Chapter 6: Political and Legal Systems

Country Risk (AKA Political Risk)

the danger that doing business in a specific country will be hurt by that country’s political decisions, economic problems, or social events.

In short: It’s the risk that foreign rules, instability, or conflict will cause your company to lose money, property, or control.

Dimensions of International Business Risk

• Cross-Cultural Risk

• Commercial Risk

• Country Risk

• Currency (Financial) Risk

Dimensions of Country Risk

• Harmful/Unstable Political Systems: Political turmoil or regime changes.

• Unfavorable Laws & Regulations: Rules that restrict or burden foreign firms.

• Inadequate Legal Systems: Weak law enforcement or poor property rights protection.

• Bureaucracy & Red Tape: Cumbersome rules and excessive administrative delays.

• Corruption & Blunders: Ethical abuses or government missteps.

• Government Intervention & Protectionism: Tariffs, quotas, or trade barriers.

• Economic Mismanagement: Failure to maintain economic stability or control inflation/growth.

Two Types of Country Risks

SYSTEMATIC: Affects ALL industries and firms in a country.

UNSYSTEMATIC: Affects only a SUBSET of firms.

Political Sources of Country Risk

• Government

• Political Parties

• Legislative Bodies

• Lobbying Groups

• Trade Unions

• Other Political Institutions

Legal Sources of Country Risk

Laws that aim to:

• Ensure order in commercial activities (domestic competitors)

• Resolve Disputes (Courts may be corrupt)

• Protect intellectual Property (steal patents, counterfeit designs)

• Tax economic output (unpredictable tax hikes)

Political Systems

A set of formal institutions that constitute a government.

This system also defines how these groups interact with each other.

Three Major Types of Political Systems

How is affects Business:

• Totalitarianism: High political risk—the government can seize assets, change laws abruptly, or shut down foreign operations without warning.

• Socialism: High-Moderate political risk—Higher taxes, strict labor and environmental laws, and heavy state control over key industries (like energy, healthcare, or utilities).

• Democracy: Low-Moderate political risk—Provides a stable and predictable environment for businesses with transparent legal protections for investments and patents.

Four major Types of Legal Systems

• Common Law: custom, historical precedents, and past court rulings rather than written statutes alone.

• Civil Law: based on a comprehensive, written code of laws and statutes created by legislative bodies.

• Religious Law

• Mixed Systems

Functions of Political Systems

• Provides protection from external threats.

• Ensures stability based on laws.

• Govern the allocation of valued resources among the members of society.

• Define how society’s members interact with each other.

Totalitarianism

Government exercises total control over all aspects of public and private life, suppressing opposition and individual freedom.

It is either theocratic or secular.

Typically has a secret police, regulates propaganda, and limits free speech.

• China 1949-1980s

• Germany 1933-1945

• Soviet Union 1918-1991

• Spain 1939-1965

Socialism

Production, distribution, and capital are owned, managed, or heavily regulated by the government/state to ensure social wealth equality.

(Western Europe, Brazil, and India).

Democracy

Power is held by citizens, who exercise it directly or through freely elected representatives under a constitutional rule of law. Typically has a limited government and citizens have the right to Private Property Rights.

Totalitarian Countries

• Cuba

• North Korea

• Africa—Eritrea, Sudan, Equatorial Guinea, Zimbabwe

Socialist Countries

• Bolivia

• China

• Egypt

• India

• Romania

• Russia

• Venezuela

Democratic Countries

• Australia

• Canada

• Japan

• New Zealand

• United States

Relationship Between Economic and Political Freedom

• Direct Relationship: Political freedom and economic freedom tend to move together—as one increases, the other usually increases.

• High Freedom Countries: USA, UK, Australia, Denmark (Democratic + Free Market).

• Low Freedom Countries: North Korea, Cuba, Iran (Totalitarian + State-Controlled).

• Key Exception: Singapore (High economic freedom, but limited political freedom).

Democracy and Openness

Core Definition: Democracy fosters "openness"—fewer regulations and lower barriers for foreign companies entering the market.

4 Key Benefits of Openness:

1. Successful market entry for international companies

2. Increased market demand and product options

3. Improved product quality due to competition

4. Lower prices & efficiency driven by competitive pressure

• Example: India's Car Market (Lowered trade barriers —> foreign car companies entered —> more car models, better quality, lower prices).

Political and Economic Systems

• Totalitarianism = Command Economy: State makes all decisions on production, quantity, and pricing.

• Democracy = Market Economy: Driven by free market forces (supply and demand).

• Socialism = Mixed Economy: Blends market and command economy features.

• Examples of Mixed Economies: Sweden and Singapore.

The Rule of Law

Rules are clear, publicly disclosed, fairly enforced, and widely respected by individuals, organizations, and the government.

Common in advanced economies.

When Rule of Law is weak, the economic activity suffers and uncertainty increases.

Common Law

The basis is tradition, past practices and precedents set by courts and interpreted by statues.

Judges have more power to interpret laws, making it relatively flexible—this is judicial.

Originated in England, Australia, Canada, USA.

Civil Law

Laws that are “Cast in stone” and not strongly subject to interpretation by courts.

Since it is mainly based on laws passed by national and state legislatures, it is legislative.

Religious Law

Strongly influenced bt religious beliefs, ethical codes, moral values and viewed as mandated by a supreme being.

Most religious legal systems are based on Hindu, Jewish, and Islamic law.

Mixed Systems

Two or more legal systems operating together.

Totalitarianism for instance is most associated with religious law and socialist law.

Democracy is associated with common low, civil law, and mixed systems.

Actors in Political and Legal Systems

• The Government, operating at national and local levels.

• International organizations—such as the world bank and world Trade Organizations.

• Regional economic blocs—European Union, NAFTA.

• Special Interest Groups—labor unions and environmental advocates.

• Local competing firms—they oppose foreign firms.

Confiscation

Seizure of corporate assets without compensation.

Expropriation

Asset seizure with compensation.

Nationalization

Takeover of an entire industry with or without compensation.

Creeping Expropriation

The government gradually modifies regulations and laws after foreign Multinational enterprises have made big local investments in:

Abrupt termination of contracts, creation of laws that favor local firms, the governments in Bolivia, Russia and Venezuela have modified tax regimes to extract revenues from coal, oil, and gas companies.

Embargoes

Makes trade activities with specific countries illegal.

Example: the U.S. has enforced embargoes against Cuba, Iran, and North Korea labeled as state sponsors terrorism.

Sanctions

Are bans on international trade with extra tariffs, trade barriers, import duties, and import/export quotas.

Boycotts against Firms and Nations

Voluntary refusal to engage in commercial dealings with a nation or a company.

Wars and Insurrection

Indirect effects can be disastrous for company activities.

Terrorism

The threat or actual use of force or violence to attain a political goal through fear and intimidation.

Country Risk Produced by Host Country Legal Systems

Specific laws, rules, and regulatory frameworks created by a host country that restrict or complicate how foreign companies operate and make money.

Key Legal Risk Areas:

1. Foreign Investment Laws: Limits on foreign ownership.

2. Operating & Contract Controls: Restrictions on business setups and contract enforcement.

3. Marketing & Distribution Laws: Advertising and selling limitations.

4. Income Repatriation Laws: Limits on transferring profits back home.

5. Environmental & E-Commerce Regulations: Pollution compliance and internet/data rules.

6. Inadequate Legal Systems: Weak courts or lack of legal protections.

Home Country Legal System Risks

Laws from a firm's domestic/headquarters country that regulate how the company must behave while conducting business internationally.

Key Legal Risk Areas:

1. Foreign Corrupt Practices Act (FCPA): Bans bribing foreign officials.

2. Antiboycott Regulations: Prohibits compliance with unsanctioned foreign trade boycotts.

3. Accounting & Reporting Laws: Governs how financial records and foreign assets are reported.

4. Financial Transparency: Requires clear disclosure of corporate earnings and transactions.

Foreign Investment Laws (Host Country Risks)

Laws and regulations enacted by a host government that dictate, restrict, or condition how foreign companies and individuals can invest capital, acquire assets, or own businesses within its borders.

Key Examples:

• Ownership Caps: Mandating that local partners must hold majority ownership in certain domestic industries (e.g., defense, media, energy).

• Screening & Approval: Requiring foreign acquisitions of domestic firms to undergo government security reviews before approval.

• Industry Restrictions: Completely banning foreign investment in sensitive or national interest sectors.

Controls on operating forms and practices(Host Country Risks)

Laws and regulations on how firms can conduct production, marketing, and distribution activities.

Example: In the telecommunications sector in China, the Chinese government requires foreign investors to seek joint ventures with local firms. This ensures local control of the telecom industry; and China gains access to foreign capital and technology.

Marketing and Distribution Laws (Host Country Risks)

Regulate practices in advertising, promotion, and distribution.

Examples—Finland, France Norway, and New Zealand prohibit cigerette advertising on television.

Laws on Income Repatriation(Host Country Risks)

Limit the amount of net income or dividends that firms can bring back to the home country.

Environmental Laws(Host Country Risks)

Aim to preserve natural resources, combat pollution, and ensure safety.

Contract Laws(Host Country Risks)

Affect the sale of goods and services; intermediary agreements; licensing and franchising; foreign direct investment and joint ventures.

Inadequate or Underdeveloped legal Systems (Host Country Risks)

Laws may be weak regarding intellectual property pollution, consumer protection and other areas, and it can happen in developing economies as well as advanced economies.

Extraterritoriality (Home Country Risk)

The application of home-country laws to other countries.

Example—the European Union pursued Microsoft for monopolistic practices.

The Foreign Corrupt Practices Act 1966 (Home Country Risk)

Made it illegal to offer bribes to foreign parties. But the act may harm U.S. firms because foreign competitors are usually not so constrained.

Accounting and Reporting Laws (Home Country Risk)

Regulations established by a firm's home country government that strictly govern how financial transactions, assets, liabilities, and foreign operations must be recorded, tracked, and reported in financial statements.

Physical Asset valuations (Accounting and Reporting Laws)

Canada and the U.S. use historical costs. Some latin American countries use inflation-adjusted market value.

R&D Costs (Accounting and Reporting Laws)

Expensed and incurred in most of the world; capitalized in South Korea and Spain. Some countries use both.

Financial Reporting

The degree to which firms regularly reveal substantial financial and accounting information. This varies worldwide.

Proactive Environmental Scanning (Managing Country Risk)

Management should develop a comprehensive understanding of the political and legal environment in target countries

• Local employees

• Embassy and Trade Association officials

• Consulting Firms

Goal to minimize exposure to country risks.

Strict Adherence to Ethical Standards (Managing Country Risk)

Firms that engage in questionable practices to operate outside the law invite redress from the governments of the host countries where they do business.

Alliances with Qualified Local Partners (Managing Country Risk)

A risk management strategy where a foreign company enters a foreign market by forming a joint venture or strategic partnership with a local firm to leverage their political, legal, and cultural expertise.

Key Benefits:

• Helps navigate complex local bureaucracies, regulations, and legal systems.

• Reduces political hostility or protectionism by maintaining a local presence.

• Provides established connections with local supply chains, banks, and government officials.

Example: Foreign firms entering high-risk markets like China or Russia often partner with local businesses to ensure compliance with strict local laws and political expectations.

Protection through Legal Contracts (Managing Country Risk)

Contract law varies widely. The firm must follow the law in each country. Three approaches for resolving contract disputes:

Conciliation (Protection through Legal Contracts)

a formal process of negotiation whose objective is to resolve differences in a friendly manner. It is the least adversarial method and common in China.

In arbitration (Protection through Legal Contracts)

A neutral third party hears both sides of a case and decides in favor of one party or the other, based on an objective assessment of the facts.

Litigation (Protection through Legal Contracts)

Occurs when one party files a lawsuit against another. The most adversarial approach, it is common in the United States.