How to Calculate Political Risk

Prepared to lose it all? No? Read on...

Sergey Dolzhenko/Corbis

UKRAINE, 2004 The Orange Revolution brought the country to a standstill. Not at all business as usual.

Small and midsize companies hesitate to venture overseas because so much is unfamiliar: the language, the regulatory environment, the tax system, the culture. But another, greater concern should be that so much is unstable. In the U.S. market, business leaders count on predictable electoral cycles and domestic peace when they calculate risk-reward ratios. In some countries, however, eruptions of violence or widespread labor unrest periodically disrupt commerce, and governments seem to sweep in and out with the seasons.

Those events and many others fall into the category of political risk--the impact of politics on markets. For entrepreneurs, countries fraught with such risks sometimes present the best opportunities. Like speedboats maneuvering nimbly among aircraft carriers, small companies can respond more rapidly than large corporations to shifting political and economic conditions. With fewer fixed-asset investments, they can more easily pounce on new opportunities and exit when changing costs and benefits warrant.

But that doesn't mean small companies don't take hits when things go wrong. Many look to foreign countries for critical functions like sales and operations, not just commodity services like call centers and data entry. These are significant business exposures. The leaders who accept them can't just cross their fingers and hope for calm.

Unfortunately, political risk is a subject many small and midsize businesses get wrong. Some see other companies making money in a country and--assuming that market has passed the canary-in-a-coal-mine test--dive in blindly. Some take what they consider adequate precautions, meaning they consult with the single employee who once spent four days traveling around the country by train and consequently ranks as the resident expert. Some hire a local person whose only qualification is that he is local and speaks English.

Before trying to manage political risk in any given market, business leaders must understand the fundamentals that pertain to all markets. Let's start with the basics. Political risk is composed of two elements: shock and stability. Shock isn't a particularly useful object of analysis because there are so many kinds and most are difficult to forecast and impossible to model. Who knows when an earthquake will hit Pakistan, the Israeli prime minister will suffer a debilitating stroke, or a recording of the Hungarian prime minister confessing to lies will be leaked to the media? Such events can change a country's balance of power and send markets tumbling.

By contrast, stability is relatively easy to assess. Stability is the measure of a government's capacity to implement policy during a political, social, or economic crisis. Consider this scenario: A presidential election in country X generates controversy when much of the population questions the legitimacy of the official outcome. The defeated candidate challenges the result in the nation's highest court. When this scenario unfolded in Ukraine in 2004, hundreds of thousands of demonstrators flooded city streets and crippled the government. A new election was held, and the original outcome was reversed. But the battle of political personalities at the heart of the dispute undermined public confidence in governing institutions. For businesses, questions remain about the state of corporate governance, the rule of law, and the regulatory environment.

Of course, something similar happened in the United States in 2000. The subsequent political and legal dogfight created bitterness on both sides, but the electorate (and international investors) had enough confidence in the country's governing institutions to allow them to resolve the conflict. The U.S. government went about its business throughout the crisis. There was no capital flight, no stock market plunge, no change in the country's credit rating. In a country as stable as the United States, it is institutions, not personalities, that influence stability. Shock happens, but even when it does, the United States remains a good bet for foreign investments.

The Pros and Cons of an Iron Fist

Risk calculations would be straightforward if stability were all that counted. Unfortunately, all stable nations are not created equal. Business leaders must also gauge a country's openness--the degree to which people, ideas, information, goods, and services flow freely in both directions across external borders and within the nation itself. In an open state, citizens can make an international telephone call, log on to the Internet, and travel abroad with minimal restrictions. They have access to reliable information about domestic and international events and are free to discuss them publicly. The government of a closed state, on the other hand, does not recognize such freedoms as rights. Stability in an open state is fundamentally different from stability in a closed state. When you're investing in a country's long-term stability, that distinction is vital.

Some countries (the United States, the United Kingdom, Japan, Brazil, Germany, and many others) are stable because they are open. Other countries (North Korea, Myanmar, Cuba, Iran, and others) are stable only so long as they remain closed. In those countries, a ruling elite has isolated citizens from the outside world and from one another. Any opening--even an incremental opening--of a closed state will generate near-term instability. Businesses can certainly make money in countries whose stability depends on maintaining the political status quo. But their long-term risks are higher.

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