Political Risk Definition
Political risk indicates the commencement of risk arises due to change in the governing body of a country and therefore poses a risk to the investors who have investments in financial instruments like debt funds, mutual funds, equity, etc. Specific terms like corruption, terrorism, etc., related to the politics of a country may arise due to change in a political scenario, which further might result in a change in the regulations of the nation.
Political risk can also be termed as geopolitical risks that arise due to conflict between two countries. There can be hindrance across the businesses and finally slash the confidence level of the investors.
Types of Political Risks
Political uncertainty arises from the market place of the country. Several businesses surround the economy’s marketplace.
Change in government leads to a change in regulations and changes in business scenarios. For example, any change in the corporate tax rate by the ruling government can change corporate profits. There are certain legal aspects also which may challenge the way of doing business and lower profitability and enhance risks for the investors.
This risk may arise at any level, such as the national level, federal level, state level, etc. Thus, based on the scenarios, political risks can be divided into two types, such as macro risks and micro risks.
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- The macro risk is related to the multinational companies which have businesses in the country and the adverse effects faced by those companies.
- While micro risks arise from internal conflicts such as corruption, poverty, cynical manipulations, etc.
How to Identify?
There are no concrete measures where one could identify such risks.
- To be specific, one has to be very keen about the existing political scenario of the country and look for the change in the qualitative aspects of the economy.
- The changes need to be followed, and the simultaneous impact on the businesses.
- The change in economic scenario depends upon the regulations of the country, while the stance taken by the existing government is hard to predict. Thus, to understand the political risk, one has to apply the qualitative techniques. Specific regulations, like enhancing individual or corporate tax, might lead to inflation or stagflation kind of scenario.
- Certain risks related to the macro-level may arise during the civil war between two countries that may result in the closed down of border by those countries. Thus, war situation can affect the business scenarios and as well the investments.
- As per the micro scenarios are concerned, strict regulations, along with changes in the legal systems, might change the profitability of the companies. Whereas, incentives offered to the weak sectors may result in boosting of the particular industry. The above action might create competition among investors.
Examples of Political Risks
After Donald Trump came into power in the U.S. during 2015, there have been several changes in the trading policies. There has been the imposition of import duties primarily on Chinese goods, which caused a trade war kind of situation, causing a business slowdown for the Chinese companies, further adding pressure to the Chinese investors. The Trump government also imposed strict regulations on the USFDA, which is the governing body of the pharmaceutical sector. Thus, this kind of change in the scenario results in the macro risks for the investors.
The entry of immigrants from Asian countries to several parts of Europe is causing an imbalance in the socio-economic structure of the continent. Thus, there may be a rise in the unemployment of local labor due to the availability of cheap labor from other countries. Therefore, the above situation might cause a positive from the business point of view while it might cause trouble for the local citizen of the country.
How to Manage Political Risk?
One of the primary solutions to deal with political risk is to take political-risk insurance, which could help to compensate for the business loss if it happens in the course of any political dilemma.
- Another school of thought suggests that one should ensure the key personnel of businesses, too, along with the business itself.
- The business should have the clause which should be flexible enough to combat the up-coming political risks.
- There should be plan B ready for the business, which could compensate the investor’s pocket if the primary plan fails.
- The company has to manage the cash cycle or rather the working capital cycle very carefully because, in case of any trouble to the business, the Management has to drag the business out of the turmoil situation.
- Thus, a business is suggested to hold cash for better business prospects.
Measurement of Political Risks
The changes witnessed by the business due to change in the political scenario depicts the actual terms of growth in real terms. Every Management of the business has its budget figures and estimates of its cash flow scenario.
Thus, the amount of deviation the business experienced should be recorded as the change in profitability due to aforesaid political risks. One can measure such risk by comparing the actual with the forecasted amount.
Political Risk Insurance
Several multinational companies offer political risk insurance, depending upon the current political situation of the country. The risks include treats like poverty, terrorism, drastic change in the economy, etc. The premium of the insurance depends upon the present scenario of the nation, followed by the socio-economic method of the country.
However, in many cases, the company does not guarantee the compensation described above in the loss. In these cases, the terms and conditions needed to match.
In many cases, multinational companies tend to avoid any kind of political nuisance. In several instances, the business houses get unique benefits from the government of the country, while the reason being that the existing government wants to motivate corporates to improve the situation of the country by creating jobs for the youth and by eradicating poverty and jobless.
This has been a guide to Political Risk and its definition. Here we discuss the top 2 types of Political risks, how to identify and manage this, along with examples. You may also have a look at the following articles –