Political Risks: Binding Constraints on Global Trade and Investments in Emerging Markets

Political Risks: Binding Constraints on Global Trade and Investments in Emerging Markets

What are political risks? How do transnational firms choose their political risk mitigation strategies? What is commercial policy? What is the nature and function of the key commercial policy drivers? These strategic policy questions relate to the role of effective political risk mitigation strategies designed to create and sustain operational performance excellence that maximizes the return on investment and shareholders' wealth while minimizing political risks exposure and the cost of operations, simultaneously.

Political economists have established in the relevant academic and professional literature that political risks are binding constraints on global trade and investments in emerging markets. Clearly, effective political risk mitigation strategies are correlated with optimal operational performance excellence and are critical to sound and effective performance management systems and any fact-based and knowledge-driven systems designed to maximize the wealth-producing capacity of the transnational enterprise. In this series on organizational performance excellence, we will focus on the pertinent strategic political risk mitigation questions and offer some operational guidance. The overriding purpose of this review is to highlight some conceptual frameworks, political risk mitigation management theory and practice, and to suggest industry best practices. For specific political risk mitigation strategies please consult a competent professional.

Many firms engage in transnational trade and investments to become competitive and more profitable. Unfortunately, the global market environment is fraught with many risks. One of the biggest risks emerges from the political situation in the host countries. Indeed, to be successful transnational firms must understand the process of developing productive strategic relationships with governments, and managing strategic alliances with foreign partners many of which are influenced by domestic and foreign government relationships.

Commercial policy-rules and regulations that govern international trade and investments.  Commercial policy or International trade policy-governmental policy governing trade with other countries. The tools of commercial policy include tariffs, trade subsidies, import quotas, voluntary export restraints, restrictions on the establishment of foreign-owned businesses, regulation of trade in service, and other barriers to international trade. Therefore, commercial policy is often at the center of a country’s economic policy. The adverse use of some tools of commercial policy such as tariffs, quotas, subsidies, embargoes, currency control, and non-tariff barriers gives rise to political risks.

Political risk is the unanticipated probability that a transnational firm’s investment will be constrained by a host government policy. Political risks can potentially drag down the investment returns of businesses or even result in a complete loss of the capital employed in the businesses. It is not an easy task to quantify and evaluate political risks as in most cases there are limited case studies or sample sizes needed to comprehensively understand the issue of an individual host country. As such, various international agencies or other similar non-governmental organizations offer insurance against some of these political risks and the attendant adverse operational consequences.

Some Operational Guidance:

In general, no transnational firm is immune to political risks. Further, some level of political risk exists in every economy at all times resulting in a need for effective political risk mitigation strategies.  There is a gathering of empirical evidence suggesting that prudent transnational trade and investment strategies must consider the three key commercial policy drivers: Political, Economic, and Social. Often, political calculus with the attendant political risks trumps sound economic analysis and social impacts in communities.

Types of Political Risks:

There are at least two broad categories of political risks that adversely impact transnational trade and investments. Macro political analysis evaluates major political decisions likely to affect all enterprises in the country. Micro-political risk analysis is focused on government policies and targeted actions that impact selected sectors of the economy or specific foreign businesses in the country.

Political risks come in various forms including but limited to expropriation- the seizure of businesses by a host country with little or no compensation; indigenization-laws that require nationals to hold a majority or controlling interest in business operations; transfer political risks-government policies that limit the transfer of capital, human capital, payments, production, and technology in and out of the country; operational political risks-government policies and procedures that directly constrain management and performance of local business operations; and ownership political risks-government policies or actions that inhibit ownership or control of local business operations.

There is a gathering of empirical evidence in the relevant academic and professional literature suggesting that prudent transnational trade and investment strategies must take into account the three key commercial policy drivers: Political, Economic, and Social. While many assessments of commercial policy tend to focus on economic analysis, political calculus with the derivative political risks often trumps sound economic analysis and social impacts in communities.

Political Risks can be classified into two broad categories – macro-level risk and micro-level risk.

Macro-Level Risk: These risks have an effect on all the participants in a given country. Some of the common types of macro-level risks include regulatory changes, currency actions, endemic corruption, sovereign credit default, declaration of war, and changes in the composition of the ruling party. These events hinder portfolio investments as well as foreign direct investment, which can potentially change the business suitability of any given region.

Micro-Level Risk: Besides macro-level risks, transnational firms also need to pay attention to the risks at the industry level and evaluate their contributions to the local economy. Typically, the micro-level risks arise when the local governments are more in favor of the local businesses than those of the international organizations that operate there. Some of the common types of micro-level risks include project-specific government stance, and nationalization of projects, and assets.

Sources of Political Risk

In most industrialized nations, the government primarily acts as a regulator and facilitator for issues related to the environment, employment health & safety, consumers, etc. But in some cases, the government restricts business activities through adverse use of commercial policy instruments such as the imposition of higher tariffs, trade quotas, higher corporate taxes, etc. Some scholars believe that government intervention of any kind is one of the major sources of political risk as it often results in a negative impact on the economy in general and transnational firms in particular. Further, opposition political parties along with other domestic stakeholders can also engender various political risks.

Political Risk Mitigation Strategies:

In order to manage any political risk, it is very important to understand the underlying risks and then decide whether the risks are worth taking or not. Usually, transnational firms or global investors retain a certain portion of the risks and hedge the remaining to maintain a diversified portfolio so that their overall investments are not affected by any specific political event. The investors manage the risks by hedging their investments against issues that may take place in the future.

For instance, if transnational firms and global investors can sense political or social unrest in host countries then they might decide to purchase options for the equity investment there. A well-planned hedging strategy can reduce the quantum of losses significantly either by limiting the loss or creating gains elsewhere to compensate for the fall to some extent.

1.       Relative Bargaining Power Strategies

Under this strategy, the transnational firms work to create and maintain a bargaining power position stronger than the host country. For example, transnational firms may safeguard a proprietary technology that will be unavailable to the host country if business operations are constrained.

2.       Integrative, Protective and Defensive Strategies

Under this strategy, transnational firms seek to become an integral part of the host country's infrastructure and ecosystem.

3.       Protective and defensive Strategies

Under this strategy, transnational firms seek techniques that discourage the host country from interfering with its business operations.

4.  Proactive Political Strategies

Under this strategy, transnational firms engage in direct actions such as advocacy, campaign financing, lobbying, support of interest groups and social causes, and political interventions designed to shape and influence public policy prior to their impact on business operations.

Effective political risk mitigation strategies are data-driven. Transnational firms seek strategic insights designed to identify growth opportunities, optimize marketing strategies, and structure offerings to align with customer demands in the global marketplace. The rigorous synergy of market research and trade data analysis empowers transnational firms to make informed choices that propel their success. Successful transnational firms assess global trade intelligence to gain critical insights and broader perspectives and have better market understanding including effective and optimal political risk mitigation strategies.

In sum, in global trade and investments, we think globally and act locally. Effective globalization strategies require transnational firms to standardize and customize simultaneously. Additionally, in a digital ecosystem, data is critical to the effective formulation and execution of political risk mitigation strategies designed to maximize the profit-producing capacity of the enterprise.

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Prof James Gaius Ibe is the Chairman/Managing Principal-At Large of the Global Group, LLC-Political Economists and Financial Engineering Consultants and a senior professor of Economics, Finance, and Marketing Management at one of the local universities. The Global Group, LLC is familiar with the effective use of theoretical and conceptual frameworks. As reflective practitioners, we seek the creative integration of rigorous academic research and best industry practices.