While political risk is a fascinating field to dive deeper into, it is also entirely objective. What this means and does is make it very difficult for businesses and financiers to make decisions based on it. The good news is that there are ways to measure political risk and get a better idea of the landscape and situation as you determine what to do with your money and business.
Foreign direct investment (FDI) has grown immensely over the years, which makes it even more vital that we can achieve accurate measures of country risk. Here you can learn more about what is political risk and the ins and outs of how is political risk measured.
The bottom line is that political risks have an impact on businesses and the political economy.
What is Political Risk?
In the simplest of terms, political risk, or “geopolitical risk,” is the risk an investment’s returns could suffer as a consequence of political changes or instability in a country. For example, there may be disruptions and changes to military control, legislative bodies, within the government, or between other foreign policymakers. There are three types of political risks including expropriation/governmental interference, transform and convert, and violence involving politics.
Why Political Risk Matters
Overall, political risks are hard to quantify since there is little data and few case studies based on an individual nation. Political risks are a big deal because they can drag down investment returns or even make it impossible to withdraw capital from your investment. You should note that some political risks can be insured. It’s always best to consult with a political risk expert before making any important decisions about your business and your investments.
How is Political Risk Measured?
Social science research and interpretation of contemporary events influence all three stages: analysis, evaluation, and management of political risks. You may also hear about the political risk index when making business decisions. The political risk index is the global risk assessment of a country calculated using all 17 component risk components of the PRS methodology such as volatility, financing transfers, direct investment, and export markets.
Factors in Measuring Political Risk
There are also several factors one uses to measure political risk including violence in a society, as sudden spikes in violence outside the mean can indicate instability and political risk. Another way is by changes of government that aren’t legal. A strong indicator of this is coups by any faction with or without violence.
Bond prices are another way to measure political risk. Generally speaking, the higher the perceived risk the more a country pays for borrowing on the international markets. An attempt to use extra-legal measures to govern is another warning sign.
Working within the legal framework of governance in which a state has set up is absolutely necessary for investors. If a government can step outside its own laws and do whatever it wants to accomplish political goals, what’s to stop it from doing the same thing to investors when its coffers run dry?
Finally, repeated natural disasters such as storms, floods, and droughts, to name a few, can weaken governments and introduce instability in all or part of a region.
Additional Factors When Measuring Political Risk
There are also multiple mundane factors that are used to measure political risk in other countries. For example, is garbage collection taking place as normal in the capital? Are power supplies undisrupted?
Are imports of goods unavailable in the host country flowing normally? Are exports of goods flowing normally? What is the official and REAL inflation rate? Do we see signs of militias based on ethnicity or political factions forming? Are they armed?
Some of this info about a given political topic is available publically and some of it requires an on-the-ground observer, people you pay to provide you with information and data. It’s essential you get the full picture of what’s really going on and understand all the potential risks involved before investing.
When we see all or part of these things taking place we usually issue an “escalatory dynamic” warning. This means a state or a region is showing signs of engaging in a dynamic by which one action is met with a counter-reaction leading to another counter-reaction, each more provocative than the last, without any off-ramp. This can lead to societal violence; we saw this in the wake of Catalonia’s attempt to secede from Spain recently as well as the events in the US leading up to Jan 6th, 2021.
Firm Level Political Risk
Generally speaking, firm level political risk management is quite volatile and unpredictable. You can try to measure it by listening to quarterly earnings conference calls and meetings to hear about how many risks are political in nature.
Studies have come to find that firms that tend to devote more time to discussing risks associated with a given political topic are more likely to increase lobbying on that topic, but not on other topics, in the following quarter.
You can measure it by showing that each of the top-scoring transcripts correctly identifies conversations that center on risks associated with politics. Keep in mind these conversations and whether they are political or not change over time and across sectors.
When there is political risk present, you will likely see a change in the outcomes such as stock prices and stock return volatility, investment, employment, political donations, and lobbying activities.
Aggregate or Sector Level Political Risk
The findings also show that the occurrence of political risk across firms is extremely more heterogeneous and volatile than previously assumed. The vast majority of the variation in the measure is at the firm level political risk measurement, rather than at the aggregate or sector level.
What this may conclude is that when firms are considering their political risk, they may be more worried about their relative position in the cross-sectional distribution of political risk (i.e. grabbing the attention of regulators to the firm’s activities) versus time-series variation in aggregate political risk.
Managing Political Risks
So, what does this all mean? It means that managing political risk and political risk measure consulting services are necessary and should be the main focus. The impact of political risk on a company is real and important. There are many types of political risks and you should know that it is also possible to insure against political risks with some simple tools.
Business leaders and executives need to take the time to map the impact of political risks across their company’s activities and portfolios to better anticipate and prepare for potential disruptions in the new reality, while at the same time mitigating their impact.
Enlisting Consulting Services for Political Risk
We work with clients to create informed, dynamic risk portraits of the political and security environment in regions and/or individual states in Europe, the Middle East, and Africa (EMEA), including but not limited to analysis and overview of domestic jurisprudence and international treaty obligations, safety, intellectual property protection, governmental and economic stability, and culture.
Audentes has deep experience with providing analysis from an on-the-ground perspective. Our management team has particular experience with governmental transitions, both scheduled and non-scheduled, in establishing a commitment to rule of law as well as establishing the safety of personnel and the security of tangible and intangible assets.
Risk Measurement and Effects
You now know more about the importance of measuring political risk and how it’s done. Hiring a pro or political risk consulting expert will help you develop your financial strategy and make more informed decisions based on economic research when it comes to running your business and investing. Be glad to know that we can help. Discussing risks is vital in helping you to make better business and political decisions.
Next Steps
We believe well-informed risk-taking means higher chances of success for your business venture.
Our specialized consulting group specializes in political risk analysis so you can feel confident about the decisions you make. We help our clients mitigate risk and make more informed decisions, making sure to uphold high ethical standards every step of the way.
Get in touch today to learn more and get the conversation started so we can help you begin to better manage political risk and safeguard your investments.