How Does Political Risk Affect International Business?

Political risk is a cost of doing business.

The concept of political risk in international business is based on the existence of possible threats to the firm from political instability and lawlessness in the area of investment. Once a firm leaves the basically standardized world of domestic business law, the global environment is much more fluid; most states can use many levers of power to extract more resources from the investing firm.

Types

There are two general types of political risk affecting international business: Firm-specific risks are those threats that target a specific business or class of business. This is often a problem for strategic investments such as gold, oil or natural gas, and these risks often center around discriminatory treatment or expropriation of assets. Country-specific risks are those not targeted to a specific firm, but affecting an entire country or region, and include such things as currency devaluation, local rebellions or the possibility of nationalization.

Features

Political risk disrupts the normal flow of business practice. Firm-specific threats can be dealt with through strong contracts and regular trade with the foreign entity, so that threats of retaliation can be effective. On the other hand, country or regional risk cannot be dealt with so easily, since it is endemic to a specific government or place. Firms can deal with this by having detailed contingency plans written up by qualified risk managers.

Significance

Political risk is a major variable in how business is run. It is clear, therefore, that businesses must work to protect themselves from the possibility of expropriation, labor struggles, poor infrastructure, terrorism or currency issues. The firm should hire a risk manager with knowledge of the region. Risks must be monitored constantly since the ability to manage risk increases firm performance and, importantly, maintains stockholder confidence.

Function

The general function of political risk and its effect on business is to force the firm to do strong monitoring of its risks. Otherwise, especially in the developing world where instability is endemic, the firm essentially is betting on the goodwill of the state or those powerful groups that might oppose it. Ultimately, the function of risk here is to optimize decision-making and to protect investments.

Benefits

Companies invest abroad to access new markets or cheap labor, or to be closer to sources of raw materials. Political risk in the developing world substantially increases the costs of doing business. But the very existence of political risk from any quarter might have the hidden benefit of forcing the firm to follow local laws scrupulously, build ties with the local population, increase local profit sharing and do all in the firm's power to have a solid, working relationship with the ruling party and the local population.

References

• IMRI: Defining "Political Risk," by Daniel Wagner
• North Carolina State University: How Managing Political Risk Improves Global Business Performance