Political risks are among the higher causes of concern for business people nowadays. Political, social and institutional instability have the potential of generating radical changes in the business and economic landscape in which local firms and multinationals compete. Only companies who understand these risks and develop the ability to compete in this changing environment can fulfill the expected value creation for its stakeholders.

Political risk arises when, because of a governmental decision a firm’s expected outcome is affected. Oftentimes the government decision affects the firm in a direct manner, for example in the case of an expropriation. We call this a direct political risk. In some other cases the government decision motivates another actor to take an action that affects the firm, for example if the government does not enforce the rule of law and third parties –in violation of the law- take an illegal advantage. We call this indirect political risk.

Both, direct and indirect political risks, affect the firm in a similar fashion. The capability of recognizing them improves our awareness and ability to identify these risks in advance, and provides tools to manage them in a successful way. Each type of political risk have a set of determinants that we need to monitor, but this will only be possible after a careful identification of these risks.

Political risks come in different flavors; there are several different ways in which a political risk can appear. The most famous manifestation of political risk is the expropriation; i.e. the government seizing the firm’s assets (or shares) from its original owners. The business press has reported several cases of expropriations by governments. Among the most famous ones we can mention Fidel Castro´s expropriation of the Cuban based Rum producer Bacardi in 1960, or Hugo Chavez’s expropriations of several companies like the Argentine steel company Sidor, the Colombian retailer Exito, the Venezuelan oil & gas PDVSA and the Mexican cement producer Cemex among many others.

It is interesting to notice, however, that the probabilities of expropriation are not uniform across industries or time. Companies in different industries will have different probabilities of being expropriated based on how appetizing they are to the government currently in power. In fact, it is useful to identify the reasons why a government might want to expropriate a firm. First, a government seeking popular support might do it just for the sake of getting some extra voters for the next election, especially if the country is under a populist regime with high levels of popular support. This is especially true for some type of firms: according to certain ideologies, natural resources, pension plans and social security among some other industries should be state-owned. Therefore, in a certain type of political environment, expropriation is more likely for firms in industries of those characteristics. A combination of these reasons explains the expropriations of several firms in Argentina during the first decade and a half of this new century, where the government has expropriated Utilities, Oil and Gas companies and the local Pension Funds. Additionally, some expropriations have been justified based on the belief that the government should manage some industries because of economic reasons such as its competitive structure.

Additionally, expropriations also need to consider the particular timing of the investment cash flows. It is very unlikely that a government will harass a firm during the time in which it is in the process of investing; they usually wait until most of the investment is in place and the firms is starting to harvest positive cash flows. In an interesting case of poor understanding of this reality, the argentine government started increasing the taxes requirements to the mining companies during their investment process and, as a result of that, the Brazilian Mining firm Vale do Rio Doce decided to leave the country, abandoning a large investment already in place. The mining industry is still adjusting to this in Argentina nowadays.

Sometimes expropriation of assets is not feasible or not economically suitable, so governments generate changes in the rule of law that essentially have a similar effect. The most common case is the one in which the government, by changing some regulation, appropriates a portion of the firm’s cash flows without seizing any physical assets. President Correa has done this in Ecuador by changing the royalties’ structure of the Oil and Gas firms and President Kirchner has done the same in Argentina by changing the export taxes for the agricultural firms. As a result of these changes the government has seized the cash flows of the private companies trying to leave enough returns to the private owners so they have an incentive in continuing the exploitation. Reality teaches, however, that this strategy hardly works in the long run. Changes in commodity prices, technological innovations, new substitute products, etc., jeopardize the whole structure and these experiments usually end in a big fail, leading to underinvestment and tragic loss of competitiveness at a firm and country level. Most of the times firms end up moving their investments towards countries in which they are allowed to keep a larger share of their cash flows.

A classic demonstration of indirect political risk is the outbreak of social unrest that might affect a firm or a given industry. We have seen several examples of this in the recent past. A few years ago, social activists have blocked the bridges connecting Argentina and Uruguay for about three years in a protest against the installation of the UPM-Botnia Pulp mill in the city of Fray Bentos in Uruguay. Recently social activists have blocked a newly built Monsanto facility, not allowing the plant to start operations. In a similar fashion, unions and social activists have blocked the plants of several US firms (the food manufacturing company Kraft, the printing company Donnelley and the manufacturing firm Lear, just to mention a few) outside Buenos Aires, Argentina in a protest for layoffs. The Argentine government has a very benevolent policy against strikes and social protests, allowing and protecting them, as a result, it is very common that argentine unions and social activists protest and go on strike every time they have an opportunity of doing so. At the time of writing this post there is a very severe situation in Peru with the Tia María Mining Project in the southern region of Arequipa. Social protests are mounting, the dead toll keeps growing and President Ollanta Humala is trying to solve the problem addressing the protesters. In some other cases, the government, for whatever reasons plays some role in the pressure put on the firms; this is the case, for example of the expropriation of PLUNA, the Uruguayan National Airline; the forced renegotiation of the agreement at Barrick’s Pueblo Viejo mining project in the Dominican Republic; or the current difficult legal situation of the Citibank branch in Argentina.

Wars and civil wars are other forms of political risks. Independently of the reasons that might have triggered them, these events generate a mayor disruption in the business climate of a region. Consider the big wars in Europe in the past century or the several examples of ferocious civil wars in the last decades to see how these affect the firm´s business. The Arab Spring started in Egypt in January 2011 and widespread through most of the region, and the ferocious Rwanda Civil War started in 1994 are examples of this.

Notice that the probabilities of social unrest are not uniform across countries and regions. In their book The Fat Tail, Ian Bremmer and Preston Keat studied the characteristics of the countries that experienced social unrest, and found several interesting regularities. Countries with more men than women, higher concentration of young people, higher number of unemployed, countries with more years of the same government in power, among other characteristics seemed to have a higher propensity of going into social unrest. Based on this idea, The Economist calculated The Shoe Thrower’s Index, a predictor of social unrest in countries in Arab countries that –looked in retrospective- worked with amazing accuracy. This idea could be reproduced in any region; it is only a matter of finding the right determinants of the risks of social unrest in a given region.

The changes in the economy and the institutional environment produced by the election of a new government are interesting forms of political risk. Especially in those countries in which an elected president has a large share of the political power, i.e. countries with poor institutional environment, each time a new president is elected, it might completely change the business and economic landscape. As a result, past winners might become new losers and vice-versa. It is interesting to notice that most of the forms of democratic government in a country are compatible with firms making profits in their operations provided they could adjust to what is required by this type of government. Just to take the example of the two extremes seen in Latin America nowadays. We have countries that move towards embracing pro-market policies, and countries that have a –higher or lower- degree of populism. In either regime firms can develop profitable businesses; the problem is that the structure needed to develop these businesses are quite different and not easy to adjust in a short time. Moreover, it is usually the case that several of these countries tend to switch between these regimes causing past winners to become losers and vice-versa fairly fast.

This was the case of Argentina: during the nineties the country embraced pro-market policies but the government failed to keep up with the necessary measures, and after a deep economic, political, social and institutional crisis, a new government embraced populist policies that have been governing the country since 2003. Some of the profitable firms from the nineties are now on the verge of bankruptcy, whereas formerly protected and non-competitive firms are now the new winners in the current political landscape. Given that these changes in regime seem to be happening, the main question posed by this fact is whether we are ready to forecast when this is going to happen and if we are able to redesign the firms in order to adjust towards the organizational form that is needed in the new political landscape. How can we know in advance when a country is going to shift towards a change in regime? There are some specific determinants of political risks that can predict these changes and we might want to keep an eye on. Doing this will allow us to foresee the evolution of political risks.

This improved understanding of political risks is only the beginning; we still need to include them in the risk management practice of the firm. The procedure is the same as with every risk; we need to make sure we identify and measure them and understand their determinants. After that, we assign owners to the risks and give somebody the responsibility of monitoring their determinants. Political risks also have mitigation strategies that we need to consider, but these will be considered in another post.