Political risk is a type of risk faced by investors, corporations, and governments.

It is a
risk that can be understood and managed with proper aforethought and investment.

Broadly, political risk refers to the complications businesses and governments may face
as a result of what are commonly referred to as political decisions—or “any political
change that alters the expected outcome and value of a given economic action by
changing the probability of achieving business objectives.”[1] . Political risk faced by
firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm
because of such nonmarket factors as macroeconomic and social policies (fiscal,
monetary, trade, investment, industrial, income, labour, and developmental), or events
related to political instability (terrorism, riots, coups, civil war, and insurrection).”[2]
Portfolio investors may face similar financial losses. Moreover, governments may face
complications in their ability to execute diplomatic, military or other initiatives as a result
of political risk.

A low level of political risk in a given country does not necessarily correspond to a high
degree of political freedom. Indeed, some of the more stable states are also the most
authoritarian. Long-term assessments of political risk must account for the danger that a
politically oppressive environment is only stable as long as top-down control is
maintained and citizens prevented from a free exchange of ideas and goods with the
outside world.[3]

Understanding risk as part probability and part impact provides insight into political risk.
For a business, the implication for political risk is that there is a measure of likelihood
that political events may complicate its pursuit of earnings through direct impacts (such
as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result,
political risk is similar to an expected value such that the likelihood of a political event
occurring may reduce the desirability of that investment by reducing its anticipated
returns.

There are both macro- and micro-level political risks. Macro-level political risks have
similar impacts across all foreign actors in a given location. While these are included in
country risk analysis, it would be incorrect to equate macro-level political risk analysis
with country risk as country risk only looks at national-level risks and also includes
financial and economic risks. Micro-level risks focus on sector, firm, or project specific
risk.[4]

Macro-Level Political Risk

Macro-level political risk looks at non-project specific risks. A common misconception is
that macro-level political risk only looks at country-level political risk; however, the
coupling of local, national, and regional political events often means that events at the
local level may have follow-on effects for stakeholders on a macro-level. Other types of
risk include government currency actions, regulatory changes, sovereign credit defaults,
endemic corruption, war declarations and government composition changes. These events
pose both portfolio investment and foreign direct investment risks that can change the
overall suitability of a destination for investment. Moreover, these events pose risks that
can alter the way a foreign government must conduct its affairs as well.

Research has shown that macro-level indicators can be quantified and modeled like other
types of risk. For example, Eurasia Group produces a political risk index which
incorporates four distinct categories of sub-risk into a calculation of macro-level political
stability. This Global Political Risk Index can be found in publications like The
Economist.[5] Other companies which offer publications on macro-level political risk
include Business Monitor International, Economist Intelligence Unit, and Political Risk
Services.

Micro-Level Political Risk

Micro-level political risks are project-specific risks. An examination of these types of
political risks might look at how the local political climate in a given region may impact a
business endeavor. This type of risk includes project-specific government review (such as
the Committee on Foreign Investment in the US (CFIUS) process in the United States),
the selection of dangerous local partners with political power, and
expropriation/nationalization of projects and assets.

To extend the CFIUS example above, imagine a Chinese company wished to purchase a
US weapons component producer. A micro-level political risk report might include a full
analysis of the CFIUS regulatory climate as it directly relates to project components and
structuring, as well as analysis of congressional climate and public opinion in the US
toward such a deal. This type of analysis can prove crucial in the decision-making
process of a company assessing whether to pursue such a deal. For instance, Dubai Ports
World suffered significant public relations damage from its attempt to purchase the US
port operations of P&O, which might have been avoided with more clear understanding
of the US climate at the time.

Political risk is also relevant for government project decision-making, whereby

government initiatives (be they diplomatic or military or other) may be complicated as a
result of political risk. Whereas political risk for business may involve understanding the
host government and how its actions and attitudes can impact a business initiative,
government political risk analysis requires a keen understanding of politics and policy
that includes both the client government as well as the host government of the activity.

Political Risk Mitigation

Companies may have a Chief Risk Officer who is charged with managing political risk
or, in many cases, this job falls to the Chief Financial Officer.

At the macro-level, political risk mitigation largely involves understanding political

uncertainties of the operating environment and the risks faced by all business operations
in individual countries. Such information can come in the form of customized analysis or
in-depth subject matter reporting; information that can enable an investor or firm to
calibrate their risk appetite. Mitigation tactics involve both macro- and micro-level
strategies. A recent article on the subject suggested that political risk mitigation should
not simply revolve around the decision to enter or avoid a given country’s marketplace,
but should rather center on the pragmatic usage of contingency planning, intellectual
property safeguards, risk diversification, and sound exit planning to guard against
uncertainty.[6]

At the micro-level, political risk insurance and hedges play a larger role. MIGA and
OPIC provide project-specific political risk insurance. This type of insurance usually
outlines specific triggers, such as expropriation or breach of contract by a local party,
which entitle the insured entity to a pay-out after relinquishing control of the insured
project to the insurer. Political risk insurance, however, often involves premiums which
must factor in considerable uncertainty and the threat that arbitrary decisions will affect
the value of insured property. Policies therefore can often be very expensive. Businesses
can also purchase hedges, which could be derivative instruments, which allow them to
reduce risk by selecting a level of return based on a given set of outcomes.

Political risk mitigation takes place before, during, and after an investment. Prior to
investment, businesses can perform due diligence related to local partners and carefully
word and structure their contracts. While a project is on-going, the investor may benefit
from building local political leverage through community activities. After a risk has been
realized, its effects may be mitigated through post-hoc litigation and retaliation, as well
as the implementation of a previously developed contingency plan, or exit from the
market.

References
Extended Bibliography

1. Ian Bremmer, “Managing Risk in an Unstable World”, Harvard Business Review, June
2005

2. Ephraim Clark & Radu Tunaru, The Evolution of International Political Risk 1956-
2001, http://econpapers.repec.org/paper/mmfmmfc05/37.htm

3. Eurasia Group and PricewaterhouseCoopers, “Integrating Political Risk Into Enterprise

Risk Management”,

http://www.pwc.com/Extweb/onlineforms.nsf/docid/F44B471C9D848314852570FF0069
BBCA?opendocument

4. Llewellyn D. Howell, “The Handbook of Country and Political Risk Analysis”, Third
Edition, PRS Group, 2002
5. Nathan Jensen “Measuring Risk: Political Risk Insurance Premiums and Domestic
Political Institutions”, Washington University,

http://www.sscnet.ucla.edu/polisci/cpworkshop/papers/Jensen.pdf

6. Martin Lindeberg and Staffan Mörndal, “Managing Political Risk—A Contextual

Approach”,

http://www.diva-portal.org/diva/getDocument?urn_nbn_se_liu_diva-1029-1__fulltext.pdf

7. Theodore H. Moran ed., International Political Risk Management: Exploring New

Frontiers (IBRD: Washington, 2001, pg. 213-214) Jeffrey D. Simon, “A Theoretical
Perspective on Political Risk”, Journal of International Business Studies, Vol. 15, No. 3.
(Winter, 1984), pp. 123-143.

8. Guy Leopold Kamga Wafo, “Political Risk and Foreign Direct Investment”, Faculty of
Economics and Statistics, University of Konstanz, 1998, http://www.ub.uni-
konstanz.de/kops/volltexte/1999/161/

Footnotes

1. ^ Eurasia Group and PricewaterhouseCoopers, “Integrating Political Risk Into

Enterprise Risk Management”,
2. http://www.pwc.com/Extweb/onlineforms.nsf/docid/F44B471C9D848314852570
FF0069BBCA?opendocument
3. ^ Kennedy, C. (1988): Political Risk Management: A Portfolio Planning Model,
Business Horizons, Vol. 31, p.21
4. ^ Ian Bremmer, “How to Calculate Political Risk,” Inc. Magazine, April 2007, p.
101
5. ^ Ephraim Clark, “Valuing political risk”, Journal of International Money, and
Finance, Vol. 16, No. 3, 1997, 484-485; Stefan H. Robock, "Political Risk:
Identification and Assessment." Columbia Journal of World Business, July-
August 1971, pp. 6-20; and Stephen J. Kobrin “Political Risk: A Review and
Reconsideration”, Journal of International Business Studies, Vol. 10, No. 1
(Spring - Summer, 1979), pp. 67-80.
6. ^ Rolling with the Punches,” Economist, October 1, 2007
http://www.economist.com/displaystory.cfm?story_id=9890890 (accessed
05/06/2008)
7. ^ Ian Bremmer and Fareed Zakaria, “Hedging Political Risk in China,” Harvard
Business Review 84, no. 11 (2006)