How Political Risks Arise in International Business

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Table of Contents

Introduction
How Political Risks arise
Mitigating Political Risks for International Businesses
Conclusion
References

Introduction

Organisations that are involved in international businesses encounter myriads of risks in their process of exploiting global markets.

While establishing businesses in new markets, especially the emerging ones, the challenge of rejection of organisational cultures and policies, economic, and political risk emerges as a significant threat.

In 1959, the government of Fidel Castro took control of Cuba. During its tenure, assets worth millions of US dollars together with several US-owned companies were expropriated (Clark 1997).

While this situation led to immense losses, most of the organisations did not have strategies in place for recovering any of the lost money.

Learning from the Cuban political risks, the affected organisations began to develop strategies for mitigating losses that accrued from political risks while engaging in international businesses elsewhere.

Successful penetration and maintenance of international business depends on the capacity to mitigate the existing and the likely risks, particularly political risks.

A company that seeks to expand its sales potential, and hence its dominance in the international markets as a measure of gaining competitive advantage, must mainly focus on establishing new business operations in the emerging markets. Such markets have most of their potential unexploited by competitors (Rogman 2004).

While this move encompasses a major strategic decision to enhance both the short-term and long-term success for an international organisation, political risks form a major drawback in such markets (Rogman 2004).

For instance, planning to operate in the Middle Eastern nations requires assessment in addition to deriving strategies of dealing with risks resulting from political conflicts such as instabilities in Afghanistan, Iran, Iraq, the Israeli-Palestine conflict, and the Syrian conflict among others.

This paper discusses how political risks can arise for international businesses. It critically evaluates different mechanisms for mitigating such risks.

How Political Risks arise

Political risks include the threats that nations in which organisations establish international operations make some decisions, which negatively reduce or severely influence its goals and/or profits.

The risks may range from destruction of the business of an organisation due to revolution and wars because of policies that hinder capital movement and other laws that negatively influence multinational organisations financially.

Ilan, Mitchell, Gurumoorthy, and Steen (2006) classify political risks into macro and micro risks. Macro risks, such as insurrection and expropriation, affect every firm that operates within a nation.

Conversely, Anderson (2009, p. 2) observes that micro risks entail, ‘adverse actions that only affect a certain industrial sector or business such as corruption and prejudicial actions against companies from foreign countries’.

Irrespective of the type of risk, political risks lead to immense financial losses for multinational organisations.

The classification of political risks into micro-level and macro-level risk factors implies that these risk factors give rise to international business risks. Micro-level risks influence a multinational business at project or industry levels.

For instance, in the Middle Eastern nations, while governments favour no tax-policies, the cost of telecommunications may out-power the rental costs of business premises (Rogman 2004).

Hence, organisations that are highly dependent on telecommunications services to conduct their businesses will encounter more telecommunication-associated risks in relation to other organisations that operate in different industries.

Although this policy may affect all organisations that operate in the Middle Eastern markets, industry-specific political risks favour the operations of local businesses in comparison with international businesses.

This observation occurs when local business owners possessing a large amount of political powers engage in nationalisation or expropriation of assets and projects (Hayes & Cummings 2001).

Macro-level political risks influence organisations that operate in all industries within a nation. However, this situation does not imply that the risks arise only at country levels.

Jeffrey (2004) reveals that regional, local, and national political events can have negative impacts on the operations of organisations in different nations within a particular region.

Macro-level political risks arise from ‘governments’ currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations, and government composition changes’ (Ilan, Mitchell, Gurumoorthy & Steen 2006, p.629).

These risks expose multinational organisations to direct foreign nations’ investments and portfolio investment risks. They reduce the sustainability and attractiveness of a given investment destination. Macro-level political risks also influence policy-making processes in foreign nations or their behaviours towards certain nations.

For instance, the rising of insurgencies within nations, which loot assets and property of multinational organisations, compels foreign nations to curtail certain business operations by their organisations within a specific region or nation.

A study conducted by the Economic Intelligence Unit (2006) found an increasing preference rates for foreign investments in emerging markets.

79-percent of the surveyed people informed that their organisations had increased financial resources that were invested in new markets over a period of three years (Economic Intelligence Unit, 2006, p.3). In the emerging markets, political institutions are weak and subject to control by the unrepresentative elite.

This leads to a subverted process for regulations and laws that make the process together with their applications.

Hence, investors encounter unpredictable and dynamic business environment. Economic Intelligence Unit (2006) reflects the significance of political risk.

96-percent of the respondents maintained that political risks in the emerging markets were incredibly important while making decisions on the location and amount of financial commitment in market investments.

For multinational organisations, political factors are important in the analysis of marketing environments before investing in a new market since they help reveal the degree of political risk in the financial performance.

For instance, the Middle Eastern markets have political volatilities that result from conflicts such as the Israel-Palestine conflict, Syrian conflict, and the instabilities in Iraq and Iran among other regions (Rogman 2004).

It is important to note that different nations play active and passive roles in the resolution of the conflicts.

Where the general public or even a given target market segment opposes the roles played by a given nation in the political conflicts within its nation, probabilities for a negative reception of multinational organisations that are established within negatively-received nations will be higher.

Such challenges may include boycotts for purchasing products and services offered in the market place by international investors.

Political instability, high corruption prevalence, and unstable institutions to control and punish organised crimes such as looting organisational financial resources amplify the risks encountered by multinational organisations.

Although all nations experience incidents of corruption, Economic Intelligence Unit (2006) reveals how corruption is common in the emerging markets.

In fact, it was the second highly important factor that worried many multinational organisations that sought to invest in foreign nations after political stability (Economic Intelligence Unit 2006). Political environments also influence legal and regulatory systems.

Their partiality and inefficiency depend on welded political powers within nations.

Thus, economic instabilities that are brought about by massive corruption and bribery and other challenges such as failing to honour contracts that are entered between the state and a multinational organisation have their roots in political systems and interactions of various key political players.

For multinational organisations that seek to establish international operations in the oil industry, political instability, nationalisation, and expropriation constitute the mega issues to put into consideration in political risks management approaches (Anderson 2009).

Expropriation arises when the host nation seizes the development rights of an organisation and/or its facilities for utilisation by the host nation through national interest guises (Anderson 2009).

Nationalisation takes place whenever a nation takes up development rights and/or facilities that belong to multinational organisations in an attempt to hand them over to a particular host nation’s company.

Even though these two forms of political risks may arise within a short-term, some nations deploy strategies for regulating the operation of foreign corporations through strategies that amount to nationalisation and expropriation in the long-term.

Greco and Meredith (2007, p. 30) support this assertion by asserting, ‘creeping expropriation can come in the form of increased regulations, confiscatory taxes, limits on the repatriation of currency, changes in exchange rates, and forced re-negotiation’.

These strategies also comprise mechanisms through which political risks in the international business arise.

The case of Venezuela perhaps explains well how political risks in international business arise. In 2007, the nation issued a decree (no. 5.200), which demanded all companies, which operate in Orinoco Belt to accept entering new contracts with Venezuela National Company (Anderson 2009).

Failure to comply with the directive amounted to expropriation. Exxon Mobil and Conoco Philips were the immediate victims. In 2006, Ecuador forced multinational oil operators to embrace subcontracting treaties in a bid to ensure cancellation of joint ventures (Zaldumbide 2007).

For this reason together with some other regulations and laws on taxation, Occidental Petroleum Company’s interests were expropriated. Anderson (2009) reveals the possibilities of increasing levies together with various payments made on oil and its related products in Ecuador and Angola among other nations.

Whether an organisation operates in the oil industry in a foreign nation or any other industry, developing strategies for mitigating political risks for international business is one of the most important strategic initiatives.

Mitigating Political Risks for International Businesses

Many firms are resulting in globalisation as a strategic initiative for gaining competitive advantage. In a bid to mitigate various political risks successfully, both in the short-term and long-term, market entry mode in foreign markets may produce imperative implications on survival in the international markets (Hague & Jackson, 2006).

Therefore, the decisions on survival mechanisms in the foreign nations depend on the prevailing political situations in a host country. They constitute one of the mega decisions a firm has to make before channelling its resources to establish business operations.

Different entry mode options in the international markets are available for multinationals. Typical examples include licensing, joint ventures, exporting, and franchising. Different entry modes possess different merits and demerits.

Hough and Neuland (2000) conducted an analysis of various market entry modes. The authors state that exporting is the easiest mode of selling the firm’s products in foreign markets (Hough & Neuland (2000, p.13).

It permits an organisation to indirectly or directly export. In case of express overseas sales, an appointed partner sells services together with commodities of an international company that is established in a foreign nation.

Direct exporting involves a firm selling its products directly to the importer or a buyer in a foreign market (Hough & Neuland 2000).

Licensing involves entering treaties that involve the substitution of privileges of insubstantial organisational assets for a particular duration that is agreed upon at the time of making the treaties. The proprietor reciprocates the licensor with disbursement benefits.

Franchising involves entering long relationships in comparison with licensing (Ross 2003). In the relationship between the franchisor and franchisee, the franchisor sells critical property, for instance, a trademark to the franchisee (Ilan & McKee 1999).

The franchisor also acquires the franchisee’s contractual responsibility to abide by all rules on its business regulations.

Joint ventures constitute business collaboration between two companies that are based in two or more countries that share ownership of an enterprise that is established jointly for the production and/or distribution of goods and services.

Elements such as opinionated jeopardy, difficulties in successful business operations between nations, and collective threats determine the relativity of the appropriateness of the preferred methods of accessing new markets.

Thus, firms that seek to establish themselves globally need to consider economics and other dynamics of the destination nations (Beamish, Morrison & Rosenzweig 2005). In particular, it is desirable for globalising companies to have plausible information about taxation, labour, and regulation on various royalties that are payable to the government of the host nation.

Hibbert (2005) supports this claim by adding that leaders of firms need to know that the attractiveness of foreign market opportunities is different for different business industries and among individual companies.

Organisations that wish to establish operations in international businesses need to do a number of things.

Hibbert (2005) reveals that these things include the evaluation of international markets business opportunities, conduct analysis of the extent to which a firm may be able to establish potential opportunities for growth in foreign nations, make a decision on the appropriate market strategy, innovate marketing strategies, and then conduct standardisation of various global operations.

While standardising the best mode of operation in a foreign nation, it is plausible for an organisation to reduce the amount of direct investments in assets in nations that have unstable political regimes and/or where trade regulations fail to favour foreign corporations.

Thus, instead of establishing business operations that are under direct management and control of a multinational company, franchising, licensing, and exporting are attractive entry modes in foreign markets that have high political instabilities.

This strategy can perhaps help reduce the risks of nationalisation and expropriation.

Political situations in different market regions foster growth of a specific corporate culture, which may help in building legacy for local or multinational organisations that are established within a given nation or region.

For instance, Rogman (2004) maintains that the lack of significant legacy challenge ensures that local multinational organisations in the Middle East have the advantage of low costs of labour and taxes, few challenges in acquiring favourable transport, and energy for the energy intensive organisations (Rogman 2004).

Therefore, foreign multinational organisations that wish to establish business operations in the region must be prepared to face intense competition from the Middle East multinational corporations such as Qatar Airways and Fly Emirates in the case of the airline industry.

This suggests a possible way of entering these markets without experiencing massive political risks through strategic partnerships with these organisations since they also have legacy advantages compared with foreign multinationals.

The best strategic partnership is the one that does not call for an international organisation to invest in physical assets to minimise losses in the event the business of the organisation comes to a standstill due to political instabilities and expropriation.

Engaging in any international business requires an organisation to invest based on the calculated risks. Multinational businesses that want to exploit new markets should conduct reviews for various ratings of different risk factors (Clark 1997).

More informed investment decisions need support from empirical data (Hamilton & Webster 2012). Hence, multinationals need to collect data, specifically for their own risk assessments.

Just like in the case of Erbil in Iraq, such analysis may reveal that even though operating in high politically unstable environment is inappropriate, such challenges may provide opportunities for success.

The opportunities may also have possibilities of lasting for long while creating the necessity for the adoption of alternative political risk mitigation strategies such as insurance (Hayes & Cummings 2001).

Insurance policies are established depending on the emerging market needs so that organisations can derive well-informed decisions depending on the most probable risks to encounter in foreign market operations.

Private insurers together with governments develop different policies that cover a range of risks including political risks such as nationalisation and expropriation threats (Greco & Meredith 2007).

Examples of organisations that offer these types of insurance coverage include, ‘the US Overseas Private Investment Corporation, the Canadian Export Development Canada, and the UK’s Export Credits Guarantee Department’ (Comeaux & Kinsella 2000, p.214).

Some multilateral organisations also insure companies that engage in international businesses against political risks such as MIGA (Multilateral Investment Guarantee Agency) (Jeffrey 2004). Such organisations operate through World Bank’s sponsorships.

Corporations that wish to mitigate their political risks through MIGA must be considering investing outside their home nations. The guarantees are only available to organisations, which have subscribed to its (MIGA) membership (Comeaux & Kinsella 2000).

MIGA helps in mitigation of risks like confiscation and nationalisation. It is particularly important while developing risks resilience against expropriation. However, Jensen (2005, p. 15) states, ‘In case of creeping expropriation or partial confiscation, coverage may be limited’.

MIGA helps organisations engaging in international business mitigate risks of currency inconvertibility and breaching contracts. Purchasing any political risk insurance is not an outright guarantee for compensation immediately the risk occurs. Some time is required in processing the claims.

This observation suggests that organisations that rely on insurance must also adopt other risk mitigation strategies at least in the short-term for them to continue doing business normally in other areas.

Conclusion

International businesses expose organisations to various risks such as economic, social, cultural, and political risks. Their success in the host nations depends on how they manage different risks. Political risks are somewhat the most dangerous risks that any organisation can encounter.

Wars, expropriation, and nationalisation can lead to total loss of an organisation’s rights and assets. Mitigating these risks can be accomplished in different ways depending on the nature of the risks.

The paper has discussed the development and evaluation of appropriate entry modes for new markets and insurance against political risks such as expropriation and nationalisation as some of the possible ways.

A possible way to avoid risks completely entails making a decision not to establish business operations in foreign nations that have high political risks. However, such markets can be so attractive so that they are worth the risks. In such a situation, the best approach to mitigating political risks is through insurance.

References

Anderson, S. 2009, Appropriation, Nationalisation and Risks Management, Davis Graham Stubbs, LLP, Dubai.

Beamish, W., Morrison, A. & Rosenzweig, M. 2005, International Management: Text and Cases, Irwin, Chicago.

Clark, E. 1997, ‘Valuing political risk’, Journal of International Money, and Finance, vol. 16 no. 3, pp. 448-484.

Comeaux, P. & Kinsella, N. 2000, ‘Reducing Political Risk in Developing Countries: Bilateral Investment Treaties, Stabilisation Clauses and MIGA and OPIC Investment Insurance’, NYL School Journal, vol.15 no.1, pp. 213-221.

Economic Intelligence Unit 2006, Operating Risks in Emerging Markets. Web.

Greco, S. & Meredith, I. 2007, ‘Getting to Yes Abroad: Arbitration as a Tool in Effective Commercial and Political Risk Management’, Business Law Today, vol. 2 no.1, pp. 23-36.

Hague, P. & Jackson, P. 2006, A guide to planning, methodology and evaluation: Market Research, Kogan Page, London.

Hamilton L. & Webster P. 2012, The International Business Environment, Oxford University Press, Oxford.

Hayes, E. & Cummings, A. 2001, ‘Political Risk and Insurance: Taming the Risks of Project Finance’, International Financial Law Review, vol. 20, no. 3, pp. 17-31.

Hibbert, P. 2005, International Business Strategy and Operations, Macmillan Press, London.

Hough, J. & Neuland, W. 2000, Global Business Environments and Strategies: Managing for Global Competitive Advantage, Oxford, Cape Town.

Ilan, A. & McKee, D. 1999, ‘Towards a Macro-environmental Model of International Franchising’, Multinational Business Review, vol. 7 no.1, pp. 76-82.

Ilan, A., Mitchell, M., Gurumoorthy, R. & Steen, T. 2006, ‘Managing Micro-Political Risk: A Cross-Sectional Study’, Thunderbird International Business Review, vol. 48 no. 5, pp. 623-642.

Jeffrey, S. 2004, ‘A Theoretical Perspective on Political Risk’, Journal of International Business Studies, vol. 15 no. 3, pp.123-143.

Jensen, N. 2005, Measuring Risk: Political Risk Insurance Premiums and Domestic Political Institutions, Washington University, Washington, DC.

Rogman, T. 2004, Entry Strategies for Middle Eastern Markets, The World Financial Review. Web.

Ross, B. 2003, ‘Market entry methods for western firms in China, Asia Pacific’, Journal of Marketing and Logistics, vol.15 no. 4, pp. 3-18.

Zaldumbide J., 2007, Nationalisation of the Hydrocarbon Industry in Ecuador, Special Institute: International Mining and Oil & Gas Law, Development, and Investment, Rocky Mineral Law Foundation, Colorado.

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