Political Risk Analysis Notes

Cardinal Rule No. 3: The Notion of Political Risk

• Political risk analysis (PRA) is always forward-looking.
• Losses occur in the past but political risk analysis focuses on future events of losses.

Temporal Considerations

• Political risk analysis needs to consider the past, present, and future.

Cardinal Rules of PRA

• The notion of political risk is always forward looking.
• Losses occur in the past.

Typology of Political-Based Losses

• Political-based losses encompasses different events.

What is Political Risk?

• Political risk refers to the possibility that political decisions or social events in a country will affect the business climate.
• This can lead to investors losing money or not making as much money as expected.
• Source: Llewellyn Howell, Ph.D., The Handbook of Country and Political Risk Analysis, Fifth Edition, East Syracuse, New York, 2013.

Definition of Political Risk (Adapted from Howell)

• Political risk refers to the probability that political decisions or political or social events will affect the business into which the investment was made.
• This can result in investors losing money or not making as much money as they expected.

Risk Calculation

• Risk is calculated by considering the event probability and impact defined as follows:
  Risk = Event\ Probability \times Impact
• Event Probability: probability that, as a result of political decisions or political or social events that affect the business into which the investment was made.
• Impact: investors will lose money or not make as much money as they expected when the investment was made.

Political Risk Flower

• Illustrates various types of politics-based loss events:
  • Non-honoring of Government Guaranties
  • Creeping Expropriation
  • Confiscation of Property
  • Expropriation
  • Improper host government interference
  • Breach of Contract
  • Expropriation of Funds
  • Nationalization
  • Conversion
  • Blocking Currency
  • Inconvertibility
  • Political Violence
  • Currency Controls
  • Blocking Currency
  • Transfer
  • Absence of Copyright Protection
  • Revolution
  • Coup d'etat
  • Civil War
  • International War
  • Terrorism
  • Civil Strife
  • Corruption
  • Attacks
  • Cyber actions against personnel

Politics-Based Loss Types

• Inconvertibility
  • Currency controls
  • Blocking currency conversion
  • Blocking currency transfer
  • Restrictions on the conversion and transfer of local-currency earnings
• Expropriation
  • Nationalization
  • Creeping expropriation
  • Confiscation of property
  • Breach of contract by a government
  • Wrongful calling of letters of credit (bid, performance guarantees)
  • Government frustration or reneging on contracts
  • Expropriation of funds
  • Non-honoring of government guarantees or financial obligations
  • Repudiation and/or impairment of a contract and other improper host government interference
  • Forced divestiture
• Political Violence (Damage to Property & Loss of Business Income)
  • International war
  • Civil war
  • Terrorism
  • Civil strife (demonstrations, protests, strikes)
  • Civil disturbance
  • Revolution
  • Coup d’etat
  • Sabotage
  • Insurrection
• Additional Types
  • Corruption
  • Corrupt competitive bidding for government contracts or improper awards
  • Discriminatory taxation
  • Actions against personnel
  • Government interference with terms of a contract
  • Limits on remittances
  • Politics-based regulations on operations
  • Absence of copyright protection
  • Payment of bribes
  • Discrimination and favoritism
  • Cyber attacks

4 Historical Approaches to PRA

Exploration of Theories of PRA

• Reference: “Learning to Fly: Evolution of Political Risk Analysis” - Darryl Jarvis & Martin Griffiths

General Trends

• 1945 - 1970: Growth of international trade, and with it, growing involvement of government intervention
• 1970 - 1990: Expropriation, nationalization and outright taking
• 1980s: Sovereign defaults
• 1990s: Currency instability; growth of sub-sovereign risk; creeping expropriation
• 2001 - today: Political violence

1st Generation: Catalogue School (1950s - present)

• Assumes:
  • Well-functioning markets
  • Rational decision-makers in host government
• Source of politics-based losses: unwanted government interference in business.
• Examples: nationalization, expropriation, contract repudiation, breach of contract, confiscation of property, currency controls, repatriation of profits, other government interference
• Solution: Limit the power and reach of government.

2nd Generation: System Event School

• High Risk Scenarios:
  • Fragile/non-viable markets
  • Low capacity and/or capability
  • State capture
  • Stress of (complex) demands on regime
  • Political profile of state (e.g., democratic, oligarchy, autocracy, hybrid)
• Low Risk Scenarios:
  • Mature/robust/viable markets
  • High capacity
  • Broad legitimacy of government
  • Can absorb complex stresses
• Pace of modernization is important!
• Variables for political and economic stability/political maturity/legitimacy:
  • State and system type
  • Capacity
  • Level of institutional development (important as both a creator and responder to significant events)

2nd Generation: System Event School (Continued)

• Jeffrey Sachs’ economic liberalization shock therapy of Central and Eastern Europe in the 1990s - were those countries ready?
• Result: e.g., labor strikes, threat of war, sanctions, political factions, unrest, expropriation, import restrictions currency/remittance controls
• Poor record of accuracy in predicting large events
• Solution:
  • Identify and invest according to system type (“risk profile” of country)
  • Modernize fragile states and liberate them from a state of "capture" by a small group, capacity and institutional building
  • Avoid LT investments, minimize sunk costs
  • Liquid investments

3rd Generation: Theory versus Method

• Abandons theories in favor of methods
• Methods to evaluate the risk environment at a more granular level with greater focus on the individual project-level
• Focus is on finding the “Holy Grail” of causation (information / expert dependent)
• Interaction of key qualitative drivers rather than broad theory
• Most commercial models operate in this space

3rd Generation: Theory versus Method (Continued)

• "The holy grail of political risk theorising—constructing quantitative models that can provide testable propositions, or the construction of data sets that can relate accurate probability indices to specific risk events, policy changes, or country settings—thus remains a highly prized goal, despite its difficulties."
• Source: Page 18

4th Generation: Quant Approach

• Cutting-edge research, focused on correlation/identification of triggering point relative to coups, state failure, humanitarian crisis, civil conflict, state-to-state conflicts, etc.
• Focus on big crisis events (e.g., seismic and tectonic shifts; country level only - not at firm or project level)
• Big data driven; early stages, untested
• Examples: Eurasia Group, Geoquant, IHS, and government institutions
• Goal: detecting situations on the horizon (e.g., “Libya”, “Turkey”, “Ukraine”, “Afghanistan”, “Russia-Ukraine”, Kazakhstan, or Sri Lanka situations)

The 5th Generation

• Probabilistic Forecasting
• Machine-Human Hybrid Forecasting

Generalization of Four Approaches

• Based on the premise that human behavior is quantifiable and predictable because our behavior is consistent and patterned.

Molano's 4 General Approaches to PRA

Molano’s General Approaches to PRA

• Considers methods of PRA falling into 4 categories with regard to:
  • Comparability,
  • Predictability (cause and effect), and
  • Timeliness (fresh insights):
• Old Hand (dependent on key persons; monopoly)
• Delphi (dependent on availability and objectivity of experts in completing surveys)
• Quantitative (checklist or sophisticated model?)
• Grand Tour (due diligence; subjective, limited shelf-life; difficult to transfer)

So what works?

Howell & Chaddick’s critique of various methods of PRA

• Comparison of 1986 forecasts of The Economist, PRS, and BERI against losses incurred from 1987-1992
• Quantitative models of the day were weak at best
• Correlation between forecast and actual losses is low, or at least significantly lacking
• What does this mean for consumers of commercial political risk models?

Additional Resources

• For a detailed discussion of each model see…
• The Handbook of Country and Political Risk Analysis, Llewellyn D. Howell, Ph.D., 5th Edition, 2013
• www.eiu.com
• www.prsgroup.com
• www.beri.com

Comparison of Forecast Models

Primary Drivers of PRA

• Policies
• Actors
• Politics-Based Loss
• Country
• Conditions

Cardinal Rule of PRA No. 4

Cardinal Rules of PRA

• Effective political risk analysis is based on an underlying approach (theory and/or model) - that is, a hypothesis or group of hypotheses that explain why occurrences of politics-based losses happen.