How Firms Should Deal With Political Risk

Cranfield School of Management

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How Should Firms Deal With Political Risk?
By Dr Tazeeb Rajwani

The Genie is out of the bottle

My research shows that a large number of multinational firms don’t fully understand or appreciate how to deal with political risk. This is significant since political risk can have a substantial impact on firms, as current world events are showing in the Middle East and North Africa (MENA). Before I discuss this, firstly we need to understand what exactly is political risk. Essentially political risk is defined as the risk of losing money as a result of unstable governments or regulatory environments. Acts of terrorism, wars, and military coups are all extreme examples of political risk. Expropriation of assets by the government – or merely the threat – can also have a devastating effect on share prices as seen from the events in Syria, Libya, Egypt, Bahrain and Tunisia.

All these countries highlight that the MENA nations have over the past few months witnessed unprecedented civil disturbances, along with mass demonstrations and disruptions to businesses. Egypt has over the years moved to become a manufacturing hub for many firms in the MENA region, while Tunisia has been a tourism sanctuary. However, these recent political problems and uncertainty around the old and new incoming governments have implications for company profits. The next part will untangle political risk and help develop some strategic options for firms to deal with future political risk.

What caused this Political Risk?

In the MENA region, the political unrest was caused by an increased toxic mix of high unemployment, high inflation, oscillations in fuel prices and long standing corrupt regimes. Broadly speaking, it was this corruption and educated people not finding jobs that ignited these regime changes. That said, the big question in most boardrooms now is how is this playing out in a wide range of other countries? It seems the genie is out of the bottle and I believe political risk needs to be taken more seriously by firms.

Some key lesson can be learnt. Looking at the Egypt example and more recently the Libyan and Syrian example, the effect of political risk means some international firms are loosing large sums of money as they temporally shut their business units. I spoke to a number of international companies who are currently feeling the pain of political instability in the region. These European and Indian sample firms have lost huge revenues from their properties being damaged, roads being blocked and a visible economic slow down. Supply chains are also getting squeezed and as a result of all these things, top management teams are assessing the damage as they feel the pinch. As such, all companies need to be considering political risk very carefully since I believe that it is here to stay for a long time. Firms should consider the following to better manage political risk:

  1. Insurance as one option

    Firstly, what companies must do is fully understand insurance as a powerful way to mitigate political risk. Whilst at a macro level political risk and catastrophes are very difficult to manage, at the company level, political risk can be defended against for a premium. This comes at quite a cost, but best used as an absolute fail-safe, especially in combination with other, more proactive political risk management strategies.

  2. Avoid Political Risk with Control Procedures

    Firms need to be proactive and avoid situations with overt political risk. The large firms use sophisticated scoring systems to evaluate political risk in regions. That said, some of the largest companies employ a professional chief risk officer or director of government affairs whose sole responsibility is to stay on top of potential political risks, such as insecure political climates, new legislation and elections among other. Smaller firms leave this responsibility to the CFO or CEO, but either way, there is always someone who is responsible for managing political risks. Careful assessment and analysis of situations is key to avoiding political risk by eschewing investment in areas that are too risky and pulling money out of areas when they become too risky.

  3. Deal With Risks On An Ongoing Basis

    Sometimes it’s hard to avoid political risk, so leaders need to come to terms with the fact that they won't be able to identify every political risk. Consequently, leaders need to have exit strategies and evaluate alternative investment options on an ongoing basis, especially as firms invest more and more money into infrastructure in those areas.

  4. Understand Macro and a Micro Political Risk Environment

    Also companies need to acknowledge the macro and a micro political risk environment. Micro level risks impact industries or projects; macro level risks affect the entire economy. Micro level risks can be managed with far more easily as they come - investments can be shifted to different industries, firms can find a new local partner, and, worst case scenario firms can file an insurance claim. Macro-level risk, however, is the variety that you need to see before it comes because if the nation in which you are investing closes its borders, devalues its currency or even enters a civil war, you and your money are left with very few options.

  5. Diversify Political risks

    Leaders need to diversify their political risks: firms that have strategic business units in various geographies need to acknowledge their cost base, and that some regions that look very attractive might also carry high political risk. For example, if you plan to move into Nigeria there may be ‘some’ political risk, but at the same time cheap materials and resources are available to those firms too. This implies that there is a trade off, and leaders should look at their costs and benefits of diversifying their strategic business units throughout different regions. That said, I think they should not put all their eggs in one basket.

What is clear is that taking political risk seriously involves companies adopting proactive steps to assess and mitigate their risks. As we have seen currently, the effects of political risks are substantial. Firms that invest in developing political capabilities, political resources, and corporate political strategies will sustain their competitive advantages despite being in risky countries.

Dr Tazeeb Rajwani is Lecturer in Strategic Management at Cranfield School of Management.

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