The map of political risk has taken on a changing form over the past twenty years. Along with new breeds of risk comes intensified concern over how it is handled. In a survey by the World Bank two years ago, approximately half of the investors said that political risk is a higher priority than it was five years before. Only thirty percent of risk managers, however, are confident of their management of this risk, according to a 2001 survey of the Fortune 1000.
Recent headlines justify this concern--the economic meltdown in Argentina, ongoing political crises in Venezuela, rising tensions between nuclear powers in South Asia, escalating violence in the Middle East and terrorist threats in Southeast Asia.
Political Risk of the, Past
Political risk is the threat that social, political or economic factors in a foreign country may affect the feasibility and profitability of an organization's global operations. Sources of political risk can include frequent or unexpected government changes, shifts in government policies, economic instability, nationalization, privatization, civil unrest, endemic corruption or a lack of infrastructure.
This framework definition--the specifics of which are debated--covers political actions that have varied depending on the location and the era.
Prior to 1985, political risks centered largely on post-colonial declarations of independence, civil wars and left-wing takeovers. The newly formed nations would confiscate or nationalize any foreign investors' properties, declaring an end to exploitation and the start of national sovereignty. During that time, around the globe, nearly two thousand expropriations occurred, and 15 percent to 20 percent of all U.S. foreign direct investment was lost.
A few notable examples:
* The abrupt fall of the Shah of Iran led to the nationalization of foreign-owned properties and contract default by the Iranian revolutionary government.
* Toward the end of the Yom Kippur War (in which Israel prevailed against its Arab neighbors), major Arab oil producers imposed an embargo (to punish the United States and other Western nations for supporting Israel); this was followed with the nationalization of foreign-held oil concessions in many Arab countries.
* Salvador Allende's Chile (one of the world's largest copper-producing countries) nationalized foreign-owned copper mines, a move that was applauded throughout the developing world as an act of defiance against the "economic imperialism" of the West.
* In India, the Janata Party, which held power from 1977 to 1980, expelled foreign firms (such as IBM) that refused to share their technology with domestic competitors. Coca-Cola was kicked out for refusing to reveal its secret formula.
The Past Twenty Years
The pace of loss due to political risk has not been tempered by changing times. Over the past twenty years, Aon alone has processed over $3 billion in such claims. And the Overseas Private Investment Corporation (OPIC) of the United States has paid out over $1 billion in claims over roughly the same period. (Established in 1971, OPIC is a U.S. government agency whose mission is to facilitate U.S. private investment in developing countries around the world through the use of financing and political risk insurance.)
The change in the nature of the risk can be seen in an expropriation in the mid-1980s of Belco Petroleum Corporation's Peruvian operations. Belco maintained offshore production until 1985, when its license to operate offshore rigs was revoked after a dispute over taxes with the Garcia government. Essentially, the Peruvian government imposed retroactive punitive taxes on the company, which it refused to pay.
This was one of the largest political risk insurance claims the market had seen at the time ($230 million). It illustrates the changing pretenses used by host governments (even leftist governments) for expropriating foreign-owned assets. While the newly elected Garcia government was certainly considered to be left-leaning, unlike the actions taken by leftist regimes during the 1970s, this was not a declared nationalization. Rather, it was dressed up to look like an economic (or commercial) issue. The Garcia government claimed that the decision to impose retroactive taxes and (eventually) revoke Belco's operating license was a legitimate response to years of collusion between the company and self-interested Peruvian presidents. The strong public protest that followed the Garcia government's attempt to nationalize the banking sector in 1987, however, suggests even more strongly that in Peru (as elsewhere in the developing world) the nationalizations of the 1970s were going out of vogue.
The 1980s produced at least as many expropriation claims for insurers as the previous decade did--in various industries, including extraction (oil and mineral), manufacturing, telecommunications, banking, hotels, construction and agriculture. Widespread sovereign debt defaults on bank loans (principally in Latin America) produced a wave of currency inconvertibility claims as well. OPIC, for instance, processed 124 different inconvertibility claims during the 1980s--more than three times the amount from the 1970s.
Although the losses remain, the sources of loss have changed. The risks are gradual--subtle developments in a foreign country that could go unnoticed (and a company go unprotected against them) until they surmount into a crisis situation. Political risk today rarely arises from the direct action of a host government to drive investors from the country.
Expropriation is now a risk from local or regional politicians rather than the new head of state, as governments decentralize their power structure. In the Brazilian state of Minas Gerais, the lone-wolf actions of Governor Itamar Franco cost AES Corp. and Mirant Corp. millions of dollars in legal fees. Franco persuaded the local courts to take away the companies' shareholder rights, for which they had paid $1.056 billion. They have been fighting, so far without success, to overturn these court decisions.
Change of government--whether voluntary or not--is another potential source of political risk. A change of government in the emerging markets could result in bad monetary policy, a deterioration of the country's balance of payments or the politicization of contracts with foreign investors. In several of the emerging markets, new governments today are more likely to negate an agreement than confiscate assets.
In one widely publicized case, the newly elected government of Maharashtra, India, which campaigned with the slogan "Throw Enron into the sea!" fulfilled this campaign promise when it unilaterally canceled the contract for a $2.8 billion electric power generation plant to be built and owned by a consortium led by Enron. Although renegotiations with the new government led to a revised deal, disputes between the government and Enron resurfaced two years later, leading to the termination of the project.
According to the Global Competitiveness Report, published by the World Economic Forum, the worst offenders of this behavior have been the politicians of the Ukraine, Russia, Ecuador and Hungary.
Governments also engage in selective protectionism--the unfair use of political influence (most often in courtrooms or local legislatures) against foreign investors. In India, for example, an investor was forced to pull out after incurring $26 million in losses, largely from politically motivated lawsuits.
Developing-country legal and regulatory systems tend to exhibit corruption, political influence and antiforeign bias. In countries where local authorities are both the owners of key corporations and the regulators of market competition, problems of this kind can be severe. In China, local authorities enact regulations that favor their own commercial interests. The Beijing municipality, for example, issued a regulation that no sports utility vehicles could travel on three main roads in the city--apart from the Beijing Jeep, made by a city government subsidiary.
The most drastic and hr-reaching political risk has been the devastating economic downturn around the globe--and the potential of a worldwide recession. In fact, a series of economic and currency crises that hit a number of the emerging markets during the past decade were responsible for some of the largest political risk insurance claims in its history.
For example, the currency crisis in Indonesia led to the government abrogating contracts with Independent Power Producers, which nullified hundreds of millions of dollars of investment in the country's power sector.
The paid and potential claims arising from the recent economic crisis in Argentina is another good example. The government there has defaulted on nearly $150 billion of its foreign debt. Foreign exchange controls were imposed, the peso devalued, many dollar-denominated contracts were translated into pesos, and other measures were taken that in some cases will amount to expropriation losses. The political risk insurance market (private and public) has received claims notices affecting over $1 billion of foreign investment.
In light of weakened economies, governments that had welcomed foreign investors are starting to question the viability of the Western economic model. When millions of people move from the aspirations of the middle class to the despair of basic survival, the seeds of political and social instability are sown. Blaming foreigners for the unpleasant byproducts of industrialization and economic liberalization (e.g., income disparities, high unemployment, pollution) is a proven political strategy. The subtle step from an economically distressed region to an area of political unrest may come in many once thriving regions.
Gradual changes--particularly in the economy--can build up to dramatic political changes. The currency crisis that swept across much of Southeast Asia had a severe impact on Indonesia. Within the span of a year, the local currency devalued by more than 500 percent. Due to the disproportionately large foreign debt burden, many Indonesian companies went bankrupt, leaving millions of Indonesians without work. Prices of popular products skyrocketed (e.g., bus fares increased by 70 percent, train fares by 100 percent, electricity rates by 20 percent, gas by 71 percent and kerosene by 25 percent). This and the Indonesians' distaste for the corrupt Suharto government, was the main force behind the revolt that toppled the regime.
Managing Today's Political Risks
Managing today's political risks requires that the investor take a systematic and comprehensive approach to risk identification and assessment. A cursory assessment may overlook types of risk--seeing a national guarantee against expropriation, for instance, while overlooking the potential for creeping expropriation through punitive regulatory measures--or key sources of exposure--outsourcing arrangements, just-in-time inventory management and logistics streamlining.
Political risk assessments should consider micro and macro levels. It is influenced by characteristics of a company's international activities, i.e., it matters very much who you are, what you do and how you do it. For instance, a bank with sovereign debt in an emerging market will be mainly concerned with that country's macroeconomic policy decisions, since such decisions will directly affect the value of the debt. If the bank has no physical presence in the country, though, it will be far less concerned with risks such as political violence. By contrast, an oil company with an exploration and production project in the same country will focus its attention on security issues and its relationship with the host government. If the oil company sells the oil outside the country, though, that country's macroeconomic policies will have much less impact on operations.
With a systematic approach, companies can do a better job identifying their political risk exposures, and by looking at both micro- and macro-level risks, companies will be able to focus on the specific types of risk that have the greatest impact on their global business operations.
A few basic techniques to mitigate political risk include:
Contractual undertakings with the host government. Although contracts cannot prevent a government from exercising its sovereign rights to change laws and policies, they can establish a right to compensation if the government makes such changes to the detriment of investors. Enforcement may be assisted by an agreement to refer disputes to international arbitration. Governments may also waive sovereign immunity to the enforcement of such awards in national courts.
Involving local private interests. Local joint venture partners can help to navigate the local political scene and may be in a position to exercise more influence over government policy making. More importantly, governments are less likely to act to the detriment of enterprises if doing so would harm significant local interests.
Joint ventures with the government are less desirable. Historical analysis suggests that public/private joint ventures are more, not less, likely to be subject to expropriation and that such joint ventures may perform less efficiently than even wholly government-owned enterprises. The government's roles as owner, operator and regulator are easily blurred.
Community relations. Common measures include educating the public on the benefits of foreign investment and the role of the private sector in providing previously public services. Schemes to promote social welfare (schools, hospitals, etc.) and rural development can be helpful.
A New Twist to Political Risk
September 11 and the United States-led war on terrorism have brought a new dimension to the political risk concerns of the future. The potential and past threats are tragic and dramatic. The Bali blast heightened fears of a growing terrorist threat in Southeast Asia. A strike on Iraq may have already commenced by the time this goes to print, followed by a prolonged U.S. occupation of the country. The effects of this on Arab and Muslim sensibilities could trigger increased anti-U.S. sentiment and cynicism, intensifying the upsurge in terrorist strikes on U.S. interests.
This intense environment, combined with worldwide economic crises, may very well bring political risk management back to its past-with the dramatic threats of unpredictable attacks and total losses. This was illustrated in mid-January when heavily armed troops in Venezuela raided a foreign-owned Coca-Cola bottling plant and commandeered trucks and product "because collective rights come above individual rights."
But despite the drama of the terrorist threat that any global company-but particularly U.S. interests--must contend with, it would be a mistake to overlook the insidious political risks that may gradually chip away at an organization's international operations. There may be new risks to grapple with, but they have not supplanted those that have proven very costly, over the past twenty years.
Political Risk Insurance
Many companies have used political risk insurance as an effective means of managing their political risk exposures. Political risk insurance encompasses a broad family of related insurance products designed to insure against government acts (or failures to act) that adversely affect a company's normal business operations. Investment coverage protects foreign direct investment and addresses interference by a host government in fundamental ownership and operation rights. Trade coverage is oriented toward export and import transactions including host government interference in the successful conclusion and payment of the transactions. Policies are often customized to address specific concerns of foreign investors or lenders.
In addition to private sector underwriters, government agencies such as the Overseas Private Investment Corporation (OPIC) and the Multilateral Investment Guarantee Agency (MIGA, par of the World Bank) also offer coverage. Although the private market is more flexible--many of the underwriting criteria, such as nationality of the insured, developmental impact of the investment and status of investment at time of application, do not apply to commercial market programs--there are distinct advantages to buying political risk insurance from OPIC or MIGA. The diplomatic assistance, leverage and political clout provided by the U.S. government (OPIC) or the World Bank (MIGA) can help resolve disputes with the host country government.
Find More: "Making Political Risk Fit" RM April 2002 Archive at rmmag.com
John Minor is senior vice president, national director, political risk at Aon in Chicago. This article is based on a presentation made at REBEX in 2002.…