Exporters and foreign investors face a wide array of risks when doing business abroad.
Political risk may be the least understood, leading some companies to ignore it altogether and take unnecessary risks, while others worry too much about it and pass on key growth opportunities.
What constitutes political risk? Technically, political risk refers to the possibility that an investment in a foreign economy could be expropriated by the host government, or irrevocably damaged by insurgency or war, or that there could be a freeze on foreign exchange transactions that prevent the investor from benefiting from its investment.
Of course, perceptions may be easily distorted - a single expropriatory act can erase many years of good business performance, simply because the act is highly publicized, while good experiences happen every day but go unnoticed.
Assessing the degree of political risk therefore requires an analysis of the fundamental drivers that lead to such actions on the part of foreign governments. For example, most governments promise to deal fairly with foreign investors, but the political-risk analyst must ask whether the host government can live up to its intentions.
The underlying driver is political regime stability - established democracies tend to be the most stable, followed by dictatorships, whereas partial democracies or failed states tend to be the least able to stand by their commitments.
Throughout history there has been a wide range of foreign investment experience. Researchers have identified a large number of variables that tend to be correlated with investor success or failure, variables that measure societal conditions.
For example, the number of days required for the average business to get an operating licence provides insight into the inefficiency of a country's bureaucracy, which in turn is correlated to expropriation risk. Similarly, infant mortality rates tell much about a society and are highly correlated with outbreaks of political violence.
Political risk can emerge on more than one level, too. A national government may have good policies in place and live by them, yet there may be elements beyond its control in close proximity to the foreign investment.
Or, it might be the interaction of the foreign investor with the local community - the way relocation is handled, or differing interpretations about local project benefits, for example - that trigger political events even when all is well in the national capital.
Identifying sources of political risk and rating them is only part of the job. The other part is to develop mitigants that will reduce risks for the Canadian investor. These can include offshore banking arrangements and clear protocols for dispute resolution. How companies deal with physical security can also be important. Failure to make any arrangements leaves an investment vulnerable, but tight alignment with government security forces can sometimes draw investors into ongoing conflict. The key to striking a balance is a solid understanding of the local situation.
The bottom line? These days, political risk often seems most apparent where opportunities appear greatest. It is therefore essential to get a handle on the nature of the risk, and its degree, rather than walking away.
This need has led to the development of a formal discipline around political risk assessment, and Canadian companies would do well to acquaint themselves with it.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
