managing micropolitical risk: a cross-sector examination

623

Managing Micropolitical Risk: A Cross-Sector Examination

Ilan Alon ■ Rajesh Gurumoorthy ■ Matthew C. Mitchell ■ Teresa Steen

Executive Summary

This article stresses the need for today’s multinational firms to adopt their own polit-ical risk-assessment and risk-mitigation strategies. A comparative study of theenergy, financial, and automobile sectors illustrates the need for all companies inthese sectors to undertake comprehensive risk-assessment strategies. Risk-assessmentmodels established by leading multinationals like British Petroleum, Bank of Amer-ica, and General Motors are examined as examples that other companies in these sec-tors can build upon. The consistent micropolitical risk variables then lead to a pro-posed practical framework for examining sector-specific micropolitical risk. © 2006Wiley Periodicals, Inc.

INTRODUCTION

[For oil companies in Nigeria,] kidnapping is just a cost of doing business. Eth-nic militants often kidnap their staff and demand money or jobs [and] oil firmsreally do hire people at gunpoint, or at least pay them to go away. Shell, thelargest operator in Nigeria, said that 10% of national oil output is lost to thieves,who puncture pipes to get at the contents. But these expenses are bearable. Itstill costs under $5 a barrel to pump Nigerian crude, so the oil firms will stay.(“Another Day at the Office,” 2003, p. 71)

Shell’s experience in Nigeria serves as an example of the kinds of political risks thatone oil company faces in its international operations. The globalization trend andever-increasing flow of foreign direct investment worldwide have integrated theglobal marketplace. Multinational corporations around the world realize the

Dr. Ilan Alon is the Jennifer J. Petters Professor of International Business and the executive direc-tor of the Rollins China Center, Rollins College, Winter Park, Florida ([email protected]). Rajesh Gurumoorthy is an alumnus of the Crummer Graduate School of Business at Rollins CollegeMBA program and a solutions architect for IBM BTO in Bangalore, India.Matthew C. Mitchell is a PhD student of international business at the Darla Moore School of Busi-ness, University of South Carolina. His research interests include political risk, emerging markets,and the intersection of religion and business around the globe. Teresa Steen is an alumna of the Crummer Graduate School of Business at Rollins College and aparalegal at Hard Rock Cafe International, Orlando, Florida.

Thunderbird International Business Review, Vol. 48(5) 623–642 • September–October 2006

Published online in Wiley InterScience (www.interscience.wiley.com).

© 2006 Wiley Periodicals, Inc. • DOI: 10.1002/tie.20113

importance of capturing an early market share, even in locales that mayseem risky prospects. Risk-averse companies face the threat of losinglucrative future opportunities to more aggressive competitors. In thiscompetitive marketplace, modern-day companies are also faced withthe fear of expropriation, whether in the most direct form of national-ization or other more indirect forms like taxes, license restrictions,license cancellations, and price controls. These changes in the landscapeof international trade have escalated the significance of the phe-nomenon of political risk in the present-day business environment.Hence, most multinational corporations today are forced to dedicate asubstantial amount of time and resources in carefully identifying poten-tial political risks and the means to manage these risks successfully.

As the conception of political risk has evolved, it has expanded fromgeneral country risk to include more specific subclassifications.Nationalizations and expropriations were once considered to be themain sources of political risk. Kobrin (1981) showed that while majordiscontinuities in the international marketplace commanded the mostattention, the less dramatic and more pervasive instances of politicalrisk had the greatest cumulative effect. He argued that the effect offorced divestitures en masse has had a much lesser effect than themore common restrictions affecting specific industries, firms, andprojects (Kobrin, 1981, 1982). This distinction between generalpolitical risk and industry-/firm-specific risk, however, is not new; in1971, Robock divided political risk into micro and macro dimen-sions. He concluded that micropolitical risk is more important forcompanies to gauge and is the reason why certain industries withinthe same country experience more political risk than others (Robock,1971). This distinction has been widely accepted and expanded byscholars, including Simon (1982), Schmidt (1986), Kennedy (1988),and Boddewyn and Brewer (1994), all of whom have further subdi-vided general political risk according to their respective risk-assess-ment systems.

CONCEPTUAL/DEFINITIONAL FRAMEWORK

Historically, political risk has been difficult to define. If there is oneagreement in the literature, it is that a consensus has not beenreached regarding the definition of the term (Alon, 1996). It hasbeen used in a broad sense to refer to the aggregate of many differ-ent types of risk. For example, policy risk, security risk, and economicrisk have all been communicated using the generically broad term of


624 Thunderbird International Business Review • DOI: 10.1002/tie • September–October 2006

Multinationalcorporationsaround the worldrealize theimportance ofcapturing anearly marketshare, even inlocales that mayseem riskyprospects.

“political risk.” For this article, Simon’s definition will be used, whichargues that political risk refers to:

the governmental and societal actions and policies, originatingeither within or outside the host country, and negatively affectingeither a select group of, or the majority of foreign business oper-ations and investments.” (Simon, 1982, p. 68)

Simon’s definition of political risk is used because (1) it views politi-cal risk in the general environmental context, (2) differentiatesbetween macro and micro risks, and (3) distinguishes between inter-nal and external causes of political risk. Simon’s (1982) definition isgermane to political risk assessment because the multinational firmfaces political risks emanating from the host-country environment,home-country environment, international environment, and theglobal environment (Alon & Martin, 1998).

We will enlarge Simon’s conceptualization by adding an economicdimension to the political risk analysis outlined by Alon (1996). Theeconomic dimension of political risk is included because (1) the eco-nomic climate is an important source of political risk (Rice & Mah-moud, 1990; Sethi & Luther, 1986; Stapenhurst, 1992); (2) politicsand economics, thus political and economic risks, are often insepara-ble at the experiential level; and (3) it provides a holistic and moreaccurate conception of political risk. Furthermore, institutions suchas Shell Oil Company (Simon, 1982), Business Environmental RiskIndex (BERI), Political System Stability Index (PSSI), and Institu-tional Investor all include economic variables in their assessments ofpolitical risk (Alon, 1996).

Political risks to a multinational company can be identified along sev-eral fronts: the prevalent legal rules and regulations within a givencountry; war and security issues, governmental economic and fiscalpolicies; the existence of trade barriers; and so on. Although all theseinfluential factors remain the same for every company operating in aparticular country, the magnitude of their effect inevitably varies fromone company to another, depending on the nature of the industryand the business these companies are involved in. Thus, while the oilproducer more heavily weighs the risk of potential wars, the bankermight consider the balance-of-payments situation to have a greaterbearing on his investment decision, just as the auto manufacturermight more profitably focus attention on governmental policies andregulations. Moreover, Frynas and Mellahi (2003) expanded the con-


625Thunderbird International Business Review • DOI: 10.1002/tie • September–October 2006

Simon’s defini-tion of political

risk is usedbecause (1) itviews political

risk in the gen-eral environmen-

tal context, (2)differentiates

between macroand micro risks,

and (3) distin-guishes between

internal andexternal causesof political risk.

ceptualization of micropolitical risk by casting transnational corpora-tions (TNCs) as “actors capable of acquiring and upgrading firm-spe-cific resources and capabilities for coping with or even benefitingfrom political risk” (Frynas & Mellahi, 2003, p. 541). Therefore,TNCs are no longer viewed as passive observers of the political pro-cesses in host countries. Depending on the risk-management capabil-ities of the firm, a major political discontinuity can have widely vary-ing impacts on the corporations operating in the environment. Thiswas made very clear by the case of transnational oil firms in Nigeria(Frynas & Mellahi, 2003).

While a number of studies in the past have focused on macropoliticalrisk assessment, very little literature is available on micropolitical risk-assessment tools and techniques. A review of the literature shows thatmacro- and micro-political risk have been defined in a number ofways (e.g., Kobrin, 1981, 1982; Markwick, 2001; Molano, 2001;Robock, 1971; Simon, 1982). In 1981, Kobrin defined macro- andmicropolitical risks as follows:

[M]acrorisks [are] environmental events, which affect all foreignfirms in a country without regard to organizational characteris-tics, and microrisks . . . are industry, firm, and even project-spe-cific. (Kobrin, 1981, p. 253)

The highest incidence of encountered risk is actually micropoliticalrisk. This is in contrast to large-scale expropriations such as massnationalizations, which have been on the decline. Such risks have notgone away altogether, as evidenced by the May 2006 news that theBolivian government, one of South America’s poorest, seized controlof Bolivia’s gas fields as a first step toward nationalizing foreign-owned energy reserves and retaking absolute control of its own nat-ural resources. The decline in nationalizations has subsequently led toa corporate shift from forecasting toward managing risk.

It should be noted that defining and assessing political risk is adynamic and evolutionary process for both academics and practition-ers. For example, general country risk was once considered synony-mous with political risk. Now it is understood that specific projects,firms, and industries face markedly different risks within countries—risks more variegated than a country-risk model can account for. Fur-thermore, although the occurrence of nationalizations and expropri-ations has decreased, the risk due to terrorism has increased. Thenature and scope of political risk changes with respect to the specifictime, home and host countries, and organizations involved. As Fry-



While a numberof studies in thepast havefocused onmacropoliticalrisk assessment,very little litera-ture is availableon micropoliticalrisk-assessmenttools and tech-niques.

nas and Mellahi argue (2003), risk depends on the standpoint of theaffected individual or group. Therefore, risk should be construed asbeing primarily a firm-specific or project-specific value assessment(Frynas & Mellahi, 2003).

This study focuses attention on understanding micropolitical risks ingreater depth and suggests techniques that modern-day companiescan use to mitigate the influence of these risks. Some studies classifyrisks as governmental vs. extragovernmental; however, for the pur-poses of this article, a macropolitical vs. micropolitical risk classifica-tion will be used. By so doing, it is easier to isolate the micropoliticalrisks that are most important to the primary consumers of risk assess-ments. Moreover, micropolitical risks are much more manageableand thereby more practically useful for modern-day companies. Thefollowing discussion adopts a special focus on the energy, financial,and automobile sectors, as these are the core sectors of an economy.

POLITICAL RISK ANALYSIS ACROSS THREE INDUSTRIES

Table 1 provides a detailed list of macro- and microvariables thataffect companies in the three target sectors. This will serve as a guide-line for companies in these sectors as they seek to adopt their ownunique political risk assessment strategies at the micro level.

FINANCIAL SECTOR

Banks, financial trusts, and money market lenders are major players inthe international financial sector. The political risks faced by these orga-nizations are characterized by monetary, economic, and fiscal policiesadopted by the governments of countries in which they operate. Thus,firms are largely affected by the balance-of-payments situation, volatil-ity in foreign exchange rates, privatization efforts, communicationsinfrastructure, monetary devaluations, prime lending rates, reserverequirements, interest rates, hyperinflationary economies, politicaluncertainties, restrictions on flow of funds, capital adequacy, marketliquidity, and the like (Massoud & Raiborn, 2003).

The following are recent examples of political risks facing companiesin the financial sector. In Asia, the East Asian economic crisis in themid- and late 1990s that triggered the real estate shutdown in Thai-land affected the risk profiles of many nations in the region. Indone-sia, marred by political and civil unrest, experienced a decreasing



This studyfocuses atten-tion on under-

standingmicropolitical

risks in greaterdepth and sug-

gests tech-niques that

modern-daycompanies canuse to mitigatethe influence of

these risks.



Tab

le 1

. Lis

t of

Pol

itic

al R

isk

Var

iabl

es A

ffec

ting

Ene

rgy,

Fin

anci

al, a

nd A

utom

obile

Sec

tors

GDP, flat economy, and very slow efforts toward privatization of gov-ernment-owned banks and corporations (Sullivan, 1999). Similarly,the banking sector in Lebanon was severely affected in the early1990s by an adverse political climate, lack of a national communica-tion system, and significant security risks (“Lebanon: The Foreigner’sGuide,” 1992), and to this date the country’s government, securitysituation, and macropolitical risks are affected by political manipula-tions of the Hizballah, Syria, Iran, and Israel among others.

In Latin America, Brazil was hit by a 40 percent devaluation in cur-rency in early 1999 even after an International Monetary Fundbailout a year before, causing an unfavorable investment climate.Finally, in 1995–1996, rioting and heavy government crackdowns inBahrain have resulted in political problems, which have had a nega-tive impact on the banking community, both locally and offshore(“Money Isn’t Everything,” 1996).

Thus, it is imperative for financial institutions to be adequately preparedto deal with such adverse risk situations. While currency exchange-ratefluctuations, monetary devaluations, communications infrastructure,political uncertainties, GDP growth rates, and inflation can be adjudgedto be macrovariables affecting all sectors, factors such as banking-sectorprivatization efforts, prime lending rates, interest rates, bank reserverequirements, current account deficit, and capital adequacy require-ments can be regarded as microvariables affecting the financial sector toa greater degree, if not exclusively. Hence, companies in the financialsector are required to place greater emphasis on these factors whendetermining their own political risk-assessment strategies.

Several models have been created by individuals and financial institu-tions in recent times to evaluate prevalent political risks, including theCAMEL model, the Zonis model, and the Bank of America model.

The CAMEL ModelThe CAMEL model involves the assessment of five variables: cap-ital adequacy, asset quality, management quality, earnings, and liq-uidity (Belcsak, 1987). Capital adequacy is symbolic of the bal-ance-of-payments situation: asset quality depicts the economicresources, while management quality refers to the government andits policies. Earnings are estimated by domestic market size, andliquidity measures the amount of hard currency and foreignexchange reserves. This model thus evaluates the risk profiles ofvarious countries to help form a judgment as to the favorability ofan investment climate.



The CAMELmodel involves

the assessmentof five variables:

capital ade-quacy, asset

quality, manage-ment quality,

earnings, andliquidity.

The Zonis ModelMarvin Zonis, a professor at the University of Chicago’s GraduateSchool of Business, created a model that, according to him, did notrely on expert opinion (Gentile, 1998). Human judgment comes intoplay in the creation of his models but does not affect the rating. Hisproprietary system consists of three broad indexes and severalsubindexes. The broad Political Stability Index measures environ-mental stability through variables such as the likelihood of riots andviolent outbursts, assassinations, revolutions, and the like. The PolicyFoundations Index measures the likelihood of formulation of consis-tent, pro-development economic policies. The Institutional StrengthsIndex seeks to evaluate the success of a country’s institutions in pro-moting stable, long-term growth. Each country is accorded a score,with the average arbitrarily set at 50. Emerging markets and Organi-sation for Economic Cooperation and Development (OECD)nations are assigned average scores in each country to form a basis forcomparison.

The Bank of America ModelBank of America has developed a unique rating index that is particu-larly helpful for financial institutions across the globe to evaluatepolitical risk and, more precisely, the economic and financial risksassociated with different countries (Howell, 2001a). Identifying tenratios as being major influential variables in the political atmospherefor banks, Bank of America accords each one of these ratios a rank ona 1 to 80 scale. Each country is assigned rankings for the currentperiod as well as four previous and five future years. The ten influen-tial variables are identified as (a) GDP per capita, (b) real GDPgrowth, (c) nominal GDP, (d) trade balance, (e) current account bal-ance, (f) gold reserves, (g) external debt, (h) money growth, (i) con-sumer price inflation, and (j) exchange rate.

Having assigned individual ratings across these ten variables, Bank ofAmerica constructs risk profiles for every country, also providingadditional information by means of an overview that lays out growthand employment trends, business conditions, fiscal policy, monetarypolicy, trade and current account details, capital account, debt, andreserves. This facilitates easy comparison between and among differ-ent countries; it has the additional advantage of identifying theinvestment atmosphere of individual nations.

There are several other indexes that can be used to evaluate politicalrisks for financial institutions, including the Control Risks Group



Bank of Americahas developed aunique ratingindex that is par-ticularly helpfulfor financialinstitutionsacross the globeto evaluate polit-ical risk and,more precisely,the economicand financialrisks associatedwith differentcountries.

Index, which ranks nations according to variables such as negativeregional influences, stability, authoritarianism, corruption, regulatoryinvestment environment, domestic economic problems, and infrastruc-ture (Howell, 2001b). It is worth noting here that financial institutionsmight want to consider several quantitative indicators such as thedebt/GDP ratio, ratio of interest service to foreign exchange earnings,ratio of debt service to foreign exchange earnings, current account as apercentage of GDP, official reserves as a percentage of annual debt ser-vice, reserve coverage of imports, and so on (Gentile, 1998).

A financial institution or a bank can use any of the aforementionedindexes to evaluate the potential political risks of countries, or evenbuild its own index from the numerous variables listed in the previousdiscussion. However, it has been observed that banks often fail to acton the basis of their own political risk assessment, even though theyare among the most sophisticated providers and consumers of politi-cal risk information. In this regard, banks are advised to pay carefulattention to infant mortality and literacy rates as well, as these variablesmeasure the willingness and ability of a state to provide for the poor-est sections of society (Zonis & Wilkin, 2000). The idea is to eventu-ally develop a composite index that would help companies adequatelyevaluate and manage political risks in an effort to become successfulglobal players.

ENERGY SECTOR

Mining and petroleum operations tend to be the “most sensitive ofall international corporate activities” because the resources involvedare a country’s “national patrimony,” and such projects can impact acountry more than other activities through the attendant wealth,international prestige, and power (Moran, 1998, p. 70). Not surpris-ingly, “foreign investment in infrastructure or natural resources tendsto provoke nationalist sentiment” (Markwick, 2001, p. 39).

Oil and natural gas, electrical utility, and power companies are influ-enced to a large extent by risks of wars and external threats, taxationsystems, terrorism, civil and labor unrest, corruption, governmentalregulations, repatriation restrictions, political instability, energy vul-nerability, and environmental activism, to name a few. Despite themyriad of risks this industry faces, “companies are able and willing towork in almost any country in the world” (Hallmark & Whited,2001). Therefore, risk assessment is primarily an ex-ante decision



The idea is toeventually

develop a com-posite index thatwould help com-

panies ade-quately evaluate

and managepolitical risks in

an effort tobecome suc-cessful global

players.

made to inform operating decisions going forward. Firms in thisindustry are willing to accept a high degree of risk if they foresee thatthey can sufficiently manage the risk to ensure profitability.

The following are recent examples of political risks facing companiesin the energy sector. The recent war in Iraq has been a major politi-cal consideration for companies looking to invest in that region. Sim-ilarly, Russia has established itself as a leading oil-producing nation,but the unfavorable tax system poses substantial potential risks there.In July 2003, a coup replaced São Tomé’s president with a militarygovernment (“Troubled Waters Over Oil,” 2003). Ethnic militantskidnapped the staff of oil companies in Nigeria and demand ransomor employment (“Another Day at the Office,” 2003).

Moreover, the governments of countries such as Saudi Arabia, Brazil,India, and Nigeria are putting pressure on multinational corporationsto adopt a local-content policy by establishing local facilities, expand-ing local purchases, and taking on local equity owners and managers(DeNero & Mahini, 1984). The twin bombings in Kenya and Tan-zania in 1998 and terrorist activities in nations like Colombia,Indonesia, and Pakistan pose serious political risks as well for coun-tries considering these regions favorably (Johnston, 1998).

Brazil’s mismanagement of privatization in the 1990s burned manyforeign investors. Eager to leverage a position in Brazil’s energy mar-ket, “they [investors] paid high prices for distribution companiesbefore the rules and a regulator for the privatized industry were inplace” (“Lighting a Candle,” 2003). Then, just when powerrationing shrank the business, Brazil’s currency crisis hit.

A final example of the risks endemic to the energy sector involves for-eign electric firms in China, where local and regional Chinese officialshave built many power plants, more for prestige (and with “dubiouslicenses”) than market demand. The resulting capacity glut led tomany regional governments reneging on contracts and refusing topay foreign power companies (“Power Politics,” 2002).

The existence of the aforementioned risks of foreign exposure—inaddition to trade regulations, embargoes, quantity restrictions, andexcessive bureaucracy—forces companies to adopt political risk-assessment and risk-management programs on a continual basis.

Among the political risk variables mentioned previously, variablessuch as war, terrorism, labor unrest, political instability, corruption,



…the govern-ments of coun-tries such asSaudi Arabia,Brazil, India, andNigeria areputting pressureon multinationalcorporations toadopt a local-content policy byestablishinglocal facilities,expanding localpurchases, andtaking on localequity ownersand managers.

and the like are macrovariables that affect almost all sectors,although in varying degrees. Factors such as energy vulnerability, oilembargoes, environmental activism, and restrictions on oil exportscan be identified as micro- or industry-specific variables that solelyaffect the energy sector. Hence, it is vital that, even as companies inthis sector monitor the macrovariables, they also lay special empha-sis on the specific microvariables that may affect them to a greaterdegree.

Companies like BP and IHS Energy have adopted their own uniquestrategies to assess and manage foreseeable political risks. It was oilcompanies that established “the use of scenarios to model theeffects of political-economic events on oil prices.” Shell Oil’sASPRO/SPAIR is a well-known risk model (Molano, 2001, p. 26).

The British Petroleum ModelWhile a detailed synopsis of BP’s calculations of political risk is notpublicly available, it is possible to view BP’s approach to risk man-agement through the perspective of its operational security; thus, itbecomes clear how BP assesses and manages the risk it encounters inpotentially risky oil-rich environments. In the words of Tony Ling,BP’s regional security advisor for the Far and Middle East in the1990s, “identifying and managing risk is what we are about. Thereare very few countries in which an oil company cannot operate. Mostrisk is manageable, but cannot be eliminated completely” (Knott,1997, p. 33). For BP, risk assessment is a continuous process: ex-antethrough ex-post FDI outlay. The preliminary assessment sets thestage for operational decisions going forward, and periodic reassess-ments update the initial risk profile. Because of the competitioninherent in oil exploration, companies are willing to accept a highdegree of risk if they believe risk can subsequently be managed toachieve profitability.

Successfully managing security risk is the major political risk associ-ated with BP’s operations. Having built up its entire structure ofautonomous businesses, the company has had field developmentoperations in high-risk regions such as Algeria and Azerbaijan besideschemical plants in China and the Far East. A number of these coun-tries are politically unstable, causing major security concerns for for-eign firms such as BP. However, the company has been patient indealing with such volatile situations, and as a measure to addresssecurity concerns, BP has an internal security system in place withspecialists from different areas of security including a police force,army, foreign offices, and even civilians. BP also keeps its outsourc-



Because of thecompetition

inherent in oilexploration,

companies arewilling to accepta high degree of

risk if theybelieve risk cansubsequently be

managed toachieve

profitability.

ing strategy in focus by recruiting most of the day-to-day guards fromlocal security firms, besides maintaining good relationships with localgovernment agencies. This security policy is also tailored according torequirements in a particular nation and situation.

BP’s security staff is involved with “[continuously] identifying threatsand risks to operations on behalf of the businesses, helping businessesprioritize responses to threats, protecting information, periodicaudits and investigations, contingency planning, and organizing secu-rity exercises” (Knott, 1997, p. 32). At the same time, BP adheres tolocal laws and conventions and also manages to maintain strong linkswith police forces in every country.

The IHS Energy Group ModelIHS Energy Group, another petroleum industry player, uses a com-prehensive index to measure the political risks it encounters in its for-eign operations. This index has in turn been used by the Societe Gen-erate (SG) equity research team to identify political risks faced by BP,Shell, TotalFinaElf, Eni, and Repsol YPF (“Derivatives: TradingPolitical Risk,” 2002).

The original IHS index (Howell, 2001a) identifies three major riskfactors: political, economic, and commercial petroleum. Each ofthese risks is further subclassified, resulting in 11 distinct variables.The host country is then ranked on a scale of 1 to 5 for each of thesevariables, with a rating of 0 being risk-free and 5 signifying maxi-mum risk potential. Weights (shown in parentheses below) areassigned to these variables, and the rating for each variable is multi-plied by its weight. The sum of weighted ratings is then divided by11 to come up with an overall rating for the country in terms of itsrisk potential. The 11 variables are (a) war and external threats (6%),(b) civil and labor unrest (15%), (c) internal violence (21%), (d)regime instability (18%), (e) economic instability (5%), (f) energyvulnerability (4%), (g) environmental activism (6%), (h) ethno-lin-guistic factionalism (5%), (i) investment constraints (7%), (j) repatri-ation restrictions (5%), and (k) threat of adverse changes in con-tracts/fiscal terms (8%).

The IHS index offers easy quantification of different variables ofpolitical risk. However, a further study conducted by SG counters theargument posed by BP’s Tony Ling about assuming risks. The study,conducted on historic company risk profiles, suggests that returns ofshareholders do not show a positive correlation with political risk.Thus, the IHS index almost suggests that companies should be pre-



The IHS indexoffers easyquantification ofdifferent vari-ables of politicalrisk.

pared to “buy or sell countries” based on risk profiles (“Derivatives:Trading Political Risk,” 2002, p. 40).

The aforementioned risk-assessment approaches adopted by BP andIHS Energy Group contradict in terms of the eventual suggestionabout whether or not a company should venture into a country withsignificant political risk; however, they both underline the eventualneed for any energy-sector company to conduct a detailed politicalrisk analysis of every place of its business operations.

A company in the energy sector can create its own index based on allthe variables mentioned previously in the discussion; otherwise, it canuse one of these proposed indices to evaluate potential political risksso as to be able to adopt timely risk-mitigation strategies and protectits interests.

AUTOMOBILE SECTOR

Car manufacturing companies as well as manufacturers of replace-ment parts are important constituents of the automobile industry.The political risk variables influencing these companies to the great-est extent may be identified as local governmental rules and regula-tions, import restrictions, excise and sales taxes, the duties levied onimports, local-content policies, political instability, exchange-ratefluctuations, terrorist activities, and social revolutions, among others.

The following are recent examples of political risks facing companiesin the automobile sector. The bombing and burning of several cardealerships in Greece in the 1990s is a classic example of political risk(Johnston, 1998). Another example is Mexico’s requirement, in themid-1980s, that six of its foreign-car manufacturers use locally pro-duced parts and materials equal to 50% of each vehicle’s value. Simi-larly, Indonesia required any exporter selling more than $750,000 ofgoods to the state sector to buy an equal value of local goods (DeN-ero & Mahini, 1984). The Indian government has established a 150%import duty on all foreign cars brought into the country.

Car manufacturers are thus required to keep themselves abreast of thelatest laws and regulations enforced by governments of the variouscountries they are looking to work within, or have already establishedtheir presence in, particularly with respect to various import policiesand the local-content regulations that seem to affect this industrymost profoundly.



The bombingand burning of

several car deal-erships in

Greece in the1990s is a clas-

sic example ofpolitical risk.

Again, the political risk variables discussed earlier can be identifiedas being either macro or micro. Political instability, exchange-ratefluctuations, terrorist activities, social revolutions, and the likehave previously been identified as macrovariables. Factors such ascar import duties in various countries, local-content restrictions,excise and sales taxes on motor vehicles, and the existence of autoindustry regulatory bodies have a special bearing on companiesoperating in the automobile sector, and these can be classified asmicrovariables.

Several companies have adopted unique risk-assessment and risk-mit-igation strategies to protect their investments in this sector. The mostnotable are General Motors and Chrysler.

The General Motors ModelGeneral Motors can rightfully be regarded as one of the pioneers indeveloping comprehensive risk-assessment strategies as early as thelate 1970s and early 1980s (Much, 1980). The company evaluates itspotential investment risk based on political, economic, and socialconditions. The International Economics Group (IEG) of the GMSEconomics Staff is entrusted with the primary responsibility of devel-oping political and economic risk profiles on a continuing basis.Organized as an independent in-house consulting unit, the IEGincludes in its assessment economic and political variables such asGNP, balance of payments, threats of expropriation, affairs of thestate, and revolutions (Ensor, 1981). Publications include quarterlyforecasts of exchange rates, inflation, population growth and GNPgrowth, an annual World Economic Review, and an annual PoliticalRisk Index that rates countries based on 15 weighted factors of poli-tics, policy, and regulation.

Other general political factors considered include the constellationsof power in society, the mechanisms of control, and the system’smechanism of legitimation. Policy issues under consideration includestrategies of economic development, industrial policy, class stratifica-tion, social structure, labor laws, energy problems, the role of foreigninvestment, and the auto industry development. Thus, GeneralMotors develops a comprehensive qualitative risk-assessment profilefor each country in which it is interested.

The Chrysler ModelChrysler Corporation has implemented its own way of mitigatingcommercial and political risks associated with global operations(Herbst & Trebing, 1997). Due to the expensive and time-consum-



General Motorscan rightfully beregarded as oneof the pioneersin developingcomprehensiverisk-assessmentstrategies asearly as the late1970s and early1980s.

ing nature of letters of credit and customers’ nonmanageability ofcash-in-advance, international sales volumes have dropped. Seekingto increase sales, the company’s International Sales Finance (ISF)department came up with an innovative risk management and whole-sale financing plan, with two key elements—export credit insuranceand factory-direct financing. The company ships vehicles to the dis-tributor after establishing payment terms. The receivable is then soldto a third-party funding source. First, the commercial risks incurredfrom the distributor, including bankruptcy and insolvency, as well aspolitical risks like currency inconvertibility and embargoes, are pro-tected against by purchasing a global blanket coverage insurance pol-icy on international receivables. Second, the insurance coverage andelimination of nonpayment risk ensures substantial improvement ofthe underlying risk profile, generating a lower funding cost that ispassed on to the distributor.

These two strategic elements produce significant benefits forChrysler. First and foremost, risk is reduced and liquidity is simulta-neously improved. The aforementioned off-balance-sheet securitiza-tion of receivables ensures immediate payment and hedges against therisk of nonpayment. Second, the streamlined internal credit approvalprocess reduces the vehicle order-to-delivery time. Third, ISF func-tions efficiently and is able to allocate time for more customers.

The aforementioned tools of risk assessment and risk elimination canbe used by car manufacturers to combat their foreign transactionrisks. Companies in this industry can also combine all the variableslisted in the earlier discussion to model their own methods of riskassessment, the end result being a successful strategy to successfullymanage political risks associated with overseas operations and marketsthat is industry- (even company-) specific.

CONCLUSION AND DISCUSSIONS

The ubiquitous political risks of international operations can be man-aged successfully through the adoption of effective risk-assessmentand risk-mitigation strategies similar to ones outlined in the earlierdiscussion. Table 2 is a summary of (1) how each industry modeldefines political risk, (2) how it assesses/manages political risk, (3)whether the risk assessment is ex-ante or ex-post FDI outlay, and (4)how the risk assessment is used by the company. The table allows easycomparison of the various characteristics of risk assessment/manage-ment for the firms and their respective models.



The tools of riskassessment andrisk eliminationcan be used by

car manufactur-ers to combat

their foreigntransaction risks.



Tab

le 2

. Com

pari

son

of R

isk

Ass

essm

ent

and

Ris

k M

anag

emen

t A

cros

s th

e T

hree

Sel

ecte

d Se

ctor

s

General economic and political risks such as exchange-rate fluctu-ations, local-content regulations, adverse balance-of-payments sit-uations, threats of war, unstable political-economic environments,terrorism, civil and labor unrest, and so on have a great bearing onall three sectors discussed here (the energy sector, the financial sec-tor, and the automobile sector). Hence, in conclusion, all threesectors are similar in that that they all are affected by these vari-ables. In fact, these broad variables may affect any sector of theeconomy.

However, each individual sector has certain unique micropoliticalvariables that signify a greater risk to companies operating in thatindustry/sector. This can be observed from the fact that while theenergy sector is affected by variables such as environmentalactivism, energy vulnerability, and constraints on oil investment,the financial sector is affected by other variables such as debt ser-vice ratio, flow of funds rate, banking regulations, and so on. Sim-ilarly, import duties and import restrictions on cars, auto embar-goes, and the like are micropolitical risks specific to the automobileindustry.

It is imperative for each company to conduct risk assessment, keep-ing in mind unique, industry-specific micropolitical risks, while atthe same time taking into consideration the general macropoliticalrisks. Table 3 proposes a simplified risk-assessment model using crit-ical variables that have been used by at least two or more companiesdiscussed in this article. This table can serve as a matrix that everycompany can start with in its endeavor to model a comprehensivepolitical risk-assessment strategy. Firms should add the appropriatecountry-/industry-/project-specific variables to the microvariablessection. Assigning a weighting factor to each critical variable shouldreflect the respective firm’s industry, location, risk tolerance, andgeneral political-economic environment. Scores should then beassigned for each country in each category and multiplied by theweighting factor. The country scores are added, and the total scoresfor each country are then easily compared to assess the relative riskof each country.

The above discussion also drives home another very significant factor:the existence of country-specific or region-specific risks. For instance,while companies seeking to operate in the Middle East, South Asia,and certain parts of Africa face a heightened threat of terrorism andcorruption, companies seeking to expand into the Scandinaviancountries do not face a similar threat. Each nation or region must be



It is imperativefor each com-

pany to conductrisk assessment,keeping in mind

unique, industry-specific micropo-litical risks, whileat the same timetaking into con-

sideration thegeneral macrop-

olitical risks.

looked upon as a unique operating environment. This suggests thatcompanies must resort to risk-assessment strategies at multiple levels.

We recommend that every company adopt political risk assessment attwo or three levels. The assessment team at the corporate headquar-ters can be assigned the task of creating a general model that identi-fies broad macrovariables applicable for all international operationssuch as exchange-rate fluctuations, GDP growth rate, and threat ofwar, and broad, industry-specific microvariables. On the other hand,assessment teams at each international location can create submodelsthat incorporate country-specific macro- and microvariables. Largemultinational corporations can take it a step further in creatingregion-specific models as well.

In conclusion, every global company in today’s world must consideradopting a comprehensive political risk-assessment strategy toensure it invests in the right places and continues making the deci-sions necessary to outperform its competitors.



Table 3. Macro/Micro Risk Analysis Using Critical Variables

REFERENCES

Alon, I. (1996). The nature and scope of political risk. In E. Stuart, D. Ortinau, & E. Moore(Eds.), Proceedings of the Annual Meeting of the Southern Marketing Association (pp. 359-363). New Orleans, Louisiana.Alon, I., & Martin, M. (1998, Fall). A normative model of macro political risk assessment.Multinational Business Review, pp. 1–10.Another day at the office. (2003, May 3). The Economist, p. 71.Belcsak, H. P. (1987). A treasurer’s guide to country risk. Cashflow, Atlanta, 8(9), 40–43.Boddewyn, J. J., & Brewer, T. L. (1994). International-business political behavior: New theo-retical directions. Academy of Management Review, 19(1), 119.DeNero, H., & Mahini, A. (1984, July 24). Manager’s journal: Local-content laws abroadneedn’t cut profitability. Wall Street Journal (Eastern Edition), p. 1.Derivatives: Trading political risk. (2002). Petroleum Economist, 69(9), 40.Ensor, R. (1981). Assessing country risk. London: Euromoney Publications.Frynas, J. G., & Mellahi, K. (2003). Political risks as firm-specific (dis)advantages: Evidenceon transnational oil firms in Nigeria. Thunderbird International Business Review, 45,541–565.Gentile, G. (1998, September 1). Can political risk be quantified? While measuring beta is a sci-ence, measuring political risk is most certainly an elusive art. Financial Planning, p. 1.Hallmark, T., & Whited, K. (2001). The HIS Energy Group’s political risk ratings and rankingindex. In L. D. Howell (Ed.), The handbook of country and political risk analysis (pp. 22–27).East Syracuse, NY: PRS Group.Herbst, F.C., & Trebing, D. M. (1997). Chrysler Corporation: Balancing global expansion andinternational risk. Business Credit, 99(10), 25–26.Howell, L. D. (Ed.). (2001a). The handbook of country and political risk analysis. East Syra-cuse, NY: PRS Group.Howell, L. D. (Ed.). (2001b). Political risk assessment: Concept, method and management.East Syracuse, NY: PRS Group.Johnston, R. (1998, August 14). Risky markets, risky business. Journal of Commerce, p. 7A.Kennedy, C. R. (1988) Political risk management—A portfolio planning-model. Business Hori-zons, 31(6), 26–33.Knott, D. (1997, June 9). BP molds security strategy to fit the country. Oil & Gas Journal,95(23), 31–33.Kobrin, S. J. (1981). Political assessment by international firms—Models or methodologies.Journal of Policy Modeling, 3(2), 251–270.Kobrin, S. J. (1982). Assessing political risk overseas.Wharton Magazine 6(2), 24–31.Lebanon: The foreigner’s guide to setting up shop. (1992, April). Euromoney, ABI/INFORMGlobal, 12.Lighting a candle. (2003, June 12). The Economist, p. 60.Markwick, S. (2001). Customizing risk analysis as a tool for strategic management. In L. D.Howell (Ed.), The handbook of country and political risk analysis (pp. 37–46). East Syracuse,NY: PRS Group.Massoud, M. F., & Raiborn, C. A. (2003). Managing risk in global operations. Journal of Cor-porate Accounting & Finance, 14(6), 41–49.Molano, W. (2001). Approaches to political risk analysis. In L. D. Howell (Ed.), The handbookof country and political risk analysis (pp. 22–27). East Syracuse, NY: PRS Group.Money isn’t everything. (1996). The Banker, 146(847), 49–51.Moran, T. H. (1998). Lessons in the management of international political risk from the nat-ural resource and private infrastructure sectors. In T. Moran (Ed.), Managing internationalpolitical risk (pp. 70–79). Malden, MA: Blackwell.Much, M. (1980, March 31). GM’s watchdog for foreign political risk. Industry Week,204(7), 79.Power politics. (2002, June 6). The Economist, p. 77.Rice, G., & Mahmoud, E. (1990). Political risk forecasting by Canadian firms. InternationalJournal of Forecasting, 6, 89–102.



Robock, S. H. (1971). Political risk—Identification and assessment. Columbia Journal ofWorld Business, 6(4), 6–20.Schmidt, D. A. (1986). Analyzing political risk. Business Horizons, 29(4), 43–50.Sethi, P. S., & Luther, K. A. N. (1986). Political risk analysis and direct foreign investment:Some problems of definition and measurement. California Management Review, 28(2),57–68.Simon, J. D. (1982, Fall). Political risk assessment: Past trends and future prospects. ColumbiaJournal of World Business, pp. 62–71.Stapenhurst, F. (1992). Political risk analysis around the North Atlantic. London: MacMillan.Sullivan, L. (1999). Surveying the territories. Risk Management, 46(7), 54.Troubled waters over oil. (2003, July 17). The Economist, p. 47.Zonis, M., & Wilkin, S. (2000). Crisis management. The Banker, 150(891), 96.



managing micropolitical risk: a cross-sector examination

Documents