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STRATEGY

How to Calculate Political Risk
 

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

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


Greg Baker/AP

INDONESIA, 2004 The Asian tsunami created uncertainty—and hence risk—across a broad region.


Christian Keenan/Getty

CHINA, 2003 China’s greatest vulnerability is public unrest. Could another SARS outbreak provoke it?

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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.

To express visually the relationship between stability and openness, and to suggest what it means for people looking to do business abroad, I came up with what I call the J curve. It's shown here.

Where Should I Go?

Risk, as entrepreneurs know better than anyone, incorporates upside as well as downside. Small and medium-size companies can manage both, starting with the decision of which markets to enter. The most important question is how long you intend to be there. Scores of small companies from around the world are reaping impressive profits by betting on China's continued growth. But China, though quite stable today, could face substantial instability as it opens to the outside world and domestic demand grows for political change. That's not to say long-term-minded companies should ignore a 1.3 billion-person market. But if you venture to China, or to any state where long-term stability is a question mark, you need a smart hedging strategy.

Hedging, of course, implies diversification. East Asia's democracies--India, Japan, South Korea, Taiwan, and others--remain sound investment bets that can help mitigate risks associated with overexposure in China. Businesses that can't diversify across countries should try diversifying their operations within a single country. For example, China is especially vulnerable to locally isolated social unrest, environmental disasters, and public health crises. For that reason, don't concentrate research and development facilities, production, and supply chains in any one province or region.

Prospects may also vary tremendously according to industry. Many businesses view Russia as a hostile market because of its much-publicized moves to restrict foreign investment in economic sectors considered strategic to the state. True, Russia is quite risky if you're in energy, metals, minerals, even telecommunications--sectors the Kremlin intends to dominate. But the investment climate is by no means monolithic. There's money to be made in construction, retail, white goods, high-end services, and other industries that attract companies of all sizes. Small companies already profit in sectors as diverse as high-tech R&D and food and beverage manufacturing and distribution. And small companies may be able to fly beneath the radar in some restricted sectors, something their large competitors cannot do.

Finally, small businesses can be reluctant to tackle preemerging (some call them frontier) markets. But growth industries exist in places such as Vietnam, Mauritania, Cambodia, and Senegal. In Africa, for example, some smaller pharmaceutical companies have profitably sold generic drugs and commercially developed local products. Another advantage: Competition in such markets is less intense (for the moment) because so many companies focus exclusively on downsides, which keeps them at bay.

Company leaders pursuing frontier markets require a thorough grasp of their politics and business environments. If a small business can't afford a well-connected consulting service, its decision makers should spend substantial time on the ground making contacts and building a reliable in-country team (see "Building a Global Network,").

Small companies with their fleet feet and low profiles have advantages large competitors can't replicate. Still, small-business leaders should incorporate risk-management practices into every aspect of their international adventures. To ignore political risk is dangerous. To avoid it is shortsighted. To use it can be very profitable.

Ian Bremmer is president of Eurasia Group, the world's largest political risk consultancy. He is the author of The J Curve: A New Way to Understand Why Nations Rise and Fall (Simon and Schuster).

IMAGE: Sergey Dolzhenko/Corbis
Last updated: Apr 1, 2007




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