Political Risk

Updated on April 11, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Political Risk?

Political risk indicates the commencement of risk that arises due to changes 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.

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Specific terms like corruption, terrorism, etc., related to the politics of a country may arise due to changes in a political scenario, which further might result in a change in the nation’s regulations. Political risks can also be termed geopolitical risks that arise due to conflict between two countries. There can be hindrances across the businesses and finally slash the confidence level of the investors.

Key Takeaways

  • Political risk arises from changes in a country’s governing body and can pose a danger to investors with assets in financial instruments such as debt funds, mutual funds, equities, etc.
  • Changes in the political environment, such as corruption, terrorism, or shifts in legislation, can lead to specific risks related to a country’s politics, exacerbating political risk.
  • Political risks, often referred to as geopolitical risks, can emerge from conflicts between nations, creating obstacles for companies and reducing investor trust.

Political Risk Explained

Political risk in business is the situation in which the business and its operations suffer due to political problems within the country. The problems may arise due to frequent changes in the ruling party of the country, political instability, implementation of military control due to any political crisis, etc.

Such risks can create a huge impact in the economic system of the country, leading to problems in the organizations working there. The impact of political risk in business may be for a long term which is enough to bring about a great impact. It is often very hard to identify or quantify them due to limited number of such cases. They often drag the entire economy down which is enough to make entities and individuals lose all their return on the investments.

In many cases, multinational companies tend to avoid any political nuisance. In several instances, the business houses get unique benefits from the government of the country. The reason is that the existing government wants to motivate corporations to improve the country’s situation by creating jobs for the youth and eradicating poverty and joblessness.

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Types

Political uncertainty arises from the marketplace 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.  Certain legal aspects also may challenge the way of doing business, lower profitability, and enhance risks for the investors.

This risk may arise at any level, such as the national, federal, state, etc. Thus, based on the scenarios, political risk analysis can be divided into two types such as macro risks and micro risks.

  • The macro risk is related to the multinational companies which have businesses in the country and the adverse effects faced by those companies.
  • Micro risks arise from internal conflicts such as corruption, poverty, cynical manipulations, etc.
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How To Identify?

There are no concrete measures where one could identify such risks. However, the point given below can through some light on the various aspects that can be used to identify such risks. Let us try to understand them.

  • To be specific, one has to be very keen on the existing political scenario of the country and look for a 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 country’s regulations, while the stance the existing government takes is hard to predict. Specific regulations, like enhancing individual or corporate tax, might lead to inflation or stagflation. Thus, to understand the political risk analysis, one has to apply qualitative techniques.
  • Certain risks related to the macro-level may arise during the civil war between two countries, resulting in those countries closing down borders. Thus, a war situation can affect business scenarios and investments.
  • As per the micro scenarios are concerned, strict regulations, along with changes in the legal systems, might change the profitability of the companies. At the same time, incentives offered to the weak sectors may result in boosting the particular industry. The above action might create competition among investors.

Examples

Here are a few examples that will help us to understand the concept of political risk management better. Let us go through them.

Example #1

Since Donald Trump came into power in the U.S. in 2015, there have been several changes in 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, the governing body of the pharmaceutical sector. Thus, this kind of change in the scenario results in macro risks for the investors.

Example #2

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 be positive from the business point of view while it might cause trouble for the local citizens of the country.

How To Manage?

Below are some ideas the business should implement to manage the risk efficiently. Let us identify them.

  • One of the primary solutions to deal with political risk is to take political-risk insurance, which could help compensate for the business loss if it happens during 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 a clause that should be flexible enough to combat the upcoming 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 leading to better political risk management.

How To Measure?

It is essential to keep track of any changes in the political scenario to identify risks that may threaten the business organization. Thus, a political risk assessment is required so that the company can measure the extent of the problem it may face and devise strategies to manage and absorb the same.

The changes witnessed by the business due to change in the political scenario depicts the actual terms of growth in real terms. Every business management has 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. Therefore proper and detailed political risk assessment helps a lot in such situations.

Political Risk Insurance

Several multinational companies offer political risk insurance, depending upon the current political situation of the country. The risks include poverty, terrorism, drastic economic change, 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.

Frequently Asked Questions (FAQs)

1. What are the causes of political risk?

The causes of political risk can vary widely and are often specific to a particular country’s political and economic conditions. Some common causes include political instability, changes in government leadership, social unrest, civil conflicts, policy changes, regulatory uncertainty, corruption, and nationalization of assets. These factors can create an unpredictable and unfavorable business environment, posing risks to investments and operations of domestic and foreign entities.

2. What is political risk vs. country risk?

Political risk refers specifically to the risks arising from political factors, such as government actions, policy changes, or social instability, that can impact businesses and investments. Country risk, on the other hand, is a broader term that encompasses political risk as well as economic risks, legal risks, and other factors affecting the overall business environment in a particular country.

3. How does political risk affect FDI?

Political risk can significantly affect foreign direct investment (FDI). Potential foreign investors may hesitate to commit capital to a country when political risk is high. Uncertainty regarding political stability, government policies, and legal frameworks can deter foreign investors and lead to declining FDI inflows. Political risk can also impact existing foreign investments by increasing operational costs, disrupting supply chains, or even resulting in the loss of assets due to government actions. 

This has been a guide to what is Political Risk. We explain its insurance along with example, types, how to manage, how to measure & identify it. You may also have a look at the following articles –

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