How political risk is defined, monitored and mitigated can make the difference between success and failure in a globalised business world
Political risk is a volatile and diverse segment of the risk landscape, with potentially catastrophic consequences for companies that don’t manage it effectively. JLT Asia’s head of credit, political and security risks Mark Wong says that while we all feel we have a good idea of what constitutes political risk, there is no generally accepted or legally agreed position on this. Wong himself defines political risk as: “The risk of the occurrence of any action or inaction of a government authority that has the effect of impairing, jeopardising or terminating a transaction or the returns of shareholders or other participants on their participation in a transaction”.
According to Martin Phelan, XL Catlin’s senior underwriter for political risk and credit in the Asia Pacific region, political risk is a term that is used in many different ways and contexts. “I have always started by differentiating political risk from broader country risk and sovereign risk,” says Phelan. “The former might bring demographic, cultural and even environmental factors into consideration for a foreign company considering investment in a new country or market, while the latter I generally view as being focused on the risk of a national government defaulting on payment obligations.”
Phelan defines political risks as those “which are or should be controllable, or are able to be influenced by, a country’s government or public authorities acting in consistent, equitable, predictable and transparent ways, and which enable commercial trade or investment decisions”. “As a final observation, political risk should not be considered to only exist in a developing economy,” he adds. “It exists in every country, regardless of political structure. The critical difference from an investor’s point of view should be the extent to which truly independent and unbiased checks and balances exist to protect legal and other rights.”
Even in countries with strong checks and balances, Phelan goes on to say, changes in governments or public opinion over time (not to mention external influences such as international sanctions) can cause shifts in policy and regulatory environments. These can then affect international trade and investment activities. He adds that political risk exists throughout Asia in different forms. “Myanmar, and to a lesser extent Cambodia and Laos, have relatively less developed political, regulatory and legal infrastructure and processes,” he says. “As such, risks associated with corruption, transparency and governance generally is a common issue in both public and private contexts. Whilst the safety and security of personnel and physical assets from all forms of political violence is generally low to moderate across much of the region, it cannot be dismissed or ignored that it applies across the region. In a number of locations it is rated as a high risk.”
Phelan says that a number of countries in Asia are heavily dependent on access to, and the continued support of, international markets or donors. This means that disruptions in markets or external shocks can result in governments adopting fiscal, monetary, exchange rate or regulatory measures that materially impact trade and investment.
If companies fail to mitigate political risks, Phelan says the consequences can be “everything up to catastrophic”. “At the extreme end of the spectrum, governments in Venezuela and Bolivia have expropriated numerous companies over the past decade or so,” he says. “At a more moderate level, a breach or termination of a commercial contract signed with a public, state-owned enterprise may result in significant losses for a contractor who has invested resources and contracted suppliers, for example.” In addition to the direct losses or difficulties such events might bring, Phelan adds, a company’s financial position, banking relationships, public or investor reputation, and even supplier or other contractual relationships might also be damaged. “Directors or officers of companies may also be viewed to be accountable for failing to manage and mitigate such risks,” he says. “As a result, political risk cover is often encouraged or required by banks or investors to protect their interests in a company. The cover can also be a tool to expand the companies’ access to funding or reduce the cost of capital.”
Wong says the decision to invest overseas is one that usually carries a high level of upfront equity injection and the amounts that companies have at risk can be very significant. “Political risk events generally tend be low frequency, high severity in nature and therefore if a government decides to nationalise or expropriate a company’s assets or operations, the entire investment value is likely to be lost, which could run into the hundreds of millions of dollars,” he explains. “From a corporate governance point of view, this will not sit well with the company’s shareholders which may in turn result in wider financial implications in addition to just the investment value.”
When it comes to putting in protections against political risk, Wong advises companies to establish clear risk assessment and management procedures for the countries that they are looking to invest in. “These risk assessment procedures should consider all political risk aspects in each country, including the legal, regulatory, investment and operating environments, as each area will vary from country to country and impact an investor in different ways,” he says. “Although there generally is a clear recognition of the importance of political risk in emerging markets, many companies still lack a formal process for assessing and managing such risks.”
Wong adds that companies with less sophisticated country risk management capabilities can subscribe to country risk analysis tools such as those offered by the Economist Intelligence Unit, IHS Global Insight and Control Risks. These provide independent quantifiable data together with qualitative insights from consultants in the country of interest. “Once the risks have been established, clients need to implement appropriate structural, legal and operational risk mitigation measures to protect themselves, such as ensuring that an investment agreement is signed on terms that are suitably favourable to the host government as they are to the investor, or that local companies have been partnered with where required,” he says.
While most companies will carry out a political risk assessment prior to making an investment overseas, Wong says, a much smaller number will continue to monitor political risks on a regular basis. “Given the volatile political environment which is usually present in emerging markets and the speed at which situations can change, companies can easily be caught out by not having a solid understanding of the latest political situation in a country,” he says. Wong adds that certain types of investments, for example hydropower projects, may also be sensitive from an environmental point of view. “Foreign investors who are deemed to be damaging the environment with their local operations are more at risk of being targeted by governments who are under pressure to be more environmentally responsible. It is therefore vital to carry out detailed environmental impact assessments to ensure that the project complies with local and international environmental laws and regulations. Multilateral agencies will also be unwilling to lend or cover projects that have not received the required environmental certification.”
An alternative risk mitigation strategy that can also be considered is political risk insurance, which Phelan says can be tailored to address many of the risks associated with international trade and investment activities. However, he cautions that insurance cannot “fix an inherent or fundamentally flawed contract or issue”. “Sound commercial relationships, due diligence, good advice and experienced advisors, internal or external, are all necessary precursors to an understanding of the environment and risk factors associated with a decision to proceed with a major transaction, such as trade or investment,” he says.
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