Political Risk and Political Due Diligence (I)

The dramatic and still undecided processes of regime change in the Arab world highlight the fundamental relevance of political risk for doing business in countries that were wrongfully regarded as stable, until the outbreak of civil unrest. Even though political violence in host countries is the most vivid case of political risk, there are other categories, such as regulatory change, that actually preoccupy the political risk perception of investors. In general, political risk analysis represents a research profession that investigates the potential sources and factors of non-commercial disruptions of foreign investments. This article, which is divided into two parts, outlines the methodological and intellectual requirements of political risk analysis. The first part argues that enhanced political risk analysis should adopt the concept of political due diligence. The second part, entitled The Political Risk Analyst, to be published shortly, will consider what makes a good political risk analyst, and detail the modules for professional training.*

Political due diligence

The job of a political risk analyst is to serve the client – usually business corporations, but also governments, international or non-governmental organizations – with country and regional expertise at the intersection of political science, economics and international law. The challenge consists in providing useful insights into future developments of the political environment concerned, which are as plausible and accurate as possible. That is the major difference to conventional political analysis which tries to make sense of past events. The political risk analyst, in contrast, is not confined to hindsight, but also strives to engage in foresight, given a particular research mandate.

The author recalls a conversation he once had with an economist about the topic of political risks. In his eyes, special political risk research was redundant. We don’t need that, he said, we read all about politics in the newspaper ourselves. What he did not understand was, that if you read about political risks in the newspaper, it is usually too late to avert or manage the impact. Therefore, political risk analysis is concerned with the early warning of shifting domestic or international forces ruling the business environment of a specific country or region.

While it is good practice for corporations doing business abroad to engage in the assessment and management of market, financial  and legal risks, enhanced due diligence also includes the integrity of prospective business partners in the host country.  Conducting integrity due diligence is not only a matter of compliance with corporate governance rules and laws but also a strategic matter of protecting an investor’s reputation and of avoiding the costs of failure. Nobody wants to collaborate with a business partner or middleman who is corrupt or unreliable or serves the interests of hidden parties. The integrity check should not stop with the business partner, however, but should also cover the personal relationships between business and politics. These connections can take a very unfavorable turn against foreign investments.

This is why political due diligence is the high art of political risk analysis. In every country, without exception, the nexus between business and politics exists. It varies in structure and thickness, depending on the political and economic system, and it usually affects the various industries in a different way. The connections can go in both directions, meaning either the closeness of business partners or competitors to state officials; or, in the opposite direction, state authorities control the leadership of certain enterprises, formally through ownership, or informally through clientelism and patronage ties.

The ‘thickness’ of the business-politics-nexus is related to the autocratic or democratic system of the host country. Some democratic countries, in particular those with a history of the interventionist state, also display that phenomenon. But the really serious cases can be identified in state capitalist systems operating in Asia and populist systems in Latin America. Of course there are common occurrences of corruption and privileges, even in Europe. Particularly unpleasant types are autocratic regimes ruled by the military or the police who use the opportunity to make some extra money by entertaining their own businesses. On the other hand, the so-called oligarchs, originally business people capturing the state, also stand as examples of a particularly thick nexus between politics and business.

That does not mean that business in non-democratic countries is unfeasible. In many countries the nexus resembles a grey area and is quite sector-specific.  Moreover, foreign investment decisions not only depend on the political risk awareness, but also on the risk appetite and the risk management process set up to actually deal with political challenges. Political due diligence, as part of a strategic risk management process, investigates the personal connections and networks in the political environment of foreign investments, because they are a major source for regulatory risk. It thereby helps to fill a notable gap in the risk mitigation field. Contractual tools, such as  bilateral investment treaties and political risk insurance, can only offer limited protection against arbitrary and discriminatory government intervention and regulation.

Perception and mitigation of political risk

The argument for political due diligence as the ultimate tool to cope with political risk is supported by two outstanding reports about World Investment and Political Risk issued by the Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group. According to its mission statement, the MIGA aims to ‘promote foreign direct investment (FDI) into developing countries’, and to ‘foster a better understanding of investor perceptions of political risk as they relate to FDI, as well as the role of the political risk insurance (PRI) industry in mitigating these risks’. The first report World Investment and Political Risk 2009 was published in 2010 (WIPR 2009), the second report focusing on investment and political risk in conflict-affected and fragile economies in early 2011 (WIPR 2010). Both reports present the results of global surveys conducted with corporations, exploring the role of political risk in foreign investment decisions.

Generally defined, political risk denotes the ‘probability of disruption of the operations of multinational enterprises by political forces or events, whether they occur in host countries, home country, or result from changes in the international environment’ (WIPR 2009, 28; WIPR 2010, 19). According to this broader understanding, political risk  does not only stem from the possible actions of governments and political institutions, or social groups in the host country, but also from actions in the home country affecting investments, by imposing sanctions on the host country, for example. With respect to the international environment, multilateral regimes, such as the  Convention on the Settlement of Investment Disputes between States and Nationals of Other States or geopolitical crises influencing international commercial relations are important, too. The multiple facets of globalization have increased the variety and the impact of ‘international political risk’, a dimension which will be covered in part two of the article.

The political risk insurance industry uses a narrower definition focusing on concrete actions in the host country. In practice that means, political risk insurance protects foreign direct investments against losses due to expropriation, currency inconvertibility and transfer restrictions, political violence (war, terrorism, civil disturbance), breach of contract, and non-honoring of sovereign financial obligations. The political risk insurance market consists of public and private insurers, who are organized in the Berne Union. Even though political risk insurance can provide contractual  investment guarantees, it should be noted, that changes in host countries’ laws and regulations are usually not covered, a gap that leaves investors vulnerable to political forces.

The global survey of investors conducted by the MIGA produced remarkable results with respect to that protection gap. First, political risk is perceived as the top restraint for FDI. Next, the major concern among investors is not so much political violence or outright expropriation, but breach of contract and adverse regulatory change (also responsible for the majority of losses). The perceived preeminence of regulatory risks in a host country can serve as an explanation for the fact that only a small minority of investors use political risk insurance as a mitigation tool, at all. The vast majority of investors rely on the risk mitigation strategy of engaging with the host government or setting up joint ventures with local partners.

Approach and method

Even though the establishment of connections to the government or local authorities in a host country seems to be indispensible, it often involves walking a fine line. The possible exposure to dubious characters and the volatility and unpredictability of engagements with local partners and officials bears new relationship risk for the investor that requires enhanced political risk analysis.

For that purpose, political due diligence includes a method, that unveils the key players with respect to an investment project, and identifies their individual power resources, evaluates their respective pro or contra positions on the issue at stake and determines the specific salience for each actor, i.e. how much he really cares about the matter. Based on the diligent collection of stakeholder information, the investor can monitor and influence the decision-making process and calculate the likely result.

Political due diligence procedures do not replace traditional political risk analysis, based on quantitative indices or general research on the evolving politics, economics and culture of a country, its regional neighborhood and geopolitical situation. Monitoring the controversial issues is still key, in order to identify sources of serious conflict affecting the investment, in time. Political due diligence is a necessary completion of the analysis providing deep insight into the relevant power structure of a host country and its social networks, that can make or break foreign direct investments.

Given the importance of political risk, the second part of the article will continue to discuss the professional qualification of the political risk analyst.

*The author teaches the analysis of political risk within a Master program of Area Studies at the German University of Rostock.