Risk Management

Managing political risk

Published: Jan 2020

Following recent developments surrounding Brexit, the ongoing trade war between the US and China, and tensions in the Middle East and Hong Kong, treasurers are paying closer attention than ever before to the issue of political risk. Although political risk cannot be completely avoided in today’s volatile world, companies can still learn how to manage it effectively.

Illustration of the earth on a roulette table with country flags

It goes without saying that we live in a volatile world. Global pressures from competing economic, political and social factors have combined in recent months to put a real strain on international businesses, local currencies and interest rates.

Between the Brexit saga, drone strikes in Saudi Arabia, the ongoing conflict in Syria, the US-China trade war, violent protests in Hong Kong and the threat of a global recession, there are numerous risks for treasurers to monitor. And as we start the new year, it seems our volatile world won’t be calming down anytime soon.

As such, there’s a growing need for companies to pay close attention to political risk. Take last September’s drone strikes at the state-owned Saudi Aramco oil processing facilities at Abqaiq and Khurais in eastern Saudi Arabia as one example. For some businesses, the strikes were completely unexpected – but for others, they came as no surprise. That’s a view held by Charles Laurie, Head of Country Risk at risk advisory company Verisk Maplecroft.

“Very rarely is an incident truly ‘unexpected’ – we had been highlighting the growing tensions in the region to our clients for some time,” he says. Following the strikes, the country’s oil production was almost halved, with Brent Crude oil futures surging by almost 20%.

“We believe the market has drastically undervalued what we call the ‘Middle East risk premium’,” explains Laurie, who recognises that mitigating against civil conflict or acts of war is highly challenging for corporate treasurers. “But understanding the local environment, having necessary contingency plans and responding swiftly can make all the difference.” But in order to take the necessary actions, treasurers first need to answer a pertinent question: what exactly is political risk?

According to Nicholas Fitzroy, Director of Risk Briefing and Middle East analyst at The Economist Intelligence Unit (EIU), political risk is notoriously broad and difficult to define. That said, it is largely about tracking political decisions and the resulting actions which impact a business’ ability to reach its goals – normally in terms of profit and/or revenue. For example, the drone strikes in Saudi Arabia have since been attributed to events surrounding the Saudi Arabian intervention in the Yemeni Civil War.

“What is most important to note when it comes to political risk is that the actors making these decisions are normally governments – but certainly, and increasingly, not always,” says Fitzroy. “Terrorist groups, nationalist movements and hacktivists (cyber-criminals) are all examples of groups that can create significant political risks for companies without being anywhere near government.”

In basic terms, political risk can be defined as any political event, or the results of any decision that has the potential to negatively impact commercial activities. This risk is often grouped and analysed on macro and micro levels:

  • Macro-level risks are those which impact all businesses operating within a specific region. These risks are often widely discussed in the media and include: political and civil unrest (eg Brexit uncertainty/protests in Hong Kong), energy-price volatility (eg Saudi Arabian drone strikes), terrorism (eg the ongoing war against ISIS in the Middle East) and civil or cross-border conflict (eg Turkey in Syria or Russia in the Ukraine).

  • Micro-level risks are firm or industry-specific risks. These types of risks are, by their very nature, discriminatory. This category includes the risk of a government nullifying a contract with a certain business, or the risk that a terrorist group will target a certain company’s operations.

“In terms of the actual risks themselves, the broad nature of the political risk definition highlights how wide-ranging it can be; from warfare and social unrest, to shifts in governmental policy and regulatory environment, to things like cyber threats and environmental boycotts,” says Fitzroy. As such, there is no doubt that political risk is hard to characterise.

Impact and management

Yet savvy investors know that any rise in political risk has the ability to negatively impact both a country and the companies operating within its borders. This is because political risk can do real damage to credit ratings and equity prices, and many countries experiencing political risk are often destabilised through reduced foreign direct investment (FDI).

Any reduction in FDI has the potential to slow economic growth and increase social unrest, inequality and corruption, not to mention a reduction in wages and the value of international equities.

In addition, these issues can affect other asset classes. For example, should a country experience slower economic growth due to a reduction in FDI, this can impact its ability to repay its debts, which would then have a detrimental impact on bond markets. Such events could also exacerbate currency-related issues, because any reduction in the value of a country’s currency could lead to slower exports which would also stall economic growth. Yet before a company can even start thinking about how to manage political risk, the first step is to find a way of identifying and quantifying the different threats that the company faces. Armed with this information, the board can then analyse how these threats might impact upon strategy and the company’s ability to access and operate in different markets.

Assessing the risk

A combination of political risk assessment and analysis is typically used for this objective. On the macro level, quantitative risk assessment considers the general attributes and variables of different political environments. Data from specific countries is aggregated to generate an overall score, allowing them to be comparatively assessed and assigned a graded risk level. A number of risk consultancies offer such indices, including both Maplecroft and The EIU.

“The EIU does two things,” says Fitzroy. “First, we measure and update 70 indicators across a range of risk categories for countries around the world. These indicators offer a form of early warning for future risk scenarios. Then, more specifically, we also create a risk scenario watchlist for countries in which we write and score the top ten-20 risks for businesses. This involves giving each scenario an impact and probability score, which we then combine to give an intensity score, allowing us to compare and evaluate, and ultimately to prioritise, certain risks over others.”

Maplecroft’s annual Political Risk Atlas includes short-term risks, such as the rule of law, political violence and regime stability, in addition to longer-term factors such as economic diversification, resource scarcity and human rights.

“We work across three defined areas that enable us to provide a 360-degree view of risks to our corporate clients,” says Laurie. “Our risk indices and predictive analytics offer a granular view of risk that is unique within the industry. These score 198 countries across 150-plus issues, ranging from civil unrest, to child labour, modern slavery, climate change vulnerability and government stability, which enables companies to pinpoint vulnerabilities in their operations, supply chains and investments.”

He continues, “This is combined with expert analysis of human rights, environmental issues and political risk from a team of 60 experts who help our clients understand what these risks mean for them and where they are going.” In addition, Maplecroft provides consulting solutions that draw on its data and research and are tailored to each client’s specific needs. These can range from a supply chain risk management tool, to horizon scanning for geopolitical issues, to developing a strategic human rights framework.

For the risk manager or CFO, the changing values of such indices can provide a useful starting point for identifying future risk events. To take human rights in Hong Kong as a recent example, if you wanted to look at the probability of large-scale social unrest breaking out, both Fitzroy and Laurie agree this could have been foreseen after the proposal of the Chinese extradition bill in February last year.

“The extradition bill was one of the immediate causes of the protests, but there are so many other indirect causes, such as wealth inequality, the quality of the living environment not being as good as it was before, coupled with the cost of living increasing rapidly too,” says Honnus Cheung, CFO, Asia and GM, China at Travelzoo. “Young people want to do something to improve the current situation.”

The four Ts

Maplecroft’s Laurie believes that when it comes to political risk, context is key. In a world of 24-hour breaking news, treasurers need to know much more than just the headlines. It’s not just about finding out what has happened – it’s also about having a clear view of the consequences. Treasury needs to understand why particular risks matter and how they will impact on the overall business – not just in the present, but in six months, two years and more.

Taking a holistic approach to understanding how these risks interconnect is the most important step. But how can treasury do this? In our increasingly-connected world, data is the new frontier for risk management: it can help treasury understand current risk, the trajectory this risk will take, and how it will change.

Civil unrest is a prime example. Protests and instability don’t happen in isolation, so understanding the drivers behind these issues, such as corruption and the human rights environment, can help treasury pinpoint where disruptive events might occur in the future.

Once a political risk is identified and evaluated, companies can then begin the process of managing it. As is the case with other types of exposure, there are four main ways in which a company can do this:

  • Tolerate – one option companies may opt for is to tolerate the risk, concluding that the level of risk they face is acceptable and decide to proceed as normal, while monitoring it to ensure that it does not increase in the future.

  • Transfer – if a company decides that the level of political risk is too high, but still wants to continue operating in a certain region or country, one option may be to take out political risk insurance in order to shield the company, should the worst happen.

  • Treatment – this involves taking actions that will reduce the likelihood of an adverse event occurring in the first place. That could mean lobbying a government in the hope of achieving a more favourable legislative outcome, or, alternatively, taking certain steps to mitigate the impact of a damaging policy decision.

  • Terminate – in cases where the level of risk is deemed unacceptable, a decision may be made to terminate a certain activity. What is determined to be an acceptable level of risk may vary between industries and companies. To take an example, companies in extractive industries such as mining have little choice regarding the countries or regions in which they operate. A company which mines for platinum must operate wherever the deposits are, forcing them into sometimes volatile regions.

For The EIU, these are clear methodologies that can help firms. But the key things for businesses to consider is where their assets are geographically financially exposed, and on which other businesses they rely.

The EIU’s Fitzroy continues: “This is important because the speed of information dissemination on the internet means that firms can often be reputationally damaged just through association, while complex global supply chains mean simply understanding a firm’s own exposure is not sufficient.”

Beyond exposure mapping, firms also need to have a system in place that helps to identify, evaluate and monitor key risks across countries. “One other thing to remember is that current stability is definitely not an indicator of future stability – so scepticism is useful,” Fitzroy comments.

Cheung at Travelzoo agrees. “It’s certainly not an easy task. When I do our budget, I will ask each respective Country Manager for more local insights, but I will also talk with respective bankers in each country to get the latest information. I also use The EIU’s reports as a reference, but with my many years’ of experience of the ups and downs of the economic cycle and political crises, these reports can only give treasury so much. Unless you know a country inside out, political risk will always be there. As such, diversification is so important – from a country or a product perspective.”

The road ahead

For The EIU, the two main things for firms to focus on in 2020 and beyond are reputational risk and geopolitical relationships. First, the combination of geopolitical polarisation, the soaring power of social media and the rise of ESG activism mean that businesses must analyse their exposure to potential reputational risks more than ever before – and it is still an area that firms find hard to manage.

Second, as with the example of conflict in Hong Kong, it is not simply enough to understand a particular market and its government – treasurers also have to understand that government’s relationship to other governments. The web of global geopolitics is particularly pertinent, with sanctions and trade tariffs being used as a weapon in geopolitical disputes.

Yet when all is said and done, political risk is dominated by human decision-making, which is notoriously hard to measure or predict. Not everything can be measured, and qualitative judgements will remain an important part of the field.

The EIU’s Fitzroy explains: “In order to give each identified risk scenario a probability score, the EIU recommends combining data on previous similar examples in the same or similar countries and, crucially, identifying a few triggers that could set off the scenario.”

While no one can predict the future, treasury does have the tools needed to anticipate political risk. Some risks are spontaneous, while others simmer for years. But it’s the combination of thorough research, due diligence and the assistance of advisory services to identify the risks – especially with regard to issues that corporates are not aware of – that can help prevent a detrimental impact on the business.

Being able to mitigate known political risks allows the treasurer to see into the unknown. Effectively handling known risks such as human rights and environmental issues, which have the potential to impact a supply chain, frees up both time and space to prepare for what the world – and therefore the business – might look like in 20 years’ time. “Where one risk ends, another begins – we help our clients see these, mitigate impact when they can and manage it when they can’t, because from risk comes reward,” says Maplecroft’s Laurie.

While political risk can never be avoided – particularly in today’s volatile times – those businesses that anticipate risk, and manage it effectively when the political heavens open, will be the ones best able to ride out the storm.

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