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Political Risk

Managing Political Risk in the New Normal

Daniel Wagner | January 1, 2011

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Now that the global economy has stabilized, trade and investment flows are returning to more conventional patterns, cross-border transactions are set to rise in 2011. Among the many challenges facing risk managers now that the economic convulsions have stopped is to effectively manage cross-border risk, which is more important today than in recent memory for a simple reason: the rules of engagement for conducting international business have changed—the risks associated with cross-border transactions are high, risk aversion is high, but the margin for error is low.

It is only natural after recovering from global economic trauma that international businesses would think more carefully about assuming and managing cross-border risk, but doing so has become more difficult. One of the things that has changed over the past 2 years is that the "new normal" includes a paradigm shift. Just as the rule book changed after the collapse of the Soviet Union, it has changed again as a result of a combination of a decade of globalization and a decoupling in growth patterns between the developed and developing worlds, which implies a change in risk profile between the two.

There was plenty of debate when the financial crisis began about whether industrialized and emerging countries would move in tandem downward. Indeed, they did, by and large, but what has become clear over the past year is that the largest developing countries are galloping ahead of the developed countries, projected to have average growth rates between 6 and 8 percent this year, while North America and Europe may have growth rates of 1 to 3 percent. You could argue, rightly, that this is really little different than the reality prior to the crisis. The difference is, the temptation among many international companies will be to trade and invest in developing countries as a result of the disparity in growth rates without, perhaps, fully considering the implications of doing so from a political risk perspective. The need to do so was always present, but the way many businesses traded or invested internationally before the crisis did not require the same degree of due diligence that is required today.

You've heard the story before—it all sounds good on paper. Country X is growing rapidly, it has a democratic government, demand for your product there is high, and the country or buyer appears to have the money to pay for it. But in an era when economic volatility is high, and many financial professionals have little more than a quarterly orientation to the future, have you considered what may happen 5 or 10 years from now, after your long-term investment has been made, the government changes, and the country can no longer pay its bills? What tools, if any, does your company have to assess and manage such risks?

Assessing the Risk

To the extent that international companies devote any resources at all to understanding cross-border trade and investment climates (and, in my experience, most do not), they tend to over-rely on externally generated country risk analyses, which are more often than not produced generically and are not entirely appropriate specific transactions. This is perhaps the most common mistake risk managers make. They believe that because they may have information about the general political and economic profile of a country, they have a true handle on the nature of the risks associated with doing business there.

What about gauging legal and regulatory risk, the country's friendliness toward foreign trade and investment, and other companies' experience there? Too often, companies get caught in an "investment trap": they commit long-term resources to a country only to find that the bill of goods they were sold—or thought they understood—turned out to be something completely different. There are plenty of stories out there about companies whose investments turned into disaster because the regulatory environment changed, a legal issue arose, international sanctions affected their ability to operate, or they selected the wrong joint venture partner. After the investment has been made, it is often too late to pull out without incurring large losses and experiencing reputational risk once the story hit the press.

Avoiding Miscommunication

Another common issue is that the lines of communication between risk management personnel, risk management and decision makers, or between decisions makers is either bypassed, convoluted, or just plain wrong. I have seen instances where:

  • Risk management is given only cursory participation in the transaction approval process.
  • Sales teams bypass risk management entirely, or ignore risk management's recommendations, because they fear a transaction will be canceled as a result of unacceptably high levels of risk.
  • A CEO delivers a presentation to a board of directors that is false, but he believes it to be true, because the risk manager's staff said it was.
  • A board of directors has no idea what questions they should be asking of corporate decision makers.

A risk manager may have the right information, but it is based on a short-term assessment of the risks. The long-term view may be completely different. In the absence of knowing what questions to ask and having clear lines of communication, the right information may not be taken into consideration.

Conclusion: Do Your Homework

The simple way to limit the possibility that unforeseen events will occur is to establish clear reporting lines and do your homework—I mean really do your homework—and either hire one or more individuals in your company to focus full time on managing these risks and/or hire an external firm to created a customized risk profile for each and every investment your company plans to make. The expense involved pays for itself many times over when a problem is uncovered and avoided, yet many companies are happy to invest millions of dollars to make cross-border investments without doing their homework.

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