lists of events, always incomplete and (2)

the confusion between what is limited to the government and what is not. Something

that has been ignored by other definitions is the fact the social upheaval per se is not a

problems for SFDI; the problem happens when the government cannot – or does not

want to - act to prevent it from damaging the access of SFDI to resources or financial

results.

Also, by inserting the definition of political risk inside the large framework of

institutional risk, but stressing the need for government action or intentional inaction,

we distinguish political risk from isolated damaging acts perpetrated to the SFDI, since

they do not necessarily relate to factors that must be included in the definition of

political risk. Institutional risk can be defined as being the probability that a company

operating out of its COI will have to deal with modifications in the institutional

framework of its host country that are considered undesirable by its decision-makers.

Institutions can be here as being the “complex social forms that reproduce themselves

such as governments, the family, human languages, universities, hospitals, business

corporations, and legal system” (Miller, 2011). By institutional framework, I define

here the set of institutional arrangements that define the way social conflict of interests

are avoided and solved.

So, the fact that collective behavioral changes have reduced the demand for a SFDI (a

TNC, for instance) does not characterizes an event that fall into the scope of “political

risk”, unless that behavioral modification had been driven by the government.

Another example is a robbery unrelated to political motivation that has happened inside

the facilities of a SFDI: except in the unlikely case where crime wasn‟t considered

possible in the initial evaluation of risk, it is not possible to envisage in such case an

institutional modification.

We must also distinguish between five categories of institutional modifications, as

related to political risk: (1) General Institutional Modification; (2) Institutional

modifications that are directed against foreigners, benefiting locals; (3) COI-specific

institutional modification; (4) Economic-sector institutional modification and (5)

Company-specific institutional modification.

Their main characteristics are (table 1):

General Institutional Modification

In this kind of situation, institutional modifications happen in a way that is driven

toward the whole society, without distinctions between foreigners and locals.

Institutional Modifications that are directed against foreigners, benefiting locals

In this kind of situation, foreign companies become vulnerable to changes that are

directed against them. A typical case is a process of nationalization of foreign

companies.

COI-specific Institutional Modification

In this situation, the institutional modification is direct toward just one or just a group of

countries. Companies related to those countries are then in a worse position than locals

and companies whose COI are not targeted by the modifications

Economic-sector Institutional Modification

In this situation, the fundamental variable is the fact that a TNC operate in a specific

sector that is targeted by the government.

Company-specific Institutional Modification

Finally, in this situation a specific company is targeted by the government.

A specific fact related to political risk –for instance, the seizure of a company‟s assets –

can be related to more than one of the above-mentioned situations.

Category

Possible Causes

Examples

General Institutional

Modification (G)

Overall modification of

power structure; new

government elected; constitutional change;

revolution

Current government is

deposed

Institutional Modifications

that are directed against

foreigners, benefiting locals

(F)

New policy; part of new

government‟s policies;

populist move to appease

social disquiet

Many restrictions limiting

activity in economic sector to nationals.

COI-specific Institutional

Modification (COI)

Geopolitical tension between

HC and COI; weakening of COI in relation to HC

US restrictions to Cuba-based

companies and vice-versa.

Economic-sector Institutional

Modification

(E)

New policy; part of new government‟s policies;

populist move to appease

social disquiet; modifications

on the global demand for specific resources

Imposition of a “winfall tax”

in he mining sector.

Company-specific

Institutional Modification

(TNC)

Company caught in the

middle of political struggle

among factions of group in

power; retaliation to companies behavior;

retaliation

Seizure of assets of REPSOL

by the Argentinian

government.

Table 1 – Categories, possible causes and examples of components involved in political

risk assessment.

We can finally present a generic equation to summarize all the information above:

RPt ∝ Pt = f(S (Gt, Ft, Nx .COIt, Et, Nx . TNCt,) (Eq. 1)

Where

RPt = Political Risk estimated for period “t”.

Pt = Probability of occurrence of a undesirable institutional modification mediated by

government action or facilitated by government inaction in the time interval t.

Gt = Probability of occurrence of a general institutional modification in the time interval

t.

Ft = Probability of occurrence of an institutional modification in the time interval t

aimed at restricting foreigners‟ ability to access resources or their freedom to deal with

their profits.

COIt = Probability of occurrence of an institutional modification in the time interval t

aimed at restricting the ability of companies from a specific COI or from a limited

group of COIs to access resources or their freedom to deal with their profits.

Et = Probability of occurrence of an institutional modification in the time interval t

aimed at all companies of an specific economic sector.

SFDIt = Probability of occurrence of an institutional modification in the time interval t

aimed at a specific SFDI.

St = Perceived stability of the current power arrangement in the country analyzed during

the time interval t. It acts as a multiplying factor that can varies from 1 (absolutely

stable power arrangement) to + ∞ (current power arrangement collapsing).

Nx = Effect of an organization being from country “X” on the occurrence of SFDIt. If

N=1, then there is no impact; if it is > 1, being a foreigner organization from country

“X” increase that possibility; if 0<N<1, being a foreigner organization from country

“X” decreases that possibility.

Definition of Political Risk

At this point finally, it is possible to offer a definition of political risk:

“Political risk is a measure directly related to the estimated probability that a SFDI

operating out of its home country will have to deal, during the time interval “t”, with

changes in the institutional framework of the host country, mediated by its government

action, by failure of its government to enforce existing protecting measures or facilitated

by its government intentional inaction that will impact negatively on that entity‟s access

to productive resources or that will impact on the control the company have on the

destination of its financial results, in a way that maybe related to which is its COI”.

Conclusion

The perception of political risk, as the perceptions of many other aspects of political

life, has changed during the last few decades. Gone is the time when it would be enough

a simple comparison of how similar the institutions of the country analyzed were to

Western institutions. A more sophisticated approach, tailor-made for each source of FDI

(TNC, Sovereign-wealth Funds, Private Equity funds, international organizations and

others) is needed.

In this paper I presented a model of political risk as a trilateral relationship between

COI, HC and SFDI. Political risk was defined in a way that focus the discussion not in

the “political risk” of a specific country, but in the “risk” involved in a relationship that

involves a SFDI, its host country, the COI, the institutional stability of the host country,

considered inside a pre-determined period of time.

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