Political Risk Assessment

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POLITICAL RISK ASSESSMENT

Support for scientific research and technological development, especially in developing countries, requires interstate and cross-border participation. Such development and technology transfer issues are subject not only to ethical evaluations but also to political risk assessments. The degree to which international investment projects, public and private, are attracted to or successful in many parts of the world is increasingly dependent not simply on technical but on social and political factors.

It has been argued that any engineering project worth $100 million or more is no longer a technical project, but a political enterprise. All political enterprises embody risks. Political risk—also known as country risk or sovereign risk—is most often defined as those conditions that a country can create at home that might undermine investment climate and cause investors to incur losses. Political risk also involves exposing a business to conditions abroad created by extra- and supranational political changes, policy decisions, social situations, inter-market relations of two or more regions, and global financial market oscillations, over which the country may or may not have control.


Political Risk Types

Developed countries as well as developing states generate political risks. More likely, such developed countries as the United States, Japan, and France can offer political risks of regulatory excesses, while developing countries such as Indonesia, Peru, and South Africa can offer structural risks such as regime instability, out-of-sync economic policies, and ethno-religious-cultural imbalances in development due to the monopoly of political power and economic wealth by a single dominant ethnic or religious group. Examples of regulatory risks are excessive environmental rules, market restrictions to favor or protect a certain domestic economic group (such as in the United States and Britain), or manipulating free market rules to promote national champion firms (such as in Japan, Germany, and France). Cases of structural political risks in the developing countries above all rest on the lack of the rule of law, an impartial court, the protection of private property, the sanctity of contracts, and transparency, as well as out-of-control corruption, excessive subsidies to state-chosen firms, and favored access to power and wealth by a state-favored ethnic or religious group. Developed countries engender fewer risks than developing countries, due to the better-developed legal institutions, norms, and practices for business. Also, multiethnic states tend to create more structural risks than countries with a single ethnicity. And a country with intractable economic and financial difficulties, whether developed or developing, runs greater risks for investors than a country with a prudently managed economy. In order to produce a carefully weighed assessment, risk variables must be quantitatively evaluated.

All countries generate and nurture five kinds of risks:

  1. political instability that can lead to regime change;
  2. macroeconomic and financial imbalances that can lead to a severe malfunctioning of the economy;
  3. social, cultural, and environmental risk that can affect human development;
  4. global linkages facilitate a country's integration into the global economy but insufficient ties can deny access to external capital, technology, resources, and markets, thus increasing the country's risks; and
  5. business environment risk, which allows the country to achieve the level of competitiveness against its neighbors.

Each of the five compartments or shells is self-defining and self-contained, while one or two inferior performances in the five shells can undermine the soundness of the other three or four, thus increasing the overall risk of a single entity, setting off a contagion effect. Conversely, two or three well-calibrated shells can lower the risks of the lesser shells, benefiting from a free ride effect. In brief, they are collectively interlinked and mutually reinforcing. A country framed in five well-balanced and well-reinforced shells offers little or no risk. And a country fraught with ethnic, racial, and religious strife as well as chronic economic crises and illiberal democratic practices will suffer from high political risk and discourage investors.

Political Risk Assessment Users

Avid users of political risk assessments are governments, global businesses, and increasingly nongovernmental organizations. Each needs to know the political, economic, sociocultural, and environmental conditions of a given country in which it seeks to successfully operate for profit, forge security and diplomatic alliances, cement friendly bilateral trade and financial relationships, or expand the participation of civil society in political processes. A visiting head of government needs to know about the strengths and weaknesses of the host country as well as his or her counterpart, while a global corporation must realistically assess the country's political risks before it commits millions of dollars to an investment project. A transnational nongovernmental organization needs to choose a right local partner in order to effect its global agenda, whether it be environmental, religious, scientific, developmental, or ethnocentric. Correctly assessing risks can increase the success of a state or corporate policy.

What constitutes a high risk for one country may be no risk for another. The United States may not be welcomed to certain countries due to historic policy differences, but Canada or Switzerland can watch over American interests. What is a risk for a bank may pose no risk for a mining or oil company. The U.S. foreign and defense policy in the post-9/11 era has increased risk for American businesses, due to escalating anti-Americanism around the world. A U.S. bank may not be welcomed in Sudan, a poor Muslin country that views with resentment Washington policies toward Islamic nations. But Sudan will welcome a U.S. oil company for its advanced technology and global market reach. Conversely, a Chinese firm can engage in a joint venture with IBM to access U.S. technology while reducing the political risks of hyperregulation and export control by the U.S. government, which considers China both a trading partner and security rival in the Asia Pacific.

Political risk is a dynamic phenomenon. Hence, political risk assessment requires a constant monitoring of all five categories of risks and fashioning of mitigation strategies. Multinational and global companies have come to manage their cash flows in a basket of currencies (dollars, euros, and yen) to mitigate the risk of the sudden devaluation and revaluation of a single currency, often a reflection of a country's fragile state of economy and unstable politics. In the contemporary globalized economy, sound assessment of political risk can save a company millions from regulatory or structural risks or can generate windfall profits, while a country can reduce security risk by engaging potential rivals in expanded trade and investment activities.

Some risks are interstate, others are regional, and still others are global. Before the days of regional free trading systems, such as the European Union, Mercado Comun del Sur (MERCOSUR), and the North American Free Trade Agreement (NAFTA), minor members wielded little influence in the global arena—politically, economically, and diplomatically. Today Portugal, Uruguay, and Mexico can wield more. To avoid an unpleasant showdown in bilateral relations, the United States often resorts to its formal and informal veto power in multilateral organizations such as the United Nations, the World Bank, and the International Monetary Fund to reject funding requests from less cooperative countries, thus reducing confrontational risks.

Political risk is therefore an outcome of policy choice; it can increase or decrease as the state chooses how to devise and implement its domestic and external policies. To maintain low political risk can lead to immeasurable loss of a country's independence, autonomy, and even sovereignty. In return, this can allow a country access to international capital, market, technology, and skilled labor. In the age of globalization, to insist on keeping independence, autonomy, and sovereignty can increase political risk and therefore be costly in both economic and political terms.


EUL-SOO PANG

SEE ALSO Globalism and Globalization; Modernization; Risk Ethics; Science Policy.


BIBLIOGRAPHY

Borner, Silvio; Aymo Brunetti; and Beatrice Weder. (1995). Political Credibility and Economic Development. New York: St. Martin's Press.

Moran, Theodore H., ed. (1998). Managing International Political Risk. Malden MA: Blackwell.

Pang, Eul-Soo, and Halim Saad. (2001). "Globalization, Regime Changes, and Political Risk." Journal of Diplomacy and Foreign Relations 3(2): 1–20.

Samuels II, Barbara C. (1990). Managing Risk in Developing Countries: National Demands and Multinational Response. Princeton NJ: Princeton University Press.