A STRATEGIC APPROACH TO POLmCAL RIsK AssESSMENT

Daniel Sauers
Lincoln University

Canterbwy, New Zealand

Recent events in the Middle East. where the outbreak of hostilities has put foreign
invesbnents in jeopardy, and the political volatility in Eastern Europe, Asia. and Latin
America, once again point to the need for the systematic assessment and management
of political risks associated with oversea investments. While a number of sophisticated
techniques for assessing political risk are available, most multinational corporations
(MNCs) use subjective, sporadic analysis by overseas staff and independent consultants
[21]. Furthermore, the integration of political risk assessments into the strategic
decision-making process of MNCs tends to be informal and unsystematic [8].

Political risk has long been identified as a prime factor to consider when making
foreign invesbnent decisions. However, it has only been in the past decade that political
risk assessment has emerged as an established managerial function in MNCs. As with
any new function, a number of problems have emerged. In an in-depth study of ten
United States-based MNCs, Mascarenhas and Atherton [9] found a general lack of
satisfaction on the part of executives with regard to their existing system of assessing
political risk. The need for a more formal assessment of political risk and its
implications for strategic decision-making is apparent.

In this article, a general framework for integrating political risk assessment into
the strategic planning process of the MNC is developed. The political risk assessment
approaches of American firms who fIrst established joint ventures in China and the
Soviet Union are then evaluated in light of this framework.

Political Risk Assessment and Strategic Management

There is a basic linkage between political risk assessment and strategic
management. Higgins defines strategic management as "the process of managing the
pursuit of organizational mission while managing the relationship of the organization
to its environment" [5, p. 3]. The primary purpose of strategic management is to
optimize the "fit" between the organization and its present and future environment.
Micallef, on the other hand, refers to political risk assessment as ''the systematic means
of assessing and managing the political risks of foreign direct investment or international
business" [10, p. 47]. While political risk assessment should play an integral part in
a MNC's strategic planning process, in practice, its role is often limited to politic8J.
forecasting [10]. As for the integration of political assessments into decision making,
most authors confine themselves to the capital budgeting process where forecasts are
used to adjust cash flows or the discount rate [6]. Capital budgeting is but one function
that can and should be affected by political risk judgements. A strategic approach to
political risk assessment is required in order to fully integrate this function into the
corporate planning process.



Spring 1992 Sauers: Political Risk Assessment 39

A strategic approach to political risk assessment involves four interrelated steps:

1. Identification and analysis of key political issues and trends.
2. Development of policy, strategy, and tactics for addressing key issues.
3. Implementation and execution of the chosen strategic plan.
4. Evaluation and adjustment of the strategic plan in light of actual experience

andchanging political conditions.

A model of the strategic approach to political risk assessment is presented in Figure
1. Phase I involves the application of environmental scanning and forecasting
techniques to identify and analyze potential political risks. Phase 2 involves the
evaluation of feasible alternatives and the development of a strategic plan which takes
into consideration political risk. factors. Phase 3 embraces all the administrative actions
associated with putting a strategic plan into action and making it work as well as
political developments permit Phase 4, evaluation and adjustment, is both the end and
the beginning of the political .risk assessment process. The march of political change
guarantees that the time will come for making revisions in strategy. Most of the time,
revisions will be of the fine-tuning variety, but occasions for major overhaul in strategy
arise--sometimes because of significant political developments.

Figure 1: Strategic Political Risk Assessment

Phase 1 Phase 2 Phase 3 Phase 4

Identification Strategy Implementation Evaluation &
& Analysis Fonnulation & Execution Adjustment

----------- ..... ---------- ~ ---------- --. ----------
-Environmental

....
-Evaluation of -Organizing -Monitoring

scanning alternatives -Resource -Strategy
-Forecasting -Strategy allocation refonnulation

selection

~~ ~ ~ ~ ~

Before examining each of the phases in the political risk assessment process in
more detail, a word of caution: it is practically impossible to construct a model of
political risk assessment which accurately portrays the dynamic, interactive nature of
the process. While the model indicates four sequential phases, this is only partially
realistic. The relationship between issue identification and analysis, and strategy
fonnulation is particularly troublesome to portray realistically. In order to focus scanning
efforts, for example, it is often advisable for management to start the process by
tentatively defining the finn's strategy [9]. This scenario highlights the fact that the
component phases of the political risk assessment process are interactive and can occur
simultaneously.



40 Journal ofBusiness Strategies

Phase One Issue Identification and Risk Analysis

Vol. 9, No.1

Schmidt [17] stresses the importance of understanding what constitutes a political
risk. Only after political risks have been defmed or identified can international
managers posit relationships, gauge risk exposure, and recommend a course of action
aimed at capitalizing, alleviating, or avoiding the various forms of this risk.

Although the term ''political risk" is used extensively in the international business
literature, there is little agreement regarding the precise meaning of the tenn. In
developing an operational definition of political risk suitable for integration into the
strategic planning process of the MNC, it is helpful to consider the concept in an
environmental context. Robock [15], for example, suggests that political risk in
international business exists when discontinuities, which are difficult to anticipate, occur
in the business environment as a result of political change. These changes in the
business environment constitute a risk if they have the potential for significantly
affecting the profit or other goals of a particular enterprise. Robock notes that
fluctuations in the political environment that do not change the business environment
of the firm significantly do not constitute a political risk. Thus, what is a political
risk fOf one fnm may not be a political risk for another.

It is also helpful to distinguish between uncertainty and risk in the political envi-
ronment. Political uncertainty describes an unmeasured, subjective doubt about a po-
litical environment. Political risk, on the other hand, denotes a relatively objective
measurement, usually resulting in a probability estimate of that doubt. Root writes:
"When the international manager makes a probability judgement of an uncertain p0-
litical event in a host country, he thereby converts a political uncertainty into a politi-
cal risk" [16, p. 57]. Political risk-assessment provides a means for the objective
evaluation of foreign investment climates by converting uncertainties in the political
environment into probability tenDs.

Finally, risk that is of a political nature encompasses governmental actions as well
as any environmental forces which could change the government or its policies. Thus,
political risk generally refers to a full range of environmental factors that may affect
a finn's performance in a particular country. Normal business risks that emanate from
pure market developments, however, are excluded from this definition.

Such a comprehensive view of political risk stresses the importance of environ-
mental scanning in identifying potential sources of political risk. Scanning activities
should have as their focus the identification of the key political issues. Such issues
represent the major opportunities and threats which could critically affect the fJrnl' s
performance in a particular country. A key political issue may be immediate or
emerging, host country, home country, international or global in origin, that will directly
or indirectly affect any facet of the firm's operations [21].

Unfortunately, several problems plague political data collection efforts ([9], [18]).
Pertinent data is often not readily available. First-hand data collection of a political
nature is not only difficult and time--consuming but also likely to be biased as the local
people respond guardedly to sensitive questioning. Data that are available tend to be
biased and not in a readily usable fonnat. Infonnation may be distorted due to internal



Spring 1992 Sauers: Political Risk Assessment 41

politics, and by communication problems arising from differences in personal orienta-
tion and from the PeCuliar nature of political data. Finally, data that is collected for
political risk assessment is often irrelevant.

Sethi and Luther [18] place an emphasis on collecting data that are strategy-
SPeCific. This can be accomplished by tentatively defming the initial strategy so that
relevant infonnation can be determined in the scanning process. Several sources of
data can also be employed to cross-check infonnation for biases [9]. Incorporating
these suggestions before initiating the scanning process should eliminate many of the
problems noted above.

Once data on the environment has been collected, it must be analyzed and
interpreted in an effort to forecast future issues and problems. There are a number of
sophisticated qualitative and quantitatively oriented techniques available for this purpose.
No one technique, however, is accurate for all political forecasting situations. Political
risk forecasting must be approached from the viewpoint of the individual ftrm.
Purchasing general reports from or utilizing the services of organizations such as the
Business Environmental Risk Index (BERI) or governmental agencies is useful, but such
practices will be inadequate unless supported by detailed interpretation with reSPeCt to
the individual fum. A fum would be well advised to follow Rice and Mahmoud's
[14] seven step managerial procedure when selecting a political risk forecasting
technique suitable for their needs and budget. Steps included in the procedure are:
problem definition; identiftcation of the lead time; identiftcation of the data pattern;
accuracy of the method; cost analysis; subjective and environmental factors involved
in the choice and implementation of a technique.

Phase Two: Strategy Formulation

Once the key political issues have been identifted and the trends forecasted, the
focus of the assessment shifts to developing strategies designed to mitigate or avoid
the effects of negative factors as well as take advantage of positive ones. Numerous
risk management strategies have been espoused in the literature ([2], [10], [13], [15],
[19]). Political risk management strategies can be employed at both the pre-investment
stage and in the course of operations.

At the pre-investment stage, for example, Shapiro [19] identiftes four separate,
though not necessarily mutually exclusive, strategies that a MNC can follow: avoid-
ance, political risk insurance, negotiating a concession agreement with the host gov-
ernment, and structuring the investment to minimize its exposure to political risk. At
this stage, all feasible alternatives should be identifted and evaluated with regard to
risk, cost, timing, etc. For example, political risk insurance can provide partial pro-
tection against such political risks as expropriation, civil or foreign war damage, and
currency inconvertibility, but premiums can run high and coverage is usually limited
to 90% of equity participation [2].

Once a foreign investment is operationalized, a number of creative conflict-man-
agement strategies can be employed to cope with political risk [4]. Poynter suggests
that more effective strategies are aimed at increasing the finn's bargaining power relative



42 Journal o/Business Strategies Vol. 9, No.1

to the host government, which is "based on the scarce and significant resources the
fum can make available to the host nation" [13, p. 267]. For example, a fmn may
increase its bargaining power by up-grading product and process technology, developing
new products, increasing exports and intrafirm trade, and providing better management.
Whatever strategy adopted, it should follow logically from previous analysis, addressing
the key problems/issues identified and analyzed.

Phase Three: Implementation and Execution

Once the course of action has been charted, attention then shifts to the task of
converting the chosen, strategic plan into actions and positive results. It is often easier
to develop a sound strategic plan than it is to "make it happen." MNCs often devote
a great deal of time to analyzing the environment and fonnulating strategies, but then
fail to plan adequately for implementation. Although the basic approach to successful
strategy implementation is the same for both foreign and domestic operations, specific
issues and their solutions are often different because of a different set of influencing
environmental factors. There are a number of conflicts that can lead to implementation
problems. Phatak [12] notes that the basic cause of most problems encountered by
international managers can often be traced to conflicts between the basic values held
by two or more groups of people. For example, cultural differences with regard to
individualism, infonnality, materialism, time orientation, and authority may influence
a MNC's ability to implement a strategy successfully. To help alleviate strategy
implementation problems an international expert, or, even better, a specialist on the
specific country involved, is often needed. This person can often pinpoint likely
implementation problems and suggest ways to reduce them.

Phase Four: Evaluation and Adjustment

TIle last major step in the strategic political risk assessment process involves the
evaluation and, if necessary, the adjustment of the finn's strategy in light of changing
political, social, and economic conditions. After the strategic plan is implemented, man-
agement must recognize that periodic adjustments to the plan may be necessary. Man-
agement must ensure that the strategies employed to control political risk factors are
working. This requires that the MNC develop an intelligence system to monitor and
evaluate political developments. According to Micallef [10], the two primaty concerns
here are: first, the development of reliable in-house expertise; second, insuring that the
necessary infonnation is distributed to all relevant parties. Simmon [20] provides guide-
lines for MNCs interested in developing their own in-house monitoring capability, which
he refers to as an "Early Warning System." Feedback from those units monitoring the
political environment is an integral part of the political risk assessment process, leading
to revisions in political forecasts and, if necessary, corporate policy and strategy.



Spring 1992 Sauers: Political Risk Assessment

Organizational Integration of the Process

43

1be problems that plague the political risk assessment effort in MNCs can be traced
to the failure to fully integrate this function into the corporate planning and decision-
making processes. The strategic approach to political risk assessment outlined above
provides a general framework for the integration of this function into the strategic
planning process. How the political risk assessment function is carried out, however,
can and must vary from one institutional setting to another. The specific procedures
used must suit the organization, fitting what has been called the "corporate culture,"
or risk being ineffective no matter how accurate the assessment. While each
corporation will want to develop its own particular procedures, the chances for the
successful implementation of the political assessment function may be enhanced by
taking into consideration some of the factors discussed below.

For optimal results, the political risk assessment function must be completely
integrated into the organization's culture, structure, and strategic planning system. The
process described in this paper can be operationalized through the setting up of a
political risk assessment unit. Kobrin [7] argues most convincingly for the
institutionalization of political risk assessment. He sttesses that environmental scanning
and communication flows can be improved through the introduction of a political risk
assessment unit.

The support of top management for the political risk assessment function is
essential. Their role is to encourage communication with respect to political
developments between line managers and staff analysts. Resistance by the corporate
culture can be overcome by encouraging full participation in the political risk
assessment process at all levels of the organization. Line management involvement in
the assessment process can be encouraged by having line managers perform some of
the assessment activities. Simmon [20] suggests a division of tasks between corporate
headquarters and overseas affiliates, with the former responsible for macro risk analysis,
and the latter perfonning micro risk assessments. Line managers. however, will usually
need training to develop their assessment skills. Thus, the political specialists must
also play an educational role within the firm.

Structure can be built into the system with the use of questionnaire survey reports
to be completed by affiliates and assessed by headquarters [20]. A formal, systematic,
uniform procedure incorporating the use of objective data should be developed. At
the same time, however, ritualized, routinized, procedure-driven approaches that lead
to a lack of flexibility must be avoided. In turbulent environmental conditions, going
through the process is often more important than the final product.

From a strategic standpoint, the political risk assessment process must be proactive,
not reactive. The common reactive stance seems to occur because assessment resources
are limited and therefore used sparingly [9]. One solution would be to marshall all
the resources necessary for assessing initial investments, but make this first group of
resources self-liquidating, leaving only a modest group to orchestrate updates and
adjustments. Furthermore, while political risk forecasters must obviously evaluate
historical conditions and results, they must avoid merely extrapolating from the past.



44 Journal ofBusiness Strategies Vol. 9, No.1

A forward looking perspective is particularly important when developing a strategic
plan in complex and turbulent political environments.
< Finally, strategic decision makers should maintain a skeptical (but not cynical)
attitude toward political risk forecasts, particularly when experience is limited. On the
other hand. over-reliance on quantitative data and long-tenn forecasts by political
analysts should be avoided. Judgement should be used and forecasts limited to the
time horizon dictated by the nature of the investment. Political uncertainty makes
forecasting for longer time horizons an exercise in futility.

Political Risk Assessment: Theory versus Practice

In 1985. Daniels. Krug. and Nigh [3] published a study of the political risk
assessment approaches used by eleven American finns who were early entrants into
joint ventures in China. This study and a more recent study by Nigh and Smith [11]
of the assessment approaches used by nine American companies who were among the
first to enter joint ventures in the Soviet Union provide an unusual opportunity to
compare practice with theory. How do the political risk assessment approaches of these
two groups of American finns compare to the strategic approach set forth above?
Below, some of the significant differences are addressed.

The approach to political risk assessment used by these pioneering American firms
can best be described as infonnal and unstructured. Neither study found evidence of
the application of an institutionalized assessment function utilizing stmctured, systematic
analytical methcxls. Rather the approach used in most of the companies surveyed
involved intuitive judgements of the political risk, made by the CEO or another
e:xecutive with country responsibility or, less frequently. by headquarters staff.

In general, the finns surveyed did not report employing individuals whose primary
responsibility was to analyze political conditions in foreign countries. Two finns did
report having a s1rategic analyst at headquarters for whom political risk assessment was
a part-time responsibility ([3], [II)). Another finn employed one fun-time individual
in the international division to collect infonnation on political factors [3]. In another
finn, government affairs personnel were responsible for political risk assessment [11].

The political risk assessments concerning the joint ventures were seldom integrated
in any formal way with economic and other considerations involved in the establishment
of the joint ventures. In general~ they were integrated implicitly by an individual or
considered in discussions among executives as they attempted to form subjective
opinions on the extent of the political risk associated with their joint ventures. One
finn did report that it used the assessment to shorten the payback pericxl and increase
the return on investment criterion [11].

In setting up their joint ventures. each finn reported using some method to reduce
their vulnerability to political risk. These included insuring through the Overseas Private
InVe8bnent Corporation (OPIC). making small initial investments, and negotiating provi-
sions in the joint venture agreement for the United States partner~s withdrawal under
certain political conditions. Fmns having larger investments tended to strocture their fi-
nancing packages so as to shift the risk: to the lenders. Once the joint ventures became



Spring 1992 Sauers: Political Risk Assessment 45

operational, however, few of the finns continued to monitor political risk.
These findings concerning the political risk assessment approaches of American

finns operating joint ventures in China' and the Soviet Union are consistent with the
findings of an earlier Conference Board study which found that a fonnal political risk:
assessment function is still very much in the beginning stages of development in the
vast majority. of United States finns [4]. In general, a fonnal, systematic, and objective
integration of assessments of political factors into the strategic decision-making process
appears to be the exception rather than the rule.

Conclusion

Political risk assessment is still in its infancy. While there are numerous articles
discussing sophisticated political risk assessment techniques, most of these techniques
do not appear to be widely used. In addiction, integration of the assessment function
into decision-making tends to .be informal and WlSystematiC. The need for more formal
assessment of political risk and its implication for corporate decision making is apparent
The process described in this article provides a general framework which can help
management better integrate the political risk assessment function into its strategic
planning process. With more strategic assessment systems, there is less likelihood that
a finn will be deterred from investing overseas by misperceptions of the actual political
risk associated with its specific investment

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3. Daniels. J.D.• King. J. and Nigh, D. "U.S. loint Ventures in China: Motivation and
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	A Strategic Approach to Political Risk Assessment