Russian troops occupy parts of Ukraine. Many parts of the Middle East remain a tinderbox. The Islamic State insurgent group is posing an increasing threat to Iraq and the West. The Chinese government’s anti-trust actions are worrying foreign investors. Brazil’s economy is under pressure. Some European countries are still battling to emerge from recession. The UK barely seemed united in the run up to the vote on Scottish independence, and could itself break away from the EU in the near future. The US remains hobbled by its own domestic politics.
In the face of so much instability, companies are having to navigate new political minefields in their FDI decisions.
“I think political risk is becoming a much hotter topic than it was in the past year or two,” says Stephen Kay, US practice leader with Marsh Political Risk and Structured Credit, a global insurance broker and risk management company. “In the past, companies felt they had to be in emerging markets. They focused on returns, not on risk. That mindset is unravelling, and people are focusing much more on risk.”
Mr Kay's view is supported by recent studies by groups such as the Organisation for Economic Co-operation and Development (OECD); the World Investment and Political Risk report by the Multilateral Investment Guarantee Agency (MIGA) within the World Bank Group; the World Economics Forum (WEF); and the Association for Financial Professionals, as well as numerous analyses by private risk consultants.
Yet it is far from clear how even the most dangerous-looking risk affects investors’ FDI decisions. “Despite elevated perceptions of political and economic risk, the majority of respondents… have no plans to withdraw or cancel investments in developing markets,” the MIGA survey reported, while the OECD report said: “The bullishness of financial markets appears at odds with the intensification of several significant risks."
Some experts on political risk are not surprised however. “You would be surprised how some very large companies are going out into the world and they have a very basic understanding of political risk, and they don’t have a systematic way of tracking or measuring it,” says Mr Kay. “Maybe those strategic risks should be thought about by the board or the chief financial officer.”
Moreover, FDI from developing countries – which represented 17% of global FDI outflows in 2013 – appears less sensitive to political risk, according to the MIGA report. Even in 2012, when global FDI flows declined, firms based in developing economies continued to invest abroad, especially Brazil, China and India, which had outflows of $68bn.
While political risk was important to these firms, it was rated lower than macroeconomic instability and access to financing, MIGA reported, noting: “This may be explained by a high political risk appetite, but also by different awareness of the impact of political risks and different first-hand experience.”
Other studies suggest firms from developing countries pay less attention to political risk either because they tend to rely on relationships that help them reduce it, or because their own home countries have weak institutions and low standards of corporate social responsibility.
Still, Mr Kay says, investors are changing their one-size-fits-all perception of emerging markets and taking a more discriminating view of individual country risks. And Europe is no longer immune from many of these risks.
“I never used to get a call from anyone who wanted to protect their FDI in Greece or Portugal. In the past few years, that has happened,” says Mr Kay, who adds that the Scottish referendum on independence from the UK also jolted investors. Meanwhile, increased political polarisation in Europe is leading to the rise of nationalist political parties that create more uncertainty.
Even so, Mr Kay believes investors are more likely to discount political risk in Europe, which investors view as having the depth and institutions to handle such crises.
Companies can purchase political risk insurance to protect their foreign investments. Policies generally cover losses due to currency transfer restrictions, expropriation or war, civil disturbance and terrorism. In addition to commercial insurers, some governments offer political risk insurance to encourage domestic companies to export. In the US, the Overseas Private Investment Corporation, or OPIC, serves this purpose, while in the UK it is UK Export Finance.
Political risk insurance does not usually cover corruption, environmental harm or labour conditions, however, as these factors are considered to fall within a company’s control, says Mr Kay. Too often, however, investors rush to buy coverage too late, after the risk has already arisen, as has happened recently in Russia. But commercial insurers refused to sell policies to companies seeking last-minute coverage, except in some cases where, according to Mr Kay, the company already had a relationship with them, or only at exorbitant rates.
“It takes forward-thinking, proactive risk managers to think of these things and buy coverage at a time when they are not sure they will need it and are able to get the best terms possible. That’s what we recommend: don’t manage risk by looking in the rear-view mirror,” says Mr Kay.
Indeed, analysing political risk is a complicated business. “At first sight, the risks appear very intuitive and hard to grasp, so firms don’t put it in their accounting,” says Mariana Magaldi, a principal analyst with UK-based Maplecroft Global Risk Analytics.
Her firm uses 53 different indices, including both quantitative and qualitative measures, to assess dynamic, short-term risks in a country, such as governance, regime stability, corruption, political violence and civil unrest, as well as long-term structural risks.
The right kind of risk
Another mistake many multinationals make is to pick and choose the country and type of risk they want to cover, according to Mr Kay. That leaves them exposed if the risk occurs elsewhere or is of a different nature. If they buy when the market is calm, it is possible to buy broad coverage for a portfolio of countries where they have operations at essentially the same price as for a single country, since the country they select is generally higher risk and subject to a high premium, he says.
Yet the underlying sources of political risk are many. The WEF’s Global Risks 2014 survey notes increasing instability in many countries as a growing middle class demands more from their governments, a feeling frequently shared by young people who are unemployed or whose education does not match available employment opportunities. That is why an integrated approach to overseas investment is advocated by Witold Henisz, a management professor at the Wharton School at the University of Pennsylvania and principal with political risk management consultancy Prima .
Mr Henisz believes FDI need not be a 'go' or 'no go' decision, if companies adopt a nuanced process to minimise political risk. For example, companies may cut costs by sourcing a product globally for a project in a foreign country, but a company that sources it in-country can create local jobs, generate a political benefit and create allies, he says. Hiring local managers is another example of what Mr Henisz calls “corporate diplomacy” intended to win the hearts and minds of external stakeholders.
However, Mr Henisz acknowledges that this approach will not always work. McDonald’s, which he says is a model of developing local supply chains and creating local jobs at its 433 locations in Russia, was not protected when the Russian consumer watchdog agency forced it to close several restaurants over allegations of health violations – a move viewed in some circles as retaliation for US sanctions being imposed against Russia. “McDonald’s was a very attractive target because its restaurants are in high-traffic places and it is so symbolic of the US,” says Mr Henisz.
Time to go?
How long companies are scared away from a particular country because of political risk depends on factors such as the type of instability, how long it lasts, how well the company absorbs risk, and whether the company needs to be in that market, according to Charlotte Ingham, senior political risk analyst with Maplecroft. The extractive industries are usually the first to come in because they have the skills to manage risk, she says.
“In Russia, the fundamentals don’t look likely to change. There is an extremely high level of corruption, an increasing decree of regulatory uncertainty, and growing economic challenges with potential long-term political implications. Companies will do the cost-benefit analysis and some will decide they want to go in, and others will decide not to,” says Ms Ingham.
In addition to these problems, Western-imposed sanctions are biting not just Russia but existing and potential foreign investors there, including financial institutions and automakers such as GM and Opel, which have cut production in Russia because of a sales slump. GM says it is reconsidering its planned plant expansion in the country, while Opel is buying more from local suppliers to avoid currency fluctuations.
On the other hand, Ms Ingham plays down fears that China’s recent anti-corruption and anti-trust crackdown on foreign firms signals a less welcoming approach to FDI, as a September statement from the American Chamber of Commerce in China suggested. “We very much see it as China coming of age. Some companies operating there for a long time got very favourable terms. Now China is rebalancing because it is in a stronger position. This is not a blip but the new normal,” she says.