Inside Political Risks: Political Stability Bias vs. Regime Type Analysis

One major lesson learnt by business investors engaging in foreign countries in the light of regime change events in 2011 is that the conventional concept of political stability may be overvalued. In contrast, it is the actual diversity of regime types which should receive the appropriate appreciation when assessing political risks. The concept of regime types concerns the manifold manifestations of democratic and authoritarian regimes and what they imply for understanding political interferences with foreign-owned businesses.

A perceptional bias

The widespread focus on political stability is understandable, but often represents a problematic cognitive bias. This is the case, whenever  political stability is equated with the longevity of a regime. The tendency to do so may increase with the experience of durable relations with the ruling elites, if they display a rather friendly approach towards international investors. This experience induces the feeling that one is familiar with the power mechanisms in place, that the future is predictable and things will stay as they are.

How misleading the stability bias focusing on persistent personal, usually authoritarian rule can be, became clear with the outbreak of the revolutions in the MENA region. Regime risks emanating from the growing frustrations of a young, urban, educated, civil but jobless population facing longstanding practices of corruption, patronage and oppression by an aging elite were not adequately taken into account. Authoritarian regimes that neglect the basic requirements of legitimacy will be challenged by disenchanted segments of the society, thus resulting in the end of stability. Civil unrest, with potentially violent clashes between protesters and the police or military, sudden regime change or civil war can occur in a matter of weeks, catching foreign governments and investors by surprise (see Regime Change by the People).

The illusion of political stability

Surviving authoritarian regimes usually balance patronage and corruption with clientelism and populism. While the first two are used to secure cohesion within the privileged elites, including the security apparatus, the latter two are used to buy the collective support by major parts of the population. However, the preeminence of clientelism and populism is something which foreign investors must fear as productive sources of political risks, because they stimulate government interventions in their businesses, such as arbitrary regulation, renegotiation of concessions, breach of contracts, or expropriatory measures. The political ambiguity of such surviving authoritarian systems gives another reason to question the concept of political stability.

The notion of political stability for foreign investments, therefore, is at best a temporary illusion driven by the desire for security and order rather than a realistic perception of political risks. The often painful processes of democratization following a regime change do obviously not promise a stable political environment, either. Democratic transitions usually imply an uncertain period of hybrid regimes, fragile or limited democracies, with immature institutions, parties and politicians. And, how reliable and predictable can even full democracies be, anyway. Looking at last year’s governmental crises in several EU member states most affected by huge debt and sovereign default risks left us loosing the faith in the superior quality of democratic stability. The iron ‘law of legitimacy’ is no less applicable to elected politicians who seriously failed to serve the interest of their people.

The relevance of regime types

The Economist Intelligence Unit recently reported that democracy continues to be “under stress” (Democracy Index 2011, also see The Corrosion of Democracy). Out of 167 countries covered, only 25 qualify as democracies; 53 democracies are “flawed”; so-called hybrid regimes number 37; and no less than 52 regimes are identified as being authoritarian. Notably, hybrid and authoritarian regimes together exist in 53,3 per cent of the countries representing 51,6 per cent of the world population. This ratio is even more concerning if hybrid regimes are precisely analyzed by they their essential characteristics. In a new seminal study in the academic field of comparative politics, Steven Levitsky and Lucan Ward proposed the term “competitive authoritarianism” for such regimes. Their definition is as follows:

Competitive authoritarian regimes are civilian regimes in which formal democratic institutions exist and are widely viewed as the primary means of gaining power, but in which incumbents’ abuse of the state places them at a significant advantage visa-à-vis their opponents. Such regimes are competitive in that opposition parties use democratic institutions to contest seriously for power, but they are not democratic because the playing field is heavily skewed in favor of incumbents. Competition is thus real but unfair.
(p. 5)

Qualifying hybrid regimes as essentially manipulative authoritarian, including harassment of the media, detainment of outspoken critics, monopolization of state resources and systematic discrimination of opposition groups, not only fills a gap in academic research on regime types, but also helps to better understand the political risks in countries that are often quite attractive for outside investors.

Regime type and expropriation

Regime types do matter and a thorough differentiation should therefore inform political risk analysis as an integral part of the investment location process. This conclusion is also supported by a study contained in the MIGA report World Investment and Political Risk 2011. Since economic shocks and political shifts often induce changes in public policies, the probability of disputes between governments and foreign investors is increasing. At the same time, the MIGA researchers managed to proved that the type of regime has the most significant influence on whether such disputes are resolved or turned into expropriatory actions.

In democracies, where there are real checks and balances, a stronger rule of law, real property rights, and where policy-makers are more concerned with international and domestic reputation, investment disputes tend to be settled by negotiation. In authoritarian regimes, where these institutional and reputational safeguards are weaker, the government will likely make a more reckless cost-benefit calculation when targeting foreign companies assets, thus resulting in an increased likelihood of actual expropriation.

While outright expropriation is still a low probability event (with a catastrophic impact though) and the binary variable democratic/non-democratic is somewhat limited, these findings bear a valuable message with clear practical implications for political risk analysis. Understanding the full continuum of regime types constitutes a prerequisite for investigating a government’s particular propensity to interfere with a foreign investment. Such interference affecting an investor’s ownership and control over his assets can also come in ascending severity, starting from legitimate regulatory takings, to unlawful and discriminatory intervention, and “creeping” expropriation, accumulating serious losses even short of full confiscation. The causal link between  regime types and such regulatory measures is the government’s motivation, which is absolutely crucial for discerning political behavior.

The year 2012 will, due to continuous economic strains, see many governments and regimes struggle to survive (with or without elections). The current geopolitical shifts, which will be treated in a separate article, are gaining momentum too, and will provide for international crises likely to intensify the mix and level of political risks in many countries. Investors who use rigorous regime analysis in order to prepare for appropriate risk mitigation measures will surely yield a competitive advantage.