Question

Describe the emergence and subsequent decline of the political risk analysis industry. Discusses what political risk means for multinational firms and various ways in which firms have tried to analyze and grapple with these risks.

Answer 1

Foreign investment is a strong way of diversifying a portfolio and increasing it. However, risk rates are also higher than in domestic investments. Many of these threats are specific to foreign investment and can be triggered by wars, instability, shifts in countries' foreign policies, and domestic politics. Policy instability is one of the most important factors facing foreign investors. The political situation in many emerging and frontier markets is influenced by more than factors being considered within the region. Middle East wars, Chinese debt issues, American policies and resource disputes across the globe directly impact the opportunities for foreign investment. Political risks are risks linked to changes that occur within the legislation, business laws, or investment regulations of a country. Certain important variables include foreign affairs and any other situation that could have an impact on a given country's economy. A common definition of political danger consists of countries in political upheaval. As of late, many countries undergo shifts in social views and perceptions, triggering instability, shifts in governance and democratic movements that are disrupting economies. Technology is fairly new to the political risk scene. The increase in ownership of mobile phones enables anyone who has a phone to be a photographer, journalist, or source of knowledge. Within a matter of seconds of a video being posted online, trust in investments, businesses and countries can be shattered. It is important to remember that political risks are not always well-defined — rumours with little to no substance behind them may be the risks in many cases. Therefore, foreign investors need to keep an eye on the press and not just look at performance data to handle those risks. A rise in political risk has several consequences for a nation and companies operating within its borders.

Reducing FDI will lead to slower overall economic growth, as well as possible social problems. Social problems like income disparities, inequality, and corruption will undermine the appeal of international equities. Such problems will impact other types of properties, too. For instance, sudden slower economic growth may affect the ability of a country or corporation to repay its debts, which could influence bond markets. Slower economic growth or a recession may also cause issues relating to currency. A decline in the currency value of a country could, in effect, result in slower exports and a reduction in economic growth. To preserve a diversified portfolio, the first step in managing political risk is realizing that such risks are indeed worth taking. Even if you keep all of your US savings, you're always vulnerable to Washington D.C. decisions. Investors should maintain a diversified portfolio to eliminate any particular political risk that would have a direct effect on the portfolio overall. Diversification would involve hedging the inherent danger of foreign investments. Foreign investors can mitigate risk by hedging their investments against potential issues. For example, an investor who senses issues emerging in Brazil can decide to purchase put options (the right to sell at a fixed price) on the iShares MSCI Brazil Index ETF (NYSE ARCA: EWZ). If your put option is set to the appropriate value, you will substantially reduce your losses if the index falls or gains are generated elsewhere in your portfolio. You will monitor the possible political consequences of your foreign investments.

The CIA World Factbook is a great place to get started with a wealth of background information on the government, politics and economy of a nation. Such indicators to look out for are the growth of different or new political parties, upcoming elections, or any new trade deals impacting a nation in the countries you might be investing in. Setting up warnings or other automatic notifications can also help keep track of possible political risks in key markets. That way, as concerns occur, you will be informed early and then take the appropriate measures to reduce exposure to more \dangerous areas. The aim is not to overreact to the news, but to assess what is going on and whether it is affecting your investments.

How are the multinationals managing political risks?

Political risk for multinationals refers to the possibility of a host country taking political decisions that appear to have negative effects on corporate profits or objectives.

Adverse political acts can range from very negative ones, such as widespread devastation caused by insurrection.

Instability affecting returns on investment may result from a change in government, legislative bodies, other foreign policymakers or military power.

Knowing How to Minimize The Two Forms of Political Threat as a Multinational Organization:

There are usually two kinds of political risk: macro risk, and micro risk. Macro-risk refers to adverse acts that would impact all foreign businesses, such as expropriation or revolution, while micro-risk refers to adverse acts that only impact a particular industry or business areas, such as corruption and prejudicial actions against foreign companies.

All in all, irrespective of what kind of political danger a multinational company faces, corporations will typically end up losing a lot of money if they are unprepared for these adverse circumstances.

For example, after the government of Fidel Castro took control of Cuba in 1959, they expropriated hundreds of millions of dollars worth of American-owned properties and companies. Unfortunately, most of those American companies, if not any of them, had no way to get any of the money back.

How can exposure to political risk be minimised:

So how do multinationals mitigate policy risk? Just before making an investment a couple of steps can be taken.

The easiest approach is to examine a country's riskiness, either by paying for reports from consultants specialized in making such evaluations or by doing the analysis yourself using the many free sources available on the internet (such as historical notes from the U.S. Department of State). Then you'll have the more educated choice not to set up operations in countries considered to be hot spots of political danger.

Although that strategy may be successful for some businesses, often the possibility of entering a riskier country is so lucrative that calculated risk is worth taking. Under such situations, businesses will also discuss terms of compensation with the host country, and if anything were to interrupt the activities of the company, there will be a legal ground for redress.

However, the issue with this approach is that the host country's legal system may vary considerably from the country of the business and in some countries, foreigners rarely win lawsuits against a host nation. Worse still, a revolution might spawn a new government that doesn't respect the previous government's actions.

Buying Insurance on Political Risk:

If you are going ahead and entering a country considered at risk, buying political risk insurance is one of the better solutions. Multinational corporations will be willing to go to one of the several firms that specialize in offering political risk insurance and purchase a policy that would cover them if an adverse event occurred.

Since premium rates depend on region, industry, the number of insured risks, and other factors, one country's cost of doing business can differ considerably from another.

Purchasing political risk insurance, however, does not guarantee that an organization can get coverage immediately after an adverse incident. Other requirements must be met, such as trying other avenues for redress and the degree to which the company was affected. Ultimately, a company can have to wait for months before it collects any compensation.