The exercise of political power is the root cause of political risks in international business. How political power is exercised determines whether government action threatens a firm's value. For example, a dramatic political event may pose little risk to a multinational enterprise, while subtle policy changes can greatly impact a firm's performance. A student-led protest for political change may not change the investment climate at all, while a change in local tax law can erode a firm's profits very quickly. It is the task of the risk manager or company CFO to identify whether a government action poses a threat to a firm's financial well-being.

The first distinction that must be made is between firm-specific political risks and country-specific political risks. Firm-specific political risks are risks directed at a particular company and are, by nature, discriminatory. For instance, the risk that a government will nullify its contract with a given firm or that a terrorist group will target the firm's physical operations are firm-specific. By contrast, country-specific political risks are not directed at a firm, but are countrywide, and may affect firm performance. Examples include a government's decision to forbid currency transfers or the outbreak of a civil war within the host country.

Firms may be able to reduce both the likelihood and impact of firm-specific risks by incorporating strong arbitration language into a contract or by enhancing on-site security to protect against terrorist attacks. By contrast, firms usually have little control over the impact of country-level political risks on their operations. The only sure way to avoid country-level political risks is to stop operating in the country in question.

There is a second distinction to be made between types of political risk: government risks and instability risks. Government risks are those that arise from the actions of a governmental authority, whether that authority is used legally or not. A legitimately enacted tax hike or an extortion ring that is allowed to operate and is led by a local police chief may both be considered government risks. Indeed, many government risks, particularly those that are firm-specific, contain an ambiguous mixture of legal and illegal elements. Instability risks, on the other hand, arise from political power struggles. These conflicts could be between members of a government fighting over succession, or mass riots in response to deteriorating social conditions.

The Impact on Firm Performance

The risk manager's ultimate challenge when assessing political risk is to determine whether a political event poses a threat to a firm's financial performance. A mass demonstration in a stable developed country may be less significant to a firm's performance than one occurring in an unstable developing country. Similarly, a worker strike for higher wages is very different from a nationwide strike to overthrow an incumbent government.

The nature of political risk varies most fundamentally by the category of investor (direct or portfolio) because their exposures to political risks differ. In general, portfolio investors are more likely to be affected by country-level risks, such as a sudden hike in interest rates or unanticipated currency devaluation, while direct investors tend to be affected more by firm-specific risks. It is therefore necessary to focus on those political dynamics that affect the overall business environment in a host country.

When assessing political stability, the focus should be on the legitimacy of state authority, the ability of that authority to impose and enforce decrees, the level of corruption that pervades the system of authority, and the degree of political fractionalization that is present. Where economic policy is concerned, the focus would be more along the lines of the degree of government participation in an economy, the government's external debt burden, and the degree to which interest groups can successfully obstruct the decision-making process. Effective political risk management requires distinguishing developments that pose true risks—a well-defined threat to corporate performance—from political events that are merely dramatic.

Risk Management

Although there are a number of ways to protect your firm against political risks, proper planning and due diligence are most important. Too many businesses begin operations in an unfamiliar country without having taken the time and devoted the resources necessary to ensure a better-than-average chance of success. Developing solid relations with relevant governing authorities is the preferred approach, but this may not always be possible or even desirable.

Another important component of creating a political-risk-friendly investment environment is to establish a good relationship with your workforce. Too often, foreign businesses are perceived as having uncaring managers who do not appreciate their workers. This can have dire consequences. One of the best ways to protect your assets is to generate a loyal workforce. Management can be replaced much more easily than can a workforce, and it is becoming more common for host governments to remove corporate managers and replace them with other experienced managers that will operate in accordance with government objectives.

Be alert to what is happening in your host country. This may sound sophomoric, but it is easy to lose track of the bigger political picture once an operation is established. After an operating environment has changed, it is often too late to do anything about it. Remain engaged with your local embassy and chambers of commerce. A collective voice is more powerful than that of an individual firm, even if the firm has a solid relationship with governing authorities.

Finally, don't underestimate the potential benefits of using Political Risk Insurance (PRI) to manage your political risks. There are now more PRI providers with greater capabilities than ever before. Whether you want to take out general coverage (against expropriation, currency inconvertibility, or political violence) or create coverage tailored to your specific needs, chances are good that one or more of the private-sector PRI providers can meet your needs. But remember to pursue coverage before a problem occurs; after it happens, coverage will be difficult to obtain.