In the era of globalization and international trade, host countries may be facing rigid legislative, judiciary and governmental institutions, unfavourable to international operations from foreign firms. Moreover, dictatorships, bribery, corruption and unstable governments are, in many cases, substantial reasons for assessing the political risk involved in a firm’s launching onto a foreign country.
Political changes in shaky countries define the nature of political risk and measure its impact on the variability in the firm’s value. Political changes may create uncertainty, yet the extent to which political risk affects the firm’s value is closely associated to the characteristics of broader business environment.
When assessing political stability in the host country, a firm should focus on the legitimacy of the state authority and the exercise of political power. For example, if the government of the host country is corrupted to a level that permeates the system of authority, it may impose trade decrees aiming to achieve price control and foreign exchange control. As far as economic policies are concerned, a corrupted government would focus on allowing a higher degree of governmental intervention in the economy of the host country, thus increasing the political risk undertaken by the firm.
Another implication of political risk is that being locally residual and unrelated to global economic conditions it eliminates the possibility of global intervention. Ideally, the firm’s cash flows should be invested in different host countries. Yet, in the absence of global intervention, the firm’s cash flows do not allow risk diversification. Within this context, the relationship between low economic growth and high political risk is substantial for effective political risk management.
In order to manage political incidents, a firm should adjust its operations and consider own bargaining power, but also the bargaining power of the host country. Factors such as product uniqueness, technological advancement, the firm’s size and operational growth are substantial for performing profitable international operations. On the other hand, the bargaining power of the host country is equally important in terms of the size of the market, its wealth, the abundance in its raw materials and the level of governmental intervention.
Another way to manage political risk is to distinguish between developments that may cause true risk in the firm’s value from simply dramatic political events. A dramatic political event may cause a certain risk to the firms’ operations, but a change in a juridical policy may affect heavily the firm’s operations. Therefore, the decision to discontinue or not the firm’s operations or to negotiate on a settlement should be based on methodically evaluated facts, taking into consideration the cost factor as well.
Political risk includes also potential losses from regulatory changes, nationalization, redistribution of the wealth from the rich to the poor, investment risks, reputation damage, riots, civil-war and terrorism.
Written by Christina Pomoni
Financial Adviser – Freelancer Writer