Political Risk Analysis is the child of two parents: political economy and area studies. Both academic fields are, per se, interdisciplinary and multifold in their approaches to studying the interrelations between political, economic, social and cultural developments in specific countries and regions, and are therefore a perfect match. As outlined in the first part of this article, Political Risk and Political Due Diligence, the added value of political risk analysis consists of helping clients from the private or public sector who get engaged in foreign countries. The problem to be solved usually derives from uncertainty regarding the political forces in a target country, who might pose a threat to the success of a business investment or a political strategy, depending on whether the client is a corporation, social organization or government.
Wishful thinking, process risks, and not so rare events
Risk denotes the likelihood of loss or failure in a project that is, in the first place, initiated out of original confidence in gaining a rewarding benefit or substantial success. Therefore, risk analysis ultimately serves the purpose of strategic risk management by identifying those factors that might increase the probability and impact of unwanted events, which would severely reduce the expected value of the undertaking. Given that, risk management is nothing more than the strategy of seeking to decrease either the probability, or the impact of a threat to one’s goals, and ideally it refers to both (1).
Because there is a common bias in the intuitive exploration of risk involved in a project, a more systematic approach to dealing with risk is necessary. This bias typically leads to overconfidence in the aimed success, as well as to an underestimation of a possible failure. Why is that so? The calculation of success refers to the outcome of the project. It is usually assigned a high value – otherwise one would not consider it. And since the outcome of success is easy to imagine, there might also be an inclination to a high subjective probability. An overly optimistic expected value of success will be the result, actually resembling wishful thinking regarding the positive outcome of the project.
In contrast, the risk attached to the process required to realize the outcome are often underestimated. Process risks are often incremental and more difficult to imagine, which means that they are not evaluated properly, seen as rather unlikely, or even largely ignored. Compared to the outcome which is represented as a defined state in the future, the process stretches not only over the period of planning and realization of a project, but may reach far beyond that, including the following operational phase of implementation. As a consequence of the asymmetric representation of outcome chances and process risks, the total expected value of a project can get easily biased towards the former, generating a risk-taking attitude founded on incomplete and erroneous information. A healthy dose of pessimism and due diligence, regarding what the famous strategist Clausewitz called the “frictions”, definitely helps. Frictions specifically concern those single process risks that halt progress and build up over time, posing a real threat to the successful outcome.
Political risks, as defined in the first part of this article, are such process risks, almost by nature. They are often ignored because they seem to be unknown, tend to be underestimated, and are not taken seriously. In addition, political risks are usually dynamic event risks that are not easily quantifiable, and therefore difficult to calculate – unless one uses a strategic approach applying game theory for instance. Rational game theory, generally suited to forecast the possible actions of partners or opponents is fallible too, if it ignores the cognitive and social-psychological factors influencing and changing preferences.
In all, the political risk analyst, even more than his colleagues in the legal or financial risk services, faces the challenge of raising risk awareness and inducing the appropriate risk perception. Extremely helpful in that regard is the metaphor of the “black swan” popularized in a book by Nassim Nicholas Taleb, who explored the “impact of the highly improbable” (2). In fact, the late Benoit Mandelbrot, one of the outstanding mathematicians of our times, and also father of the fractal geometry, managed to prove earlier that extreme events, different from the normal probability distribution, are not so rare at all (3). The curves of the probability functions for events in certain areas show literally “fat tails”. A rich source for confirming examples is the financial market, as one can witness in view of the frequent crises over the course of the last 15 years, alone. At the time of writing, the severe nuclear accident in Japan stands for a sad case of unpreparedness for the impact of natural disasters on an unexpected scale. In the political area, for example, the 9/11 terrorist attacks in the United States, but also the current revolutions in the MENA region remind us that we should pay more attention to indications for hidden processes of unfolding political forces and dynamics. The concept of “fat tails” is definitely useful to promote the cause of political risk analysis (4).
Political risk assessment and risk analysis
Even though political risk science and its application is decades old and by now quite sophisticated, is has not yet evolved into a well defined academic discipline. The literature is dispersed and only a small number of articles give a detailed historical account of the field (5). Within the context outlined above, the question to follow is, which approaches the political risk professional can pursue in order to assist his client in uncovering process risk. Based on the academic training as a political scientist or economist with a profound knowledge of a country or region, these approaches may also offer careers options according to methodological specialization.
Political risk assessment
As a starting point, it is necessary to differentiate between political risk assessment and political risk analysis. Quantitative political risk assessment is concerned with the macro perspective looking at the general attributes and variables of the political environment in a target country. This is the domain of ratings and rankings, using indicators and scores in order to build indices. The aggregation of data, generating an overall score for each country, allows for sorting those countries assessed within intervals of scores and assigning a uniquely graded risk level to them. Most commercial political risk outfits offer such indices, especially designed to account for domestic and international risk factors and thereby providing basic information about the underlying trends in the political environment for doing business in a country.
Examples comprise the classical offerings of Political Risk Services, the Economist Intelligence Unit, Eurasia, or Maplecroft. Other rating and ranking sites which can be used for political risk assessment are publicly available, such as the Worldwide Governance Indicators, which also incorporate specific indices, such as Transparency International’s Corruption Perception Index. The program Country Indicators for Foreign Policy, directed by the Carleton University, Canada, is to be recommended for its methodology as well as outstanding risk assessments.
What are the benefits and limits of indices? The benefits clearly come with the systematic and coherent assessment of data, which allows for comparative and longitudinal studies of country samples. If an index is updated frequently, say on a monthly basis, changing values for single variables can also issue clear warning signals indicating future political risk events. Regarding the likelihood of large-scale social unrest in a country, for example, one would watch the variables concerning socio-economic disparities, most notably the youth unemployment rate, the severity of oppression by the regime, the loss of legitimacy of a corrupt government, combined with discrete events, such as the recent history of local protest and sudden increases of the cost of living.
The limits of quantitative risk assessment stem from faulty variables or missing data, from single-minded focus on one index, or from excessive ‘number-crunching’. As it is good research practice to appraise various sources, one should also evaluate multiple indices of different origin, in order to discern the potential for critical political developments. The combined assessment of long-term structural conditions and currently occurring discrete events will, however, hardly capture the dynamics of political power relations.
Political risk analysis
At this point, political risk analysis comes into play. The most important feature of political risk analysis is the micro perspective pursuing a qualitative approach towards exploring the interactions between powerful individuals and groups in a target country. Note that real people are completely missing in the picture provided by quantitative risk assessment. In contrast, for specifying the process risks facing a project it is critical to know: who are the relevant actors in a concrete political context, what are their hidden motivations, possible interests and real intentions, what are their resources and how are they connected to each other? Furthermore, who are foes or friends and who will gain or loose influence during the political proceedings? Ultimately, who can foster and who can disrupt the process of realizing a foreign business investment or a political initiative? Political risks do have human faces, and they can be quite ugly.
According to the micro perspective, political risk analysis is context based, and customized to the needs of different sectors, industries and projects. It goes without saying, that the exposition to political interference is not the same for every enterprise. At the same time, political risks may unfold on levels lower than the central government, which underlines the importance of identifying powerful regional and local players too. Therefore, political risk analysis should not be confused with providing some basic information about the political system of a foreign country, as such. This is by far too general, compared with the required understanding of the unique decision-making affecting a project. This particularly includes the informal relationships between business executives and political officials and well-connected agents who are pulling the strings behind the scene.
Analyzing to what extent a specific power structure poses political risks for a project in foreign country, demands a lot of effort. However, systematic methods are available in order to assist the investigation. Apart from organizational analysis, social network analysis and individual profiling, a really intriguing tool is median actor analysis which, within certain constraints, is even suited to predict the bargaining process over controversial issues and the ultimate outcome (6).
The main benefit of this diligent approach to political risk analysis certainly lies in taking account of all domestic stakeholders who retain an interest with respect to a foreign investment or project. It also reminds the client that the strategy of mitigating political risk by building good personal relations to individual government and administration officials is limited by ignoring other actors, such as oppositional forces or social entrepreneurs, who could become more influential in the future. Ignoring stakeholders also means ignoring political issues that might evolve into sources of serious trouble.
Political risk and dispute prevention
Strictly speaking, all political risks involve conflict risks between the client and the political forces interfering with his business or project. Therefore, the strategic role of the Political Risk Analyst really consists of dispute prevention. It is always very costly and detrimental to the reputation of a corporation in particular, if it gets caught in political risk events entailing disputes with governmental or non-governmental actors in a host country. Avoiding such entanglement can build on the sound judgment of a political risk analyst, who needs to identify the potentially relevant issues and evaluate the scenarios under which they will take a cooperative or a confrontational course. Political risk analysis might, after all, benefit more from conflict research than has been recognized so far.
1. In the following paragraphs the author draws from his own risk research – particularly conflict risk studies – as well as from advisory practice.
2. Nassim Nicholas Taleb (2007): The Black Swan. The Impact of the Highly Improbable (Random House).
3. Benoit B. Mandelbrot (2004): The (Mis)Behavior of Markets – A Fractal View of Risk, Ruin and Reward (Basic Books).
4. Ian Bremmer/Preston Keat (2009): The Fat Tail. The Power of Political Knowledge for Strategic Investing (Oxford University Press).
5. For recent overviews see Yadong Luo (2009): Political Risk and Country Risk in International Business. Concepts and Measures, The Oxford Handbook of International Business, 2nd. ed. by Alan M Rugman (Oxford University Press), 740-764. Darryl S.L. Jarvis and Martin Griffiths (2007): Learning to Fly: The Evolution of Political Risk Analysis, Global Society, 21, 1, 5-21. Still instructive is José de la Torre/David H. Neckar (1988): Forecasting political risks for international operations, International Journal of Forecasting, 4, 221-241.
6. For applications see William D. Coplin and Michael O’Leary (1972): Everyman’s Prince: A Guide to Understanding Your Political Problems (Duxbury Press). Bruce Bueno de Mesquita (2002): Predicting Politics (Ohio State University Press).