Business in the Global Political Environment

This article will focus on business practices in the global political environment. It discusses globalization and the challenges of political risks for businesses operating in the international economy. This article will provide an analysis of the different types of political risk as well as the strategies most commonly used for identifying, assessing, and managing political risk. Strategies used by companies to mediate political risk, such as political risk insurance and cross-border alliances, will be discussed. In addition, a case study of the political risks facing international e-commerce companies is included as an example of an industry-specific response to political risk.

Keywords Cross-Border Alliance; Globalization; Policy Risk; Political Environment; Political Risk; Political Risk Insurance; Social Risk

Business and Public Policy > Business in the Global Political Environment

Overview

Business practices and operations in the international political environment are influenced by the forces and processes of globalization, including political, social, and policy risks. Political risks refer to the potential effects of a change in government on a business. Social risks refer to pressures put on businesses by environmental or other pressure groups. Policy risks refer to the potential effects resulting from change in policy or rights on a business (Frynas, 2002). The process of globalization refers to the increasingly free flow of ideas, people, goods, services, and capital that is leading to the integration of economies and societies. Businesses have adapted to the changing global political environment by identifying political risks prior to investment in foreign business activities and investments. The following sections provide an overview of the current global political environments and political risks.

Global Political Environment

A political environment is characterized by the regulatory environment, local attitudes towards corporate governance, reaction to international competition, and labor laws. Political environments around the world are changing due to the forces of globalization. Globalization is characterized by the permeability of traditional boundaries of nations, cultures, and economic markets. According to Thruow (1995), the fundamental economic forces and events influencing globalization and political turmoil around the world include:

• The end of communism
• The shift from an economy based on natural resources to one based on knowledge industries
• Demographic shifts
• The development of a global economy
• Increased trade liberalization
• Advances in communication technology
• Increased threat of global terrorism
• An era without a dominant economic, political, or military power

Globalization creates a turbulent global socio-political environment characterized by competing political actors, shifting power relations, and politically-driven changes in national economies around the world. Businesses work to find opportunity and profit to be had from these political and economic changes. The political turbulence and upheaval has resulted in a move from centralized economies to a decentralized global economy and has created numerous emerging markets. These emerging markets refer to the capital markets of developing countries that have liberalized their financial systems to promote capital flows with nonresidents and have become broadly accessible to foreign investors.

Business opportunities, including international investments and joint ventures, in the global economy are increasingly tied to trade pacts such as the North American Free Trade Agreement (NAFTA) between the United States, Canada, and Mexico, the Mercosur trade pact between Argentina, Uruguay, Brazil, and Paraguay, and the Asia Pacific Economic Cooperation (APEC) trade zone. In addition, business opportunities are resulting from privatization worldwide. Countries are privatizing many state-owned industries and allowing foreign investors to purchase pieces of them through joint ventures or allowing local operations to participate in these projects (Stites, 1995).

Emerging markets, often occurring in countries experiencing political upheaval, will continue to increase in the expanding global market. Businesses, participating in the new global economy, will continue to seek out new manufacturing and sales opportunities in foreign markets and countries. Ultimately, globalization brings businesses new opportunity and new risks. Political risks are one of the major problems and considerations for businesses in the global political environment. Opportunities and liabilities are growing proportionately in the new global economy. The following section describes and analyzes the influence of political risk on business activities and operations.

Political Risk

Multinational corporations conducting global business in emerging markets experience lucrative investment opportunities as well as challenges and turmoil. Multinational corporations conducting business in today's global political environment are challenged by political risk. Political risk refers to the risk of a strategic, financial, or personnel loss for a firm because of events related to political instability such as riots, terrorism, coups, civil war, and insurrection, as well as non-market factors such as macro-economic and social policies (fiscal, monetary, trade, investment, industrial, income, labor, and developmentally) (Morales & Kleiner, 1996).

Political risk arises from factors and events such as governmental change, shifts in national ideology or policy, civil war, social unrest, economic instability, nationalization, and corruption. Political, economic, and religious environments influence business operations for exporters, traders, investors, banks, and other organizations involved in international commerce. In addition, national governments may institute forced shutdowns and relocations of foreign business. Companies entering foreign markets for the first time, either as investors or manufacturers, as well as established multinational corporations expanding into new foreign markets or ventures must address certain questions in order to assess potential political risk (Wade, 2005):

• Is there a tradition of peaceful governmental transition?
• How resilient is the political system?
• How do nongovernmental agencies, such as trade unions, churches, media, and the legal system, influence the society and government?
• Is there demographic stability?
• Are there internal social, ethnic or religious tensions that could lead to a civil war or unrest?
• What is the country's trade credit history?
• What is the level of unemployment among citizens?

Political risk, as a general, global category, is characterized by three factors: catastrophic events, business environment, and public policy (Dugan, 1999).

• Catastrophic events: catastrophic events refer to the political developments that can affect operations of all foreign firms in a country. Theoretical examples include racial and ethnic unrest, civil strife, terrorism, civil war, international conflict, and systemic failure. Real word examples include former Yugoslavia's ethnic unrest, civil war, and international conflict.
• Business environments: business environment risks faced either by all foreign businesses in a region or industry specific risks (related to government corruption, labor strife, and the judicial system). Examples include labor and elections. Labor organizations through much of the world are closely tied to political organizations. This connection between labor and politics brings foreign companies into the midst of political struggles and issues. Foreign elections, which seldom influence foreign business operations directly, do influence public policy. Elections may bring in new officials who alter or shift the business environment to match the new regime. For example, new officials may change the tax code or structure.
• Public policies: public policy risks include political initiatives such as changes in the tax system, regulatory structure, and monetary system. For example, when a foreign government is forced to devalue currency due to economic crisis, interest rates rise and alter domestic spending habits. This change in monetary policy could potentially ruin a foreign business' investment.

The new global political environment is often unpredictable or dangerous. Multinational companies may experience work stoppages, hijackings, physical attacks, and more as they manufacture or distribute their products and services in the global business environment. In addition, goods produced by foreign companies may be subject to confiscation by competing political actors and manufacturing facilities may be nationalized (Stites, 1995).

Applications: Assessing and Managing Political Risk

Companies manage political risk through global strategies and organizational planning. These two approaches, global strategy and organizational planning, differ in scale. Global strategy is a macro-level activity that actively tries to connect the proposed project to a firm's overall goals and objectives. Organizational planning is a micro-level activity that actively works to connect the proposed project with project-level goals, objectives, and tools. The following sections describe how global strategy and organizational planning aid companies in the identification, management, and avoidance of political risk.

Global Strategy

Companies develop global strategies, in part, to assess and manage political risk. Global strategy refers to the methods, approaches, and objectives developed by a business to increase competitive advantage in the market by increasing competitive scope worldwide. A global strategy allows a company to determine the real cost of capital for a foreign investment. The majority of global strategies involve a combination of trade and direct investment in foreign countries. Global strategy requires capital investment decisions. The investment decision-making process involves seven steps:

1. Determine that the project meets the firm's strategic objectives.
2. Compute the costs, revenue, and benefits of the project.
3. Assess the risk associated with the project.
4. Determine the cost of capital to be used in the evaluation.
5. Conduct the evaluation analysis.
6. Select or reject the project.
7. Perform a follow-up evaluation and tracking on selected project.

Determining the true cost of capital required for a foreign project is crucial to the profit margin of the project. Martinson (2000) argues that the appropriate cost of capital for an investment project is a function of the perceived risk of the investment. Country specific factors that influence perceived investment risk include political risk, interest rate differential, and tax rate differential. Examples of political risk include frequency of government changes, amount of violence in the country, number of armed insurrection, conflicts with other countries, inflation, balance of payments, deficits, surpluses, and the growth rate of the gross national product (GNP). Country risk surveys and country ratings, produced by independent services, provide the information businesses use to measure political risk. Organizations that rate and quantify political risk of different countries include the following (Martinson, 2000):

• Euromoney magazine: Euromoney magazine produces an annual country rating risk report based on different countries' access to international credit and payment record.
• Economist Intelligent Unit: Economist Intelligent Unit produces an annual country rating risk report based on external debt, foreign-exchange reserves, and consistency of government policy.
• International Country Risk Guide: International Country Risk Guide produces an annual country rating risk report including composite risk rating as well as individual ratings for political, financial, and economic risk.
• Country Forecasts: Country Forecasts produces a semi-annual country forecast.

Risk managers are responsible for understanding the potential problems and complex risks of emerging markets. Political risk assessment, including organizational planning, knowledge of the political environment, and diligence, has developed in response to the influence that the political environment has on foreign business operations. A business' foreign or overseas operations will inevitably be influenced by the actions of host governments and competing political actors (Stites, 1995).

Organizational Planning

Political risk to specific foreign investment is managed, in large part, through organizational planning. Organizational planning is conducted prior to final investment decisions. The pre-entry planning or pre-investment stage involves the following steps:

• Describe investment objectives.
• Assess company's knowledge and expertise related to proposed foreign investment.
• Integrate political risk assessment into global strategy.
• Identify opportunities that benefit the company and avoid risk.
• Establish a structure of operations.
• Development of strategy and contingency plans.
• Develop security plans for the protection or evacuation of employees.
• Choose insurance coverage.

Organizational planning occurs both within and outside of organizations. In-house centers gather, process, and disseminate information. Consulting firms also assess country, regional, and global political risk and monitor foreign political environments (Dugan, 1999).

When political risk assessment is completed, the information and knowledge gained through global strategizing and organizational planning allows managers to make informed decisions about the type, degree, and probability of political risk in a business scenario. With this information in mind, political risk managers may choose to mediate political risk through the use of a political risk strategy such as adapting, politick, negotiating, or withdrawing (Morales & Kleiner, 1996).

Issues: Political Risk insurance and Cross-Border Alliances

In addition to political risk management strategies such as adapting, negotiating, and withdrawing, businesses mitigate political risk by obtaining coverage against possible losses resulting from political actions or inaction by the host government through the purchase of political risk insurance and the formation of cross-border alliances. The following sections describe and analyze political risk insurance and cross-border alliances as they relate to the problem of political risk.

Political Risk Insurance

Worldwide political upheaval has resulted in the demand for political risk insurance (PRI) to protect businesses engaged in international business. Businesses obtain political risk insurance coverage during the initial stages of the project. Businesses pay a small commitment fee to the underwriters and are guaranteed coverage often for the life of the project.

The market and demand for a political risk marketplace has grown throughout the 1990s. In addition, political risk insurance has expanded and adapted to meet the changing needs of global businesses. Political risk insurance guarantees small business transactions and ever increasing amounts. Increasingly private sector and public sector political risk insurance underwriters work together to increase insurance capacity (Wagner, 1999). Common political risk insurance options include the U.S. government's Overseas Private Investment Corporation (OPIC) (which pays claims on losses occurring from expropriation, inconvertibility and political violence) and the World Bank.

The World Bank issues political risk insurance through their Multilateral Investment Guarantee Agency (MIGA). MIGA helps investors mediate political risk by ensuring eligible projects against political losses caused by currency transfer restriction, expropriation, war and civil disturbance, and breach of contract by the host government. MIGA simultaneously works to prevent incidents and claims as well as promises to make prompt payments if a claim is made. MIGA insurance includes services such as:

• Mediating disputes
• Accessing funding
• Lowering borrowing costs
• Providing extensive country knowledge
• Providing environmental and social expertise

The World Bank's political risk insurance and political risk insurance in general, creates new investment opportunities for businesses in developing countries by covering risks the private market is unable or unwilling to sustain.

Cross-Border Alliances

In addition to political risk insurance, cross-border alliances offer the opportunity and means to mitigate, reduce, or control political risk. Cross-border alliances are international agreements on collaboration between two or more independent companies who exploit a tangible or intangible asset. Examples of cross-border alliances include joint ventures, cooperative business arrangements, supplier contracts, and management or technology contracts. Cross-border business alliances involve shared risk, cost, and reward. Cross-border alliances are particularly useful for new market entries and new business start-ups in foreign countries. Cross-border alliances are formed when they promise economic or structural benefits that cannot be achieved by the company alone or through outright acquisition or mergers. Cross-border alliances allow businesses to participate in emerging markets where involvement of a local partner is desirable or required by the local government.

The main principles for successful cross-border alliance design include:

• Strategic objective
• Mutual dependence
• Alliance independence
• Shared vision and rewards
• Barriers to exit

Challenges to cross-border alliances include management difficulties, costs, inflexibility, coordination difficulties, and risk of competitive conflict (Jagersma, 2005).

Case Study: Political Risk and International Internet Firms

Managing political risk improves global business performance for all types of companies conducting international business. Political risk affects companies with physical and intellectual products alike. For example, internet companies worldwide are currently struggling to assess and manage political risk caused by government efforts around the world to regulate new technology.

Frynas' study of the political risks faced in international e-commerce reveals that internationally operating internet firms face serious political and legal challenges in different countries and markets (2002). The country-specific variations between issues such as consumption tax and intellectual property rights demonstrate that internet firms experience country or region-specific risks and uncertainties. National governments tax internet businesses and try to regulate various aspects of internet activities such as e-commerce. Examples of government efforts at internet regulation include the Chinese government's efforts to introduce Web site censorship and the European Union directives on copyright.

Internet firms face political risks such as non-enforcement of intellectual property rights, uncertainty over the legal validity of electronic contracts, changes in taxation, non-recognition of electronic signatures and legal liability of internet service providers for third-party content. Internet businesses are vulnerable to changing national feelings toward technology. Unpredictable changes in political business environments worldwide affect the profits and future of internet businesses.

Risk managers of international internet and e-commerce companies minimize risk in the international political environment by following these strategies:

• Research and monitor the legal and political developments in target markets
• Design the firm's Web site carefully to ensure strict compliance with the law
• Carefully choose the jurisdiction when deciding on the home base for the Internet firm
• Purchase political risk insurance
• Use legal and political weapons to fight competitors

In the final analysis, political risk for internet companies, as for all types of businesses, is a subjective account of how events may affect business activities and operations (Frynas, 2002).

Conclusion

Profitable foreign investment strategies in the new global political environment depend on political risk management. Political risk assessment and management is particularly important to foreign direct investment in the economies of developing countries. Companies committed to foreign investment have systems in place for analyzing a country's political risk. The main principles of political risk management include (Morales & Kleiner, 1996):

• Staying in touch with a country's daily developments
• Analyzing industry, project, and management characteristics
• Following a proactive instead of reactive management

Risk assessment and management mediates risks and allows for ever-increasing global expansion of multinational corporations into established and emerging markets.

Terms & Concepts

Cross-Border Alliance: International agreements on collaboration between two or more independent companies who exploit a tangible or intangible asset.

Globalization: The increasingly free flow of ideas, people, goods, services, and capital that leads to the integration of economies and societies.

Global Strategy: Methods, approaches, and objectives developed by a business to increase competitive advantage in the market by increasing competitive scope worldwide.

Multinational corporations (MNC): Companies with holdings in multiple countries.

Nationalization: Seizure of private, foreign-held assets by a host regime.

Policy Risk: The potential effects on a business resulting from change in policy or rights.

Political Environment: A country's regulatory environment, local attitudes to corporate governance, reaction to international competition, and labor laws.

Political Risk: The threat that social, political or economic factors in a foreign country may affect the feasibility and profitability of an organization's global operations.

Political Risk Insurance (PRI): Insurance that protects businesses engaged in international business from loss associated with political upheaval such as regime or policy change.

Social Risk: Pressures put on businesses by environmental or other pressure groups.

World Bank: An international economic development assistance organization that was founded in 1944.

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Suggested Reading

Althaus, C. (2005). A disciplinary perspective on the epistemological status of risk. Risk Analysis: An International Journal, 25, 567-588. Retrieved April 01, 2007 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17588531&site=ehost-live

Bremmer, I. (2005). Managing risk in an unstable world. Harvard Business Review, 83, 51-60. Retrieved April 01, 2007 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17276634&site=ehost-live

Noordin, B., Harjito, D., & Hazir, A. (2006). Political risk assessment of Malaysian based multinational corporations. Investment Management & Financial Innovations, 3, 91-99. Retrieved April 01, 2007 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23039266&site=ehost-live