Political Risk Management

Political risk is a broad term to collectively describe the risks companies and investors face due to
the exercise of political power. These include potential losses from expropriation, nationalization
and regulatory changes, as well as the potential risk of a government or government agency not
honoring a contract. Political risks also include potential losses due to riots, civil-war and
terrorism, as well as soft threats such as reputation damage and firm specific boycotts. Political
risks are sometimes divided into country specific risks (which affect all companies operating
within a particular country) and investment specific risks (such as discriminatory regulations).
Political risks to portfolio investors tend to be country specific whereas political risks to foreign
direct investors and individual companies tend to be investment specific.2 It is the company’s
chief financial officer or the risk manager who is responsible for assessing a company’s exposure
to political risks, as well as to develop specific risk mitigation strategies. Companies frequently
outsource the country analysis to political risk advisory firms, which specialize in assessing these
types of risks. Companies may also develop relations with relevant authorities and community
groups to mitigate investment specific risks.

Political risk is always a factor in international commerce due to the unavoidable differences
between the laws, customs and policies of foreign governments. As foreigners entering new
markets, we often lack the local market knowledge and culture to understand these differences
and must depend on outside sources for information and forecasts.

In most Westernized nations, a vast library of economic statistics and political analysis is publicly
available for review. These countries tend to have well-developed and predictable economies and
relatively stable governments. Developing countries offer less transparency and access to accurate
economic or industry statistics may not exist at all.

By understanding the elements of political and economic risk, it is easier to define a model for
risk management and decision-making and to collect appropriate data for analysis. This article
will review the various components of economic and political risk and offer a method used for
quantifying and comparing the "riskiness" of doing business in different countries.

If a company has global business interests, your assets and investments may be at risk. A foreign
marketplace not only offers great business opportunities, it also presents greater financial
uncertainty. Some of the unforeseeable events include:

ƒ Economic instability
ƒ War & Political violence
ƒ Foreign Policy changes
ƒ Confiscation
ƒ Fluctuation in Currency Exchange
ƒ Deprivation of capital
ƒ Embargo or license cancellation
Political Risk management helps mitigate the risk to your assets, while allowing your business to
expand its international interests. Protect your company against:

ƒ Unpredictable changes in government policy towards foreign investors

ƒ Repatriation of profits, intra-company fees or dividends, which can be interrupted if
the host country’s economic priorities change and approvals for foreign exchange
and currency transfer and not forthcoming
ƒ Physical damage to your assets due to politically motivated violence
ƒ Losses of permanent, mobile and leased assets due to confiscation, non-repossession,
or political violence

There are many services that measure Political country risk. The appendix provides information
on the following providers:
1. Bank of America World Information Services
2. Business Environment Risk Intelligence (BERI) S.A.
3. Control Risks Information Services (CRIS)
4. Economist Intelligence Unit (EIU)
5. Euro-money
6. Institutional Investor
7. Standard and Poor's Rating Group
8. Political Risk Services: International Country Risk Guide (ICRG)
9. Political Risk Services: Coplin-O'Leary Rating System
10. Moody's Investor Services

Shifts in global conditions are changing the acceptance rate for international resource projects.
Major projects, unviable as recently as two to three years ago, are now attractive investments.
Rising prices in commodity markets, strong demand growth from China and increasingly India,
combined with limited mineral and energy prospects in developed nations, have caused resource
companies to look to a new geographical frontier for mining and energy projects. This frontier –
in places where mineral or energy exploitation has not previously occurred, or was deemed too
remote, dangerous or difficult – is not well understood and faces a number of issues including
changing agendas of governments, the presence of separatist groups, ethnic and cultural conflict,
and civil war. The new frontier is complex and introduces an element of risk for investors which
management must consider.

Political risk is 'the possibility that political decisions, conditions, or events in a country will
affect the business climate in such as a way they investors will lose money or not make as much
money as they expected when the investment was made. Risk evaluation is 'an effort to determine
the level of risk pr probability of losses, given the character of the situation'. The requires a
method of forecasting risk because 'there is much less utility in simply describing conditions to
day than there is in what the conditions will be in 18 months of five years when investments
achieve some kind of maturity.' 1 A number of models formulated to evaluate risk are reviewed
below.
Formal Political risk evaluation models:

Formal risk evaluation models scrutinize statistic and are unlikely to omit significant risk factors,
allowing countries to be compared on a direct statistical basis. 'They are systematic, lend
credibility to analysis, employ experts who test the viability of the models or their components
and serve as a 'cross-check against subjective assessments.

Formal systems help companies not wishing to formulate in-house models, which are expensive,
time-consuming and of little geographic coverage. They help to educate staff in their target
country and they are generally transparent, allow company officials to 'see the reasoning and
methodology behind a judgment.'

Formal systems can be, however inflexible. Their statistical base may cause analysts to overlook
important country-specific variables. They may appear objective while based on subjective
foundations, and the accent on statistic may emphasize economic data at the expense of political
input.

Dependence on systems may impede judgment. The quest for objective may detract from a
desirable 'subjective element,' leading to an overly-scientific approach. The selection of factors,
the importance attributed to them and the interpretation of results are subjective judgments.

ƒ Checklist systems aim to be comprehensive. They include 'specific indicators and

general questions that need answering through a subjective judgment.' they aim at 'a
country risk Rating with the maximum objective' achieved via a ' scientific route.'
Checklists offer a 'formal ' score, but specific indicators must carefully assessed.
Analysts may favour quantifiable factors and statistics, but statistics can be misleading
and do not guarantee objectivity. Though analysts select 'the important factors', the
selection process is a subjective one. Analysts could improve checklists by combining
them with other models. While checklists are useful, there is no guarantee that
'relationship that existed during the period of empirical observation remain valid now or
in the future. They might add more increases and cross-referenced so that they 'cover
some of the same ground as a way of guarding against misleading statistics.'

ƒ Statistical systems use' a weighted set of indicators' to predict risk. The system samples
countries which have rescheduled debts and others that have not. Variables are then
identified to differentiate the two groups of countries. These systems are a 'useful cross-
check' against other method and function as an early warning device. If rescheduling is
expected, 'resources can then be focused on an in-depth country risk investigation,
including visits, relying on the economic, political and social structure.'

ƒ Sampling, however, is not an objective process, and the factors that lead countries to
reschedule can vary if economic and trade circumstances change. Consequently,
definitive judgments about countries cannot be made, and if the economic paradigm
changes, comparisons become invalid. System should be redesigned to forecast debt
rescheduling, rather than explain it retrospectively.

ƒ Economic forecasting, or econometric modeling, is useful, though time-consuming. It

may help analysts to understand an economy, but data is often unreliable or incomplete
as 'developing countries are relatively less stable than developed countries'. Econometric
 models' suffer from the difficulty of securing current sources of data for many of the
important independent variables necessary for the analysis.'

ƒ Scenario analysis seeks to forecast country risk by the 'elaboration of two or more
alternative scenarios'. A 'sensitivity analysis' then indicates 'the importance of particulars
parameters to the final outcome.' Firstly, the parameters have to be selected:external
factors (world trade growth, oil prices) and internal factors (national trade polices,
political regime etc.). Then the scenarios are plotted. This is good, general method which
can be adapted to include specific country indicators. It is a useful ' framework for
analyzing a group of countries to provide a comparative analysis.'

ƒ Bank evaluate risk with economic and credit surveys, quantitative or statistical analysis,
political, social and strategic analysis, or a qualitative analysis of economic, social,
political and financial situation).

ƒ Survey-based models often combine expert opinions with a scoring system for country
risk ranking. A model that linked ' political instability to the accumulation of public
external debt, private capital outflow, income distribution, restrictions on capital outflow
and repudiation of external debt' would be an improvement. This is in progress.

ƒ Statistical models, though arguably more objective than politico-judgmental models, are
not necessarily more reliable. They have methodological weaknesses and assume that'
historical data has significant value for predicting future outcomes.'

ƒ Country rating systems have generally been unsuccessful. The problem may lie not with
the individual analyses but ' in the way they are exploited.' While an analysis may
accurately describe country risk, it may not effectively applied.

ƒ Selection of the appropriate model depends on the purpose for a bank's assessment of
risk.

ƒ Qualitative models may prove sufficient if comparisons are required, some

quantification of risk is required. Qualitative models can allocate score, but it is difficult
to ensure a 'consistency of approach to all countries. 'Though subjectivity cannot be
wholly removed, the process should be ' as scientific as possible.'

ƒ Though 'economic risk factors involve some subjectivity', decisions can be based on
them. Political factors such as internal unrest or external conflict offer no hard data on
which to base a judgment.

ƒ A mixed-model may be the solution, perhaps a checklist scoring system supported by a

statistical model ' or a qualitative report-orientated system'

ƒ While 'experts based system can be criticized for not always making causal relationships
explicit and for their potential bias in the judgment of its members. They ' can help a
great deal in lending order and some precision to qualitative analysis . Expert and Delphi
systems 'exploit the expertise of analysts', but while they enjoy the 'strength of group
forecasting', analysts 'must be extremely diligent about the selection of "experts" as they
tend to disagree as often as the agree.
What tools are there available to understand and manage political risk?
While quantifying these abstract issues remains important, embracing shades of grey requires the
firm to look very closely at the tools that generate the assumptions underlying their numbers. To
ask the right questions, for both the initial investment decision and ongoing monitoring of the
project, the assessment should include the academic or expert regional perspective and the
technical experts in conjunction with a number of other key sources. This allows for a strategic
framework which provides context from which political risk can be better understood. Context is
critical because it leads to better questions, analysis of the correct information and improved
assumptions upon which decisions can be made.

The ideal evaluation of political risk should be made on the basis of the following tools:

Academic Expertise:
Engaging experts on the culture and history of a region is an important aspect of understanding
political risk. While too much emphasis, we believe, can be put on their interpretations, this
background information is critical in providing the context for understanding contemporary
issues.

Technical Acumen:
A basic understanding of the technical aspects of the economic cycle, business decision making
and resource projects is required to evaluate political risk. This allows a broader review of
influencing factors to be considered.

Humint or (Human intelligence):

On-the-ground information is critical for new projects. In regions where there are no other
international resource projects, and a lack of press reporting, knowing what is occurring at the
street level is critical.

Trend Analysis:
Contextual trend analysis, such as the work done by the Australian Office of National
Assessments, can provide important information and context which is not obvious to regional or
country experts and not initially obvious to business. This involves continuous review of
demographic, social, environmental, financial, military and political trends across states and
across regions.

Given the significant value of new resource projects coming on stream over the next few years,
political risk will become a significant success factor for a number of companies.