Reconsidering Political Risk In Developed Economies

Journal of Political Risk, Vol. 4, No. 8, August 2016

By Julian M. Campisi

Introduction: A Macro Analysis of Political Risk

Nigel Farage, leader of Britain's UK Independence Party laughs as he points to a UKIP poster, before delivering a speech on the forthcoming EU referendum, in London, Friday, April 29, 2016. (AP Photo/Kirsty Wigglesworth)

Nigel Farage, leader of Britain’s UK Independence Party laughs as he points to a UKIP poster, before delivering a speech on the forthcoming EU referendum, in London, Friday, April 29, 2016. (AP Photo/Kirsty Wigglesworth)

The concept of political risk has landed at the forefront of media and scholarly outlets in the fields of international politics and economics after a turbulent first half to 2016. Exposure to a number of recent global ‘shocks’, including the latest waves of terrorist attacks, Brexit, and a failed coup d’état in Turkey, has led to a renewed sense of political and economic instability across the globe. However, until recently, the majority of scholars and practitioners working in the sub-field of political risk have mainly engaged with the political and economic factors that affect investments in developing economies—albeit for good reason. In many such countries, the stability and profitability of foreign investments or business ventures is more difficult to guarantee and to predict due to concerns related to political volatility, social upheaval, expropriations, and regulatory uncertainties. Yet developing nations are at the forefront of political risk analysis precisely because of the potentially lucrative business opportunities that accompany fairly rapid economic growth and development in frontier markets. Indeed, recent global foreign direct investment (FDI) flows to developing countries, spurred by growth in Asia, significantly outweighed those to developed ones as table 1 shows below.

Table 1: Global FDI Inflows 2012-14, by major economy type (billions of USD)

Type of Economy 2012 & (% total) 2013 & (%total) 2014 & (% total) 2014 growth (%)
Developing 650 (49.1%) 677 (49.7%) 704 (55.9%) 4%
Developed 590 (44.6%) 594 (43.6%) 511 (40.6%) -14%
Total World Economy  

1,324 (100%)

 

1,363 (100%)

 

1,260 (100%)

 

-8%

(Source: UNCTAD, 2015)

Although investing in developing economies is popular and profitable in a globalizing world, investors know that with those opportunities come inherent risks. In many cases, firms venturing abroad therefore procure detailed political and economic risk assessments a priori in order to identify potential impediments to their investments, whether they may be firm/industry specific (micro-risks) or political uncertainties facing the entire national or regional economy (macro-risks)[1]. These assessments may be in the form of general commercial political risk indices[2], through the placement of insurance policies, or via custom and tailored evaluations. There are a variety of public agencies, risk consultancies and insurance companies that provide such services with opposing (and complementary) methodologies behind the assessments. These include qualitative and quantitative methods such as multivariate analyses, Delphi techniques, and on-the-ground expert opinions. In short, political risk analysis elaborates on specific causes, variables and actors in political and institutional settings (e.g., government, army, business, and civil society) to calculate the probability functions of future opportunities and risks, including all potential payoffs and costs.

In many developing economies, rampant corruption, the threat of nationalization, legal and regulatory insecurity, civil strife or political violence, weak state institutions or abrupt political changes, and a host of other economic factors continue to be significant and common political risks that foreign firms must seek to mitigate when investing abroad. These, and many other risk variables, are important topics that scholars such as Howell and Chaddick (1994), Howell (2001, 2014), Lensink et al. (2000), Sottilotta (2015), Jensen (2008), Brink (2004), Campisi & Caprioni (2016), Alon and Herbert (2009), Brown (2016), and many others have examined from a variety of perspectives including the issue of capital flight and authoritarian regimes, FDI in the mining industry, the modeling of political risk, or in specific contexts such as the Arab Spring, instability in Eastern Europe, and the South China Sea.

Moreover, in the past few years we have seen the importance of political risk analysis come to light across the developing world as investment flows have increased in some areas, but decreased in others. For example, political-economic uncertainties remain regarding Russian aggression in the Ukraine and peripheral Europe, Argentine debt repayments, Iranian sanctions, Brazilian economic and corruption woes, the Chinese stock-market crisis and difficult transition to lower-growth, continuous upheaval in the MENA region, terrorism and ethnic violence in central Africa, and a variety of other warranted issues that deserve our attention in both the academic and civic senses.

Investment, Democracy & Risk – What about Developed Countries?

I would also suggest that the greater political risk community, and for that matter global investors as well, ought to similarly consider political risk in what are often considered to be more stable economies and large advanced liberal democracies – in other words, the so-called ‘developed’ economies of the West. Though many academic papers, consultancies and businesses are focused on emerging opportunities and risks as outlined above, there is ample space—and indeed a necessity—to consider comparable, if more subtle, causes and consequences of political risk in the West.[3] Granted, there are fewer developed and industrialized economies than developing ones in the world, meaning that there may be scarcer ‘new-investment’ opportunities. However, the specific factors that can contribute to differing levels of political risk in a given nation-state have become more complex due to the rapid expansion of global business, the international nature of finance and capital, and the narrowing of traditional state barriers in complex jurisdictions, for example, the European Union or international free trade agreements that have accompanied globalization. Again, this calls for in-depth scrutiny into the study of the various political determinants of investments in the increasingly shaky developed markets. Socio-economic indicators in many parts of Europe and North America (see table 3 below) point to a number of poignant questions on the stability of business investments that are central to political risk analysis. Accordingly, it is important to consider if the past assurances of steady economic growth, an open and accountable political environment and strong investment climate in the West may be on the wane, especially in the post-crisis era.                                                                                                             In the context of mature democracies, political risk is more likely to assume forms of adverse policy change, unstable governance, or issues with the overall investment climate; hence, a decline in attributes such as democracy, rule of law, relative political-economic stability and growth, and investor confidence in ‘stable’ democracies is something that should not be overlooked in the world of political risk (see table 2[4]). Emphasized in the table below is a negative trend in the vast majority of governance and business scores in the major advanced economies since the 2007/8 onset of the financial crisis. The combined indicator averages of G7 countries (+ Spain & Australia) were selected due to their status as the larger democratic advanced economies in the world. Together, these measures form a fairly accurate idea of government stability, institutional and policy effectiveness or uncertainty vis-à-vis global investment, which enables us to reflect on the root causes of political risk in democratic regimes that manifest in many different ways, and are often distinct from typical risk perils such as confiscation, expropriation or violence[5] found in many developing economies.

Table 2: Average Global Indicator Score Changes in Large Advanced Economies, 2007/8–2014/5

Indicator Total % gain/loss
Net FDI Inflows -10.27%
International Competitiveness -0.02%
Government Effectiveness 1.52%
Corruption -2.67%
Accountability -0.92%
Democracy Quality -1.09%
Business Freedom -2.93%

 

(Sources: EIU, 2015; World Bank, 2015; The World Economic Forum, 2015; Transparency International, 2015; The Heritage Foundation, 2015)

Indeed, the relationship among FDI flows, political risk and democratic institutions (and their authoritarian counterparts) has been well mapped by scholars (Jensen, 2008; Li and Resnick, 2003), and has currency in the literature. Foreign investments are subject to the operational rules and political-economic environments of sovereign states (Brink, 2004), and political risk analysis is thus concerned with political continuity and stability in given markets and state institutions. In a similar vein, table 3[6] below highlights various governance and international business indicators[7] and scores in large developed economies since the financial crisis, in order to underline the importance of a strong investment and policy-regulatory climate to FDI levels. The results are somewhat worrisome, especially when examined in light of their actual political risk rankings which generally score quite well.[8] Though understandably still ahead of the global averages for most measures, the relative decrease in each of the indicators is something investors need to monitor, particularly as they coincide with lower FDI levels. It would thus be prudent for students to further investigate the economic, institutional, and social factors that can determine investment successes in democratic regimes and advanced market economies as well as popular developing ones, given the complex and often ‘societal’ nature of political risk, as both Bremmer and Howell have noted.[9]

Table 3: Select Governance and Business Indicators in Large Advanced Economies, 2008-15

table 3

 

(Sources: EIU, 2015; World Bank, 2015; The World Economic Forum, 2015; Transparency International, 2015; The Heritage Foundation, 2015)

(In)stability & Evolving Investment Difficulties in the West

When choosing an investment location abroad, firms take into account essential characteristics such as political stability, legal transparency, labour market traits, productivity, infrastructure, civil unrest, tax regime and flexibility (Ernst and Young, 2014). Additionally, they consider other socio-political issues such as the role of special interest groups (Akhter & Choudry, 1993), and the influence of powerful individuals in politics, which is complex in democratic regimes. This reminds us that in an era when global companies do their due diligence before committing to an investment, the issues of stability, safety, continuity of open markets, clear procedures and the rule of law, are important to both the investor and host-country looking to attract investment. This is significant given that FDI inflows are known to contribute to economic growth, domestic savings, employment, trade, income distribution, technology transfers, and tax revenues (Whyman & Baimbridge, 2009)—the benefits of which Western governments are critically in need.

Only a few decades ago, some of the issues highlighted above would not have been on the radar of investors in most advanced economies. But today, the geo-political equilibrium is rapidly changing, and the relationship between politics and the activities of international investors has been further complicated by the persistent economic crisis, the sluggish recovery, and new forms of political instability in the West. This has also been accompanied by scores of investment issues, domestic and regional political concerns, competition from the BRICS nations, and a negative turn in international rankings as is noticeable in the classifications above. Though certain developed economies have recently returned to the path of economic growth, their future prospects are becoming harder to predict, which presents challenges for political risk forecasting as well. Given the complex trajectory of EU member states in the post-financial crisis period, including perennial struggles to keep up economic growth, and recent developments in reaction to deep austerity measures that have swept across the continent, real concerns persist on the horizon. This is reflected through the rise of protest-parties on the left such as Syriza in Greece, or Podemos in Spain, as well as populist and anti-establishment activities in the relative centre such as the 5-star movement in Italy, which in early June 2016 won an unprecedented number of Italian municipal elections in large cities such as Rome and Turin. This may have a detrimental effect on the stability of PM Renzi’s government and its reform efforts. Further, an unfortunate rise of far-right and reactionary nationalist parties and movements embodied by the Euro-skeptic and anti-immigration stances of Le Pen’s National Front in France, Salvini’s Lega Nord in Italy, or like-minded right-wing governments and parties in Central-Eastern Europe (such as Austria, Hungary) continue to threaten the very fragile fabric of the EU.

The ongoing spectre of a Grexit has even been eclipsed by the recent Brexit campaign and outcome. In the mere hours after the astonishing results of the UK referendum on EU membership on 23 June 2016 (52-48% in favour of a ‘leave’) came out, tremors reverberated across global financial and currency markets causing selloffs, panic and significant ‘unknowns’ for investors and European governments. Over the course of the coming discussions between the UK and EU on the mechanics of a withdrawal agreement, the only certainty will be uncertainty. This spells even more serious trouble for the already sluggish Eurozone and its many unsatisfied members and struggling citizens. And with this surprising result, Euro-skeptics across the continent will now feel emboldened to push for further referenda or EU ‘exits’, meaning that extreme political uncertainty will accompany the economic fallout over the next few years. Finally, the continuous migrant crisis from the MENA region and specifically the influx of refugees has seemingly pushed the EU to the breaking point, both socially and politically, with no real resolution in sight to the humanitarian crisis. On top of this, there are persistent threats of home-grown terrorism and political violence[10] at the heart of the EU, which might deter investment and even leisure travel in the near future. The shocking and failed attempt at a coup d’état by factions of the Turkish military will also undermine stability on Europe’s eastern border, and contribute to further uncertainty for the migrant and Syrian crises, in addition to a frightening consolidation of power under President Erdogan. Such realities, coupled with unstable political regimes on Europe’s southern borders, continuous corruption and political discontent in places like Italy, Portugal and Spain, high levels of public debt, and an increasingly delicate banking system across the continent, do not bode well for future investments, and contribute to existing significant political risks.

Moreover, according to a recent exposé, the Panama Papers, on the vast amounts of offshore wealth (estimates from $7 to 40 trillion in assets) ‘hidden’ from many government tax coffers has begun reverberating across the world. Authoritarian states will be better positioned, and able, to suppress any fallout from this, but particularly in Europe and North America, we may yet see other high-level resignations, political shuffling and panic, on top of social movements, protests and other tricky consequences.[11] On the other side of the Atlantic, though economic growth and financial stability may be in better shape in North America, there is no immunity to political risks there either. The continued rise of a Trump-led anti-establishment Republican party with increasingly negative rhetoric only contributes to the worsening of American hyper-partisanship and the risk of US government stalemate over key policy issues (including a Supreme Court appointee) which has been growing for years. The rise of discrimination and conservative challenges to progressive policies and court decisions on, for example, same-sex couples, LGBT rights, and drug policies, has become commonplace in some states, and has migrated to the business world, enabling large companies to threaten to leave certain states due to such discriminatory policies.[12] Continued racial tensions over the past two years across cities in the US have also been highlighted throughout the Presidential Primary season and have contributed to widespread social unease. Finally, political-economic difficulties that have surfaced in advanced economies such as Canada due to housing bubbles and the fall in price of crude oil, or in Australia due to resource-export market slowdowns are worth monitoring, as is Japan’s continuous demographic and regional security predicament, that is, the Senkaku/Diaoyu islands dispute with China.

Accordingly, many of these issues have also been picked up by the Economist Intelligence Unit’s Global Forecasting Service, which in Spring 2016 ranked the possibilities of a Grexit, a Trump Presidency, global jihadi terrorism, and a Brexit and breakup of the EU as numbers 5-8 out of the top 10 current global risks.[13] Moreover, there does not seem to be any immediate resolution to these risks in the foreseeable future, meaning that political-economic instability in the West will likely persist. It is thus evident that politically charged risks, though perhaps sometimes found in subtler forms in developed countries, are not confined to developing or frontier markets and authoritarian states. Ultimately, they are realities that all countries will have to grapple with in different ways in a complex global market, and the first place to start to evaluate and tackle them may be in our own backyards. Indeed, over the next few months, Europe and the US will be at the heart of political and economic risk analysis—and for good reason.

Julian Campisi is a PhD Candidate in Political Science at York University, Toronto. His research interests are predominantly in the field of political risk analysis (with a focus on developed economies, and Italy in particular), the methodologies that underpin risk assessments in the private and public realms, and how this intersects with democratic and economic development. He also looks at determinants of FDI at the institutional, political, and socio-cultural levels, and how these can contribute to business and political risks.

JPR Status: Working Paper.

Archived: 8/11/16.

References

Alon, I. and Herbert, T. (2009) “A stranger in a strange land: Micro political risk and the multinational firm”, Business Horizons 52, 127-37

Akhter, S. & Choudry, Y. (1993) “Forced withdrawal from a country market: managing political risk”, Business Horizons, May-June, 47-54.

Bremmer, I. (2005) “Managing risk in an unstable world”, Harvard business review 83 (6), 51-60.

Brink, C. (2004) Managing Political Risk: Risks to Foreign Investment. Aldershot: Ashgate Pub.

Brown, K. (2016) “Foreign Policy Making Under Xi Jinping: The Case of the South China Sea”, Journal of Political Risk 4 (2)

Campisi, J. and Caprioni, E. (2016) “Social and Political Risks: Factors affecting FDI in China’s mining sector”, Thunderbird International Business Review, doi. http://onlinelibrary.wiley.com/doi/10.1002/tie.21830/abstract

Campisi, J. and Sottilotta, C. (2016) “Unfriendly or Unwanted? Reflections on FDI Attraction Policies in Italy”, Italian Journal of Public Policy (Rivista Italian di Politiche Pubbliche), no. 2 (August)

EIU- Economist Intelligence Unit. (2015) ‘Democracy in an Age of Anxiety’, Democracy Index

EIU. (2016) Global Forecasting Service – Global Risk. April 2016 https://gfs.eiu.com/Archive.aspx?archiveType=globalrisk

EIU. (2016) Risk Briefings – World Risk Alert. 4 April http://viewswire.eiu.com/index.asp?layout=RKArticleVW3&article_id=644090648&country_id=1510000351&refm=rkCtry&page_title=Latest%20alerts

Ernst and Young. (2014) ‘EY’s Attractiveness Survey – Europe 2014.’ Available at http://www.ey.com/Publication/vwLUAssets/EY-2014-european-attractiveness-survey/$FILE/EY-2014-european-attractiveness-survey.pdf

Guardian, The. (2016). ‘Coalition of 400 companies fight Georgia’s proposed ‘religious liberty’ bill’, 28 February. http://www.theguardian.com/us-news/2016/feb/28/georgia-religious-liberty-bill-first-amendment-defense-act

Heritage Foundation. (2015) Index of Economic Freedom-Business http://www.heritage.org/index/

Howell, L. (2001) The Handbook of Country and Political Risk Analysis, 3rd Ed. Syracuse: The PRS Group

Howell, L. (2014) “Evaluating Political Risk Forecasting Models: What Works?” Thunderbird Int’l Business Review 56 (4), 305-16

Howell, L. & Chaddick, B. (1994) “Models of Political Risk for Foreign Investment and Trade.” The Columbia Journal of World Business 29 (3), 70-91

Jensen, N. (2008) “Political Risk, Democratic Institutions, and Foreign Direct Investment” The Journal of Politics, 70(4), 1040-1052

Lensink, R. et al. (2000) “Capital Flight and Political Risk”, Journal of International Money and Finance 19: 73–92

Li, Q. and Resnick, A. (2003) “Reversal of Fortunes: Democratic Institutions and Foreign Direct Investment Inflows to Developing Countries.” International Organization 57 (1), 175-212

Robock, S. (1971) “Political risk: identification and assessment”, Columbia Journal of World Business 6, 6-20

Sottilotta, C. E. (2015) “Political Risk Assessment and the Arab Spring: What Can We Learn?”, Thunderbird Int’l Business Review 57 (5), 379-90

Transparency International. (2015). Corruption Perceptions Index. http://www.transparency.org/research/cpi/overview

UNCTAD. (2015) ‘Global Investment Trends Monitor’. No. 18 January. http://unctad.org/en/Pages/Statistics.aspx

Whyman, P. & Baimbridge, M (2009). ‘Labour Market Flexibility as a Key Determinant of Foreign Direct Investment: Evidence from the UK’, in (ed) Blaine, H. Foreign Direct Investment. New York: Nova Science.

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[1] For more on the Micro-Macro distinction, see Alon and Herbert, 2009; Robock, 1971.

[2] On the complexities around commercial political risk indices, see Howell (2014).

[3] Brink (2004) also notes the need to move away from the traditional political risk focus on developed economies in order not to divert attention away from other vulnerable issues and places.

[4] The 7 indicator score changes are based on calculations made from Table 3 below.

[5] Insurance companies that provide political risk coverage often refer to CEND–confiscation, expropriation, nationalization, & deprivation—as the traditional insurable perils.

[6] The same indicator scores for Italy, France, Spain and the UK have been recreated by the author as another table for a forthcoming article; see Campisi & Sottilotta (2016).

[7] These indicators are also used in a variety of commercial political risk indices.

[8] In the 2015 Political Risk Index, with the exception of Italy (73), Spain (75), France (76), all other major developed economies scored well over 80/100, meaning they are seen to have relatively low-medium political risk (global mean = 73). See https://www.prsgroup.com/category/risk-index

[9] Bremmer, 2005; Howell, 2007

[10] Political Violence is an insurable political risk, one that a few of my research respondents have highlighted as significant for the future in Europe.

[11] EIU (2016) Risk Briefings. Accessed 11 April. http://viewswire.eiu.com/index.asp?layout=RKArticleVW3&article_id=644090648&country_id=1510000351&refm=rkCtry&page_title=Latest%20alerts

[12]The Guardian (2016) Accessed 9 April. http://www.theguardian.com/us-news/2016/feb/28/georgia-religious-liberty-bill-first-amendment-defense-act

[13] EIU (2016) Global Forecasting Service. Accessed 10 April. https://gfs.eiu.com/Archive.aspx?archiveType=globalrisk