A normative model of marcro political risk assessment

A normative model of marcro political risk assessment

Alon, Ilan

The purpose of this article is to develop a qualitative, structured model for analyzing comparative political risk at the host country level. To achieve this purpose, we review the literature of political risk, putting special emphasis on the causes and sources of political risk. We use this information to develop a macro political risk assessment framework. According to this framework, the sources of political risk are internal and external and related to societal, governmental, and economic factors. Our model posits macro political risk in several environmental contexts, consistent with the broadening conceptualization of the political risk construct.

INTRODUCTION

Political risk assessment by multinational corporations is increasing in importance. One study reported that all surveyed multinational corporations are assessing political risk for their affiliates (Hashmi and Guvenli 1992). Managing risk became one of the most important functions of a multinational company (Miller 1992). Political risk assessment has grown in importance because foreign direct investment by US multinationals has proliferated since the 1960s, political events have emerged unexpectedly, as in the case of the Iranian revolution, and the impact on the profitability of foreign operations has been swift and powerful. Consequently, the number of political risk assessment firms has increased and more firms have instituted political risk analysis in their strategic plans.

The stock of US foreign direct investment (FDI) reached 1.3 trillion dollars in 1995, according to the Economic Report to the President (Council of Economic Advisors 1997, table B-105). Since much of this investment is vulnerable to expropriation, confiscation, terrorism, discrimination, and nationalization, assessing political risk is of critical importance. To help in this task, this article provides a macro political risk assessment model. This model has a number of advantages: (1) it is forward looking allowing managers to be proactive to their political risk environment, (2) it is parsimonious, (3) it is comparative in nature, (4) it can be used to assess many different political and economic systems, (5) it differentiates between causes and symptoms of political risk, and (6) it allows the political risk analyst to change the weights or importance of the variables in order to adjust the evaluation to company specific concerns. Therefore, this article develops a structured qualitative approach to assessing the political risk of a country in foreign direct investment situations. We focus on the macro political risks because they represent the systematic portion of the analysis that can be generalized across industries.

POLITICAL RISK DEFINITIONS

Early definitions of political risk concentrated on adverse governmental actions (Fitzpatrick 1983). Three problems were inherent in the early definitions. First, the scope of political risk was too narrow and led to inappropriate conceptualization, wrong selection of data, improper choice of analytical tools, and misinterpretation of the results (Sethi and Luther 1986; Oseghale 1993). Second, the assumption that political risk necessarily exerts negative influences on the firm is not always true. A number of researchers have challenged the assumption that the orientation of political risk is necessarily negative (Robock 1971; Ting 1988). An example of a positive variation in political risk is the transition of former communist countries to market economies. Torre and Neckar (1988) wrote that political risk is neutral, containing both negative and positive variations. Third, the emphasis of government actions and political events distracts the analyst from other causes of political risk. Fitzpatrick (1983) suggested that political risk should be viewed as a process that changes over time. Political risk can be caused by internal, external, social and governmental sources (Simon 1982). (For a review of political risk definitions (See Kobrin 1979; Simon 1982; Fitzpatrick 1983; Alon 1996).

In this article, we use Simon’s (1982) definition of political risk because it defines political risk in the broader context of the environment. Simon (1982, p. 68) defined political risk as “governmental or societal actions and policies, originating either within or outside the host country, and negatively affecting either a select group of , or the majority of, foreign business operations and investments.” This definition (1) views political risk in the general environmental context, (2) differentiates between macro and micro risks, and (3) distinguishes between internal and external causes of political risk. Simon’s (1982) definition is germane to political risk assessment because the multinational firm faces political risks from the host country environment, home country environment, international environment, and the global environment. Oseghale (1993) surveyed political risk definitions and concluded that Simon’s (1982) definition provides “a more complete conceptualization of the political risk facing MNCs in their respective business environments” (p. 24). Therefore, we use Simon’s (1982) definition of political risk as a starting point of building our model.

POLITICAL RISK ASSESSMENT

As global firms have become more aware of their political risk exposure, the demand for political risk assessment firms has increased. The political risk assessment models used by political risk assessment firms have a number of deficiencies from the standpoint of the company. First, the political risk definitions used by these organizations vary. For example, Business International ‘s Country Assessment Service defines political risk in terms of governmental attitudes and actions, Political System Stability Index defines political risk narrowly in terms of political events, and World Political Risk Forecasts defines political risk in terms of political and economic conditions (Simon 1982). As mentioned earlier, different conceptualization of political risk may lead to wrong choice of data, analytical tools, and interpretation of results. Second, the focus of the political risk analysis is different. For example, Institutional Investor focuses on creditworthiness, Business Environmental Risk Index and World Political Risk Forecasts concentrates on adverse reactions toward any foreign business activity, and Euromoney’s index centers on political risk from the standpoint of international money markets. Third, the databases used by the organizations vary from hard data (Political System Stability Index) to expert and executive opinions (Business International Country Risk Assessment and Business Environmental Risk Index). Fourth, the variables used in the political risk assessment of the various institutions are different. Fifth, many firms concentrate on the symptoms, such as the number of demonstrations or civil disorders, instead of the causes of political risk. Torre and Neckar (1988) wrote that the major political risk assessment models are based on historical data which may not be indicative of future political risk. Finally, despite the sophisticated analytical tools and quantitative formulas used in some of the political risk models, the assessment is often found to be erroneous.

The deficiencies of many political risk assessment models, coupled with increased investment abroad, convinced many companies to move political risk assessment in-house. Kennedy ( 1987) showed that many of the major organizations which perform political risk assessment failed to forecast the Iranian revolution. Simon ( 1982) stated that the Iranian revolution marked a new era in political risk assessment, which moved political risk assessment in-house. Although many companies have shifted political risk assessment in-house, Hashmi and Guvenli (1992) found that the majority of firms are still relying on external providers of political risk assessment. Given the weaknesses of the former models, a need exists to accurately identify the political risk variables important for foreign direct investors. This article is a step in that direction. It provides a structured qualitative approach for political risk assessment that is forward looking. This should allow managers to better assess, manage, contain, and forecast political risk.

THE MODEL

Four complementary conceptual models are synthesized to develop the overall outline of the political risk model (Robock 1971; Haner 1979; Simon 1982; Alon 1996). In a path breaking article, Robock (1971) differentiated between micro and macro political risk. Micro political risks influence a select group of firms, while the macro dimension consists of more pervasive factors, such as a civil war, affecting most or all of firms in the host country. Haner (1979) further categorized political risk into internal and external dimensions. Internal causes are domestically generated, while external causes are induced by the home country, a third country, or the global environment. Simon (1982) combined both approaches and added that political risk can emanate from either society-related or governmental-related factors. Alon (1996) extended Simon’s model by adding an economic-related dimension, resulting in a 2 x 2 x 3 construct of political risk.

This article focuses on the macro political risk factors emanating from the governmental, social, and economic environments, both internal and external. Therefore, macro political risk is a multidimensional construct consisting of six cells (See table 1). Kennedy (1987, p. 20) stated that “the systematic and theoretical integration of sociopolitical factors and macroeconomic variables remains a fundamental difficulty that often prevents corporations from doing good, accurate country and political risk analysis.” He added that a need exists to develop a macro conceptual model of political risk that posits political risk in the overall macro environments because it is within these environments that economic policy and bargain power analysis takes place. This model contributes to political risk assessment models by differentiating between the causes and symptoms of political risk and concentrating on the internal and external factors of political risk, emanating from governmental, social, and economic environments (See figure 1).

THE INTERNAL DIMENSION

Government-Related Factors

The three internal governmental factors include: (1) the degree of elite repression, (2) the degree of elite illegitimacy, and (3) the likelihood of regime change. The first two factors have been defined by Kennedy (1987) and they summarize the extent of political instability. The third factor summarizes the policy fallout if a regime change should occur, from a political risk perspective. Robock (1971) maintained that political instability does not always translate into political risk that influences the firm. A good example of this is Italy, where successive governmental changes did not influence the business environment in any major way. First, the degree of elite repression is the extent to which the government uses sanctions or force against its own citizens. Second, the degree of elite illegitimacy is defined relative to the portion of the population that does not respect the current regime. In this case, there is not necessarily any use of force by the current government against its populace, but the population perceives the government as lacking credibility. Negative scores in both these areas indicate that there is a good probability that the current regime will by overturned in some fashion. Third, the likelihood that regime change will affect economic policy requires an assessment of the potential differences between the current regime and the likely successor regime, should a power transfer occur.

Society-Related Factors

Three important internal society related factors are: (1) the degree of fragmentation, (2) the extent of congruent cleavages, and (3) the sense of alienation. The degree of fragmentation refers to the social diversity of a nation. The higher the diversity of the population, the more likely it is that the demands of some groups will not be met (Kennedy 1987). The fractionalization of society can occur along lines of ethnicity, language, tribes, territory, class, religion or some combination thereof. This contributes to the political risk of a country (Haner 1979). Examples of countries that suffer from such fractionalization include India, Israel, Ireland, Northern, the Republic of Congo and South-Africa. Congruent cleavages relate to the extent that the fractionalization of society can lead to social conflict. If social diversity overlaps with the low, poor, or repressed class, political instability is a possibility (Kennedy 1987). Finally, a sense of alienation from the home country, including a sense of nationalism, xenophobia, or fundamentalism, can contribute to the political risk of a host county. Rapid modernization in Iran rubbed against the religious fundamentalism in that country and contributed to the overthrow of the Shah. Taken together the internal societyrelated factors of political risk are extremely important to assess since they can bring about a revolution of events that will change the investment climate in the host country.

Economic-Related Factors

The three internal economic variables are: (1) per capita GDP growth, (2) income distribution, and (3) the likelihood that economic goals will be met. Each variable captures several important aspects regarding the domestic economy. First, per capita GDP growth accounts for economic growth relative to population growth. It also is the most ready measure of a country’s standard of living. Second, income distribution is related to the level of development and the size of a country’s middle class. As a country develops, the working class benefits from gains in productivity leading to more a more equitable distribution of income. Persistent stagnation could lead to public demands for policy change or more radical measures. Third, the likelihood that economic goals will be met embodies both the stated economic goals and the consistency of current policy given those goals. Often, a country pursues policies that are inconsistent with stated economic goals, although the goals themselves might be desirable. The last variable is related to the current institutional structure of the country’s policy making organizations. For example, price stability may be a stated goal, but fiscal difficulties may force a less independent central bank to support the government’s budget by printing too much money. Recent hyperinflations in Argentina and Brazil were partly due to too much money growth, despite stated policies of monetary discipline.

THE EXTERNAL DIMENSION

Government-Related Factors

The governmental factors relating to external sources include: (1) the likelihood of political violence, (2) the degree of the country’s involvement in international organizations, and (3) the possibility of regulatory restrictions on investment, capital, or trade flows. The likelihood of political violence requires an evaluation of potential future conflicts, including war, border disputes, regional conflicts and terrorism. Also, conflicts in one country may engulf neighboring nations that house refugees or were sympathetic to the ousted regime. For example, the ousted regime of the country formerly known as Zaire continues to fight the current regime from neighboring Republic of Congo, generating new tensions between the countries. The extent to which a country is involved in international organizations is an indication of potential aid in crisis (International Monetary Fund), as well as potential aid for infrastructure (World Bank). Lack of membership, because of sanctions or past misdeeds, is an indication that the country may be left to fend for itself during a crisis, thus contributing to political risk. As damaging as the recent Asian crisis has been, further financial collapse in many of these countries has been averted because of IMF involvement, so long as the recipient country has indicated acceptance of IMF reforms. The possibility of regulatory restrictions represents a host nation’s tendency to place restrictions on international payments of all types, including restrictions on all capital flows, repatriation limits, trade restrictions, and even expropriation. It also includes international boycotts or sanctions, expropriation, and interference with contracts.

Society-Related Factors

The society-related external variables are: (1) world public opinion, (2) disinvestment pressures, and (3) regional diversity and incongruent interests. World public opinion is a powerful risk factor emanating outside the host country. The recent Desert Storm war against Iraq is an example of world cooperation against a perpetrator. It led to a destruction of Iraq’s infrastructure, economic well-being, and diplomatic ties. Disinvestment pressure is exemplified by the negative media attention regarding the Apartheid issue in South Africa. Many companies have left South Africa not because of danger in the host country, but to avoid the wrath of home country constituents. The Arab boycott on Israel is another example of international pressure on multinationals to avoid investing in the Israeli economy. Given the purchasing power of many of the Arab countries, the result is foregone export and investment opportunities for both Israeli firms and foreign companies operating in Israel. Regional diversity and incongruent interests can lead to an outbreak of war and general political instability. Examples of regions that suffer from incongruent interests of regional players are the Middle-East, SubSaharan Africa, and the former Soviet Union. The sources of society-related political risk are elusive because they can emanate from the home country, a third party, or the global environment. The external society-related causes of political risk are often beyond the control of governments because they transcend national and even regional boundaries.

Economic-Related Factors

The three sources of external economic political risk are: (1) future economic policies regarding FDI, (2) the likelihood of balance of payments problems, and (3) the likelihood of currency inconvertibility or instability. A nation’s economic policies regarding FDI may include foreign ownership restrictions or limits, difficulties establishing business ties in the foreign country, discrimination, and mandatory turn over of assets to domestic ownership. Changes in policy toward FDI are often motivated by economic rather than political reasons (Robock 1971; Juhl 1985). In response to increasing FDI into developing countries, and the increased potential for a policy change harmful to U.S.-based firms, the United States is currently negotiating bilateral investment treaties with these governments. Currently, 38 treaties have been signed and 26 are in force (Council of Economic Advisors 1997). As additional treaties are negotiated, firms can expect formal government restrictions on investment to decline. This is no guarantee, however, that the attitude of the host country business community will change, so that discrimination and related barriers may still exist. Finally, we have included both currency inconvertibility and instability since the former is often used in reference to the problems of a fixed, official exchange rate, while the later generally refers to the extreme fluctuations of a floating currency.

Balance of payments difficulties may be a signal that future policy changes may affect international payments. Balance of payment problems include current account, capital account, and reserve fluctuations. For example, trade deficits can lead to repatriation restrictions or tariffs as countries seek to gain hard currency. The likelihood of currency inconvertibility may be signaled by balance of payment difficulties and government debt repayment problems. The Mexican Peso crisis of 1994 was precipitated by debt repayment problems in the presence of a sizable trade deficit, leading to devaluation and eventual abandonment of the currency system specifically designed to provide currency stability.

THE SYMPTOMS OF POLITICAL RISK

The symptoms of political risk fall into three categories: (1) political, (2) economic, and (3) social. The symptoms of political risk can be seen as red flags. They are indicative of problematic conditions that may precipitate high levels of political risk. Many political risk models use the symptoms as proxies of political risk. These measures therefore are often reactive to preexisting conditions, instead of being predictive to allow proactive management of political risk. Symptoms are not given scores but should be used to red-flag problems in the socio-political economy of the host country. See table 2 for the political risk symptoms.

HOW TO USE THE MODEL

Using this model to assess political risk involves several steps. First, each variable is assigned a value between -2 and +2, where a -2 represents a high degree of political risk. The zero point is neutral reflecting no anticipated change or problem in the rated variable. We chose this range as a starting basis for the ordinal scoring of relative risk among the countries being considered. Allowing for both positive and negative values is consistent with the notion that political risk has positive and negative variations. See table 3 for the macro political risk assessment questionnaire.

The symptoms are indicators that particular categories may be significant contributors to political risk. Particular attention should be made to assess the potential for political risk in the years to come, especially as it relates to the life of the project being considered. Although this is not an easy task, the sources of macro political risk that we have identified include forward-looking, expectational elements.

A weight may be assigned to each variable to control for specific company concerns. For example, franchising firms may be highly concerned with currency convertibility problems because of the adverse effect on repatriation of revenues. Other multinational corporations, on the other hand, may be less concerned with currency issues because of their ability to use transfer pricing. Once the scores and the weights have been assigned, the political risk analyst can arrive at a cumulative score for each country. These scores reflect the relative risk exposure of different countries.

In the past, some political risk analysts have divided the scores into ranges, identified by particular political risk characteristics. The divisions are somewhat arbitrary because (1) the political risk characteristics are difficult to generalize across countries and (2) the measures are derived from ordinal not cardinal scales. For these reasons, no such division is made in this article. Additionally, we do not provide divisions as the weighting structure used by the individual analyst may lead to a different range of possible scores. A simple sum of the assigned scores in this model will fall within a -36 to +36 range. Alternate weighting schemes may result in different ranges. In the end, however, the political risk analyst has comparable relative scores from all countries that are being considered. This is useful for firms that are considering various foreign investment possibilities at the macro level.

Who should do the political risk assessment is a critical question because the success of the ratings is dependent on it. Haner (1979) suggested that a rating panel of at least five individuals should be used. A high standard deviation of the ratings lowers their reliability. To minimize the standard deviations, he suggested that that the lowest and highest scores be eliminated. Haner (1979) also noted that ideal analysts should have the following characteristics: (1) be experts in the country being evaluated, (2) have experience with the culture, (3) speak the language. We agree with Haner’s ( 1979) assessment and add that an ideal political risk analyst should be adequately trained in economics, politics, and sociology.

CONCLUSION

The product of the model is a cumulative score of macro political risk which can be used as a starting point for comparing the risk structures of different investment climates and for suggesting a mode of entry for different countries. Countries with relatively high risk should receive less direct investment, necessitate higher returns on investment, or be entered through a low risk mode of entry, such as licensing. Political risk insurance is available through private firms, such as American International Group and Citicorp, public agencies, such as Overseas Private Insurance Corporation and Foreign Credit Insurance Agency, and international organizations, such as the World Bank and the Multilateral Investment Guarantee Agency (Hashmi 1995). Companies should compare their perceptions of political risk with insurance rates to decide whether to obtain coverage. It is hoped that this article will help academics to build improved political risk models and assist managers in understanding their political risk environment.

NOTES

1. The authors wish to acknowledge the helpful comments of James Baker, Aviad Israeli, and Michael Mayo.

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Ilan Alon Kent State University

Matthew A. Martin Kent State University

Copyright College of Business Administration. University of Detroit Mercy Fall 1998

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