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Political Risk

The Impact of Political Change and How to Protect Your Business Against It

Daniel Wagner | April 1, 2000

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Political risk insurance cannot be a panacea for every conceivable political risk that can confront an international trader or investor. But in a world filled with political change, obtaining political risk insurance can make the difference between operating a profitable business and making a costly mistake.

Almost any event can trigger political change. An unexpected resignation, a terrorist act, or a currency collapse can completely transform the political and economic landscape. Politics and economics are forever entwined, as was dramatically demonstrated with the collapse of the Thai Baht in 1997. The collapse of the Thai currency set off a chain of events that ultimately led to the economic meltdown of many of Asia's economies and impacted most of the rest of the world. It took Asia and the world 18 months to recover from that crisis, and much of Asia has yet to fully recover. It could be argued that one of the disadvantages of globalization is that the impact of political change is felt instantaneously. There is less time to react, as someone else has or will already have reacted while we were sleeping, by the time we receive the news. Perhaps the impact of the collapse of the Thai Baht would not have been so dramatic if the international marketplace were not so interconnected—if currency and stock trading didn't occur 24 hours a day. This trend toward seamless international financial transactions will continue at an even faster, even more breathtaking pace in the new decade.

Consider the impact that political change has had on us all. The Islamic Salvation Front, which is fighting for political change against the government of Algeria, is an organization few North Americans had ever heard of before the end of 1999. Yet this group, which has been fighting the Algerian government for decades, apparently decided to export its version of political change to the United States by attempting to smuggle bomb-making equipment into the United States around the new year. The actions of perhaps three or four individuals from this organization had a huge impact on the New Year's celebration plans of tens of millions of people. In tandem with the expected (but unrealized) Y2K impact, about 70 percent of Americans decided to stay home on New Year's Eve. The incident also underscores the need for closer scrutiny of Canadian immigration practices, which is sure to have an impact on the manner in which Canadians and Americans can cross each other's borders in the future.

Consider what impact Turkey's accession to the European Union may have on Europe and beyond in the coming decade. For decades, Turkey has tried to join the European Union (and previously, the EEC), but strenuous objections from Greece and other members kept it from succeeding. Germany, for example, has long expressed concern about the impact that Turkish immigrants have had on the composition of the country's ethnic composition. Now it appears that Turkey will soon become an E.U. member. Turks will have the right to travel freely throughout the European Union (as all other E.U. members do), but Turkey is Europe's only primarily Muslim nation. There will undoubtedly be a corresponding rise in the influence of Islam in European life and, because the United States has close ties to European politics, economics, and culture, what impacts Europe, could impact the United States.

What about the Panama Canal? When President Carter granted ownership of the Canal to Panama in 1978, who imagined that in 1999, when ownership was transferred, a Hong Kong company (Hutchison Whampoa) would spread enough money around the power brokers in Panama City to buy itself control over the ports at both ends of the canal. As a result, some argue, Chinese political influence has a strong foothold in Central America. In granting the concession to operate the ports to Hutchison, Panama, which has no national army, has virtually assured that U.S. military influence will be present in Panama for decades to come. This, in turn, will impact how future U.S. military budgets are allocated and how tax dollars are spent.

The Impact on International Businesses

The impact of political change on businesses is no less significant than it is on individuals—perhaps even more so. At stake are trillions of dollars of revenues derived from trading and investing abroad. For a business, the political risks associated with political change are multifaceted. For instance, the question of whether China is admitted to the World Trade Organization certainly has an implied impact on U.S. consumers (cheaper imported goods), but consider what is at stake for businesses operating in or with China. If China is admitted, businesses operating in and with China will be given a new level playing field. Suddenly, China will have to play by everyone else's rule, rather than its own. However, if China is not admitted to the WTO, there is likely to be a backlash against foreign-owned businesses. China could make them pay for failure to secure its place in the organization. If the U.S. Congress fails to approve the entry, U.S. businesses could endure serious hardships. New laws restricting access to the Chinese market by U.S. investors could be one result.

In general, an international investor often faces the risk of expropriation of assets when a new government takes power or an existing government changes its stance toward foreign investment. The risk of not being able to convert local currency into hard currency or to transfer hard currency out of a country because of a shortfall in the national foreign exchange supply or a change in law is ever-present. And, depending on where an investment is located within a country, the risk of damage to a facility or an interruption of business operations because of political violence can arise without warning.

For international traders, political risks are every bit as real. Imagine exporting goods to a government buyer only to discover after the fact that it doesn't pay its bills or the United Nation has just imposed an embargo on the country or your own government has just cancelled your export license. Wrongful calling of on-demand guaranties (for bid bonds, performance bonds, or advance payment guaranties) by governments happens all the time. Political change only accentuates the political risks inherent in trading abroad.

Political Risk Insurance

Surprisingly, many international businesses are unaware that they can protect themselves against political risk through insurance. Political risk insurance has been in existence for decades and is now more widely used than ever. Whatever the risk, an insurance product should exist to protect a business against government actions that impact the ability to trade or invest across borders.

The key test for whether a risk can be covered by political risk insurance is determining whether the occurrence was caused by a government action (a "political" risk) or was the result of a commercial risk. Insurers make a distinction between the two types of risk because a political risk is presumably not within the control of the trader or investor, and a commercial risk is. For example, a provider of electricity should be able to determine the nature of market demand for electricity and a realistic price for providing it. A loss derived from inaccurately assessing market demand or a realistic price for electricity is a commercial risk the power provider accepts by engaging in a project. However, it may not be within the provider's control to be able to ensure that the supply of coal required to operate the plant remains uninterrupted or that the government doesn't arbitrarily change the tariff arrangement between the provider and the national power company. Usually, answering the simple question of whether an action was in an insured's control or a government's control will answer the question of whether a risk can be covered by political risk insurance.

Since more businesses are trading and investing abroad than ever before, it is important that they realize that protection against government-inspired risks is available and that increasingly more underwriters are providing the coverage. Political risk insurance cannot be a panacea for every conceivable political risk that can confront an international trader or investor. But in a world filled with political change, obtaining political risk insurance can make the difference between operating a profitable business and making a costly mistake.

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