Risk Management

Political risk: the impact on corporates

Published: Jan 2015

Switch on the TV on any given day and you are likely to see the results of political instability around the world. From Argentina’s debt crisis, to ongoing troubles in Ukraine, the past year has seen new political risks erupt that look set to rumble on throughout 2015. The question many corporates will be asking is, what is the knock-on effect on us?

“The impact of political risk on corporates is vast,” says Charlotte Ingham, a Principal Political Risk Analyst at risk and strategic consulting firm Maplecroft. “This risk can be operational in nature, in terms of the physical security of their facilities and staff or the potential disruption to their logistics, or legal, if you look at things like corruption risk and the potential ramifications of violating the US Foreign Practices Act or the UK Bribery Act, as well as financial.”

At the extreme end of the political risk scale is the forced expropriation or nationalisation of a company’s assets in a country. While this is extremely rare, there have been cases of this occurring over the past century, including in Libya, Iraq and Venezuela. “This is the worst-case scenario for a corporate, where the company loses not just its profit, but its entire means of making money in that country – everything it’s invested, everything on its balance sheet in that country, is taken away,” says John Drake, Head of Intelligence and Risk Mitigation at AKE Group.

Wholesale expropriation of privately owned assets aside, there is a wide spectrum of less drastic ways political decisions can hit corporates. “Changing tax regulations and the revision of tax codes can significantly impact a company’s bottom line. Similarly, if a country’s government chooses to impose a tariff on certain commodities, this can make a big dent in profitability for foreign investors,” says Drake.

Beyond the purely financial consequences, political risk can damage a corporate’s image as well. “There are big potential reputational risks for corporates with operations in countries which have poor records on democratic governance, political violence, or human rights. There are a lot of challenges in these countries, but also lot of opportunities if the risks are managed well,” says Maplecroft’s Ingham.

Business carries on

Often the highest-profile risks are not necessarily the most detrimental from a corporate perspective. Despite the awful human cost of terrorism, countries with a high incidence of terrorist activity are not necessarily no-go zones for corporates.

“Terrorism generates a lot of headlines, but often the impact on companies might not be very significant if they are able to mitigate the risk. Many companies are still making a lot of money in Iraq, for example, especially in the oil and gas sector, despite some of the terrible atrocities that are going on in the country at the moment,” adds Drake. “The political violence risks from terrorism, riots, and war can have a big impact on private companies, but not as much as full nationalisation, because if a country nationalises a whole sector without paying proper compensation, you lose everything. However, even in a war situation, you might not lose your assets in the longer term – you might be able to come back and reclaim them after a few years.”

While political risks – in particular the risk of political violence – are often a significant deterrent to potential investors, with sound advice companies can successfully mitigate many of the risks. Implementing appropriate security measures, engaging with local communities, and selecting lower-risk parts of the country to do business in are just some ways corporates can cover themselves in higher-risk countries.

Beyond monitoring political risk hotspots, tell-tale macroeconomic signs – even in jurisdictions where political risk is not currently high – can help predict regions where problems may erupt in future. “We don’t just look at risks and perils,” explains AKE’s Drake. “There are lots of indicators to look out for too, including macroeconomic developments. If there is a massive economic downturn, that usually raises the risk of political risk incidents occurring – it could lead to more unrest in the streets, it could lead to the government resorting to hostile and unpredictable actions in an effort to restore its control and authority.”

Take the Eurozone, for instance. “We are seeing rising threats to the level of institutional stability which could have a knock-on effect on the investment climate,” says Drake. “There is a major risk of deflation in the Eurozone over the coming years and this could have a huge impact on voting patterns, and the overall trajectory of EU and Eurozone evolution, with quite significant threats to the ongoing existence of the Eurozone and the European currency.”

The Middle East also presents some interesting cases for the student of political risk. Political and social upheavals across the region have created challenges for corporates – some of which are easier to cope with than others, in this land of contrasts.

“Tunisia is a really good example of how a post-Arab Spring political system can evolve into what looks like an emerging credible democracy, where governance is more stable and there is potential for development. However, right next door you have got a complete basket case – Libya, which is falling apart with virtually no institutional framework, and is totally lacking in the evolution of civil society,” says AKE’s Drake.

Yet even in Libya some corporates are finding opportunities. “Despite the political environment in Libya, the oil industry is continuing to function – albeit under major threat with lots of interruptions – these companies are still pumping oil out of the ground and generating revenue.”

This goes to show that countries which appear to be disaster zones from the outside could still offer attractive opportunities to corporates. Lebanon is another example. “Throughout the civil war in Lebanon, the country’s banking sector managed to function completely, and it’s still regarded as one of the better run banking systems in emerging markets around the world.”

Enhancing reputation

Companies that do business in politically risky countries not only stand to get an advantage on competitors who refuse to take the risk. They can also help bring stability to the country in question. “Corporates could be playing a major role in the stabilisation of the world by going in and investing in countries that are seen as more hazardous because that investment will eventually provide job security and stability in a country,” says AKE’s Drake. “By helping companies do business in unstable regions, this helps build an economic framework and eventually assists the development of those countries into something less volatile. You can’t build civic society without economic progress.”

Furthermore, by investing in a country when times are hard, companies can establish crucial reputational benefits if and when stability improves. “If you invest when a country is unstable and provide jobs to a number of people in a community, when the situation starts to stabilise in the longer term and the market becomes more competitive with more companies moving in, provided you have managed to remain in that environment, your company will be at an advantage, because there will be local brand recognition,” says Drake. “Investing in the local market during times of turbulence as opposed to leaving the country is likely to result in favourable treatment from local consumers, as well as the authorities, in the longer term.”

Indeed, Drake says the ‘three Ps’ are crucial when investing in countries with high political risk: presence, patience and perseverance.

However, while investing in politically risky countries when they are not ‘en vogue’ can bring reputational benefits to a corporate, reputational damage can also arise if this investment is not carefully controlled. “When countries are unstable, there’s more susceptibility to corruption – and the massive reputational risk that can result from this,” warns Drake. “Signing contracts with illiberal governments brings a high risk of corruption, which could come back to haunt the company in the longer term. If you are going to invest in an emerging market with high political risk, you have got to know who the key players are, and be mindful of the reputational risks of doing business – especially of doing bad business.”

In addition to the in-country risks of corrupt practices, many corporates are also subject to anti-corruption laws at home which extend to overseas operations. The UK Bribery Act, for example, has extra-territorial reach both for UK companies operating abroad and for overseas companies with a presence in the UK.

Corporate awareness of the political risks they are subject to varies widely. Given that they often operate in more unstable regions of the world, oil and energy companies typically have more sophisticated political risk monitoring capabilities. “In our experience, a number of corporates in the oil and gas sector have paved the way in terms of their knowledge, understanding and monitoring of these kinds of risks,” says Maplecroft’s Ingham. Shell, for instance, has a dedicated ‘Scenarios Team’ which is responsible for monitoring geopolitical shifts, as well as long-term trends in economics, energy supply and demand, and social change.

However, as supply chains become more and more internationally interconnected, corporates in other sectors are starting to pay more attention to political risk. “As a result of the increasing complexity of global supply chains, large corporates in several sectors are increasingly looking at the impact of political risk on their business in the way that companies such as some of those in the oil and gas sector have been doing for some time,” adds Ingham. “Many companies, either directly through their own operations or through their supply chain, are going into territories they have not been in before, and an increasing number are using systematic, comparable ways of assessing this risk.”

Maplecroft indexes the political risk of 197 countries across 52 indices. Its political risks include what it calls dynamic political risks, which focus on short-term challenges, such as rule of law, political violence, the macroeconomic environment, resource nationalism and regime stability, as well as structural long-term political risks, such as economic diversification, resource security, infrastructure quality, societal resilience and the human rights landscape.

In its 2014 Political Risk (Dynamic) Index, Somalia was ranked as the country with the highest political risk in the world, and was in the ‘extreme’ risk category, followed by Syria, Afghanistan, DR Congo, Sudan, the Central African Republic, Yemen, Libya, South Sudan, and Iraq (see Diagram 1).

And according to Ingham, the world is getting riskier. “Since 2012, we have seen a notable increase in the number of countries that we would consider extreme and high risk,” she says. “This category has gone from about 32.5% of countries in 2012 to 36.5% in 2014, and this growth has been driven by events in the Middle East and North Africa following the Arab Spring. Four out of our top ten riskiest countries are in the MENA region.”

Furthermore, countries tend to deteriorate much more rapidly than they improve. “At the end of last year, Ukraine was medium risk by our dynamic risk assessment. We have done two updates since then, and it has now moved to the 36th highest risk in the world,” explains Ingham. “The political violence level is the main driver behind that.”

Global fragmentation

But besides high-profile outbreaks of instability, such as that in Ukraine, why does political risk seem to be on the up in the longer-term? “There’s now a general trend of fragmentation in the world at all different levels – on a global level, regional level, national level, supranational level, and individual level,” says Andy Langenkamp, Global Political Analyst at financial research consultant ECR Research.

Diagram 1: Maplecroft’s political risk (dynamic) index 2013

Diagram 1: Maplecroft’s political risk (dynamic) index 2013

Source: Maplecroft TM

Legend Rank Country Rating Rank Country Rating
Extreme riskExtreme risk 1 Somalia Extreme 6 Iraq Extreme
High riskHigh risk 2 DR Congo Extreme 7 Libya Extreme
Medium riskMedium risk 3 Sudan Extreme 8 C.A.R Extreme
Low riskLow risk 4 Afghanistan Extreme 9 Syria Extreme
No dataNo data 5 Myanmar Extreme 10 Yemen Extreme

Source: Maplecroft TM

“The world is increasingly being divided into regional blocs. On the one hand this can be positive, because it encourages co-ordination and stability, but at the same time it undermines global corporates because these blocs are competing with each other. On a national level, there is increased nationalism – such as in India, Japan and Russia, and at the level below that there is a push for autonomy, as we have seen in Catalonia and Scotland recently. At the individual level it is much easier for people to contact like-minded citizens in other countries using the internet and mobile phones, which played a big part in events like the Arab Spring. This all goes to make the world much more unpredictable,” adds Langenkamp.

Often companies – even ones operating on a global scale – integrate their political risk policy within their broader risk management policies and leave it at that. But AKE’s Drake thinks many corporates could be doing more given the level of risk they face. “The potential losses in terms of assets, people, profits and reputational harm that can come about as a result of political risk is huge. Every company should have a board member who specialises in security and political risk, because something like the nationalisation of a company’s operations – even though it doesn’t happen very often – can wipe out your entire investment in a country,” he says. “Political risk needs to be addressed as part of an organisation’s core culture if it wants to specialise in investing in challenging parts of the world – and these challenging parts of the world might not be that far away at all.”

ECR’s Langenkamp believes companies are waking up to the importance of the risk. “Geopolitics is a big part of the backdrop of financial markets,” he says. “It is having a much bigger impact on financial markets and economies than it did five to ten years ago. Since the financial crisis, the corporate world has taken politics increasingly seriously as companies have started to notice that politics has a very big influence on their activity,” he says.

Maplecroft’s Ingham concludes that political risk per se should not deter corporates from entering a country. “We would never say to a company not to invest somewhere – it’s just about fully understanding the risk profile, and then making sure that a very robust risk management policy is put in place,” she says. “Continuity is important. It is not the particular level of risk, but uncertainty which creates the most challenges for corporates. If you know there is a high risk of political violence in a country, measures can be put in place to mitigate that – the challenge is if you don’t properly assess the risk and plan for the possibility of a rapid deterioration.”

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