Managing the political dimension

Authors: Courtney Rickert McCaffrey with James Chang and Nick Consonery

The Argentine government’s expropriation of 51% of the shares of Repsol YPF, the largest oil company in the country, from Repsol, a Spanish oil group, has once again highlighted the political risks facing foreign investments. The case underlines the importance of a full assessment of political risk as a key step in the strategic decision making process. How are political risks evolving, and how can your business gauge the risks against the potential rewards in the most effective way?

Emerging and frontier markets have a stronger growth outlook than developed markets — 5.7% for the former and 1.4% for the latter in 20121 — so the former are increasingly attractive to business decision makers seeking production, sourcing and consumer sales opportunities. PwC’s 2012 Global CEO Survey shows that 80% of global executives are hoping to expand their customer bases in China, Brazil or India.2

However, business risks and opportunities are determined not only by a country’s economic growth prospects, but also by political risks and policy decisions. Political risk — the risk that a political action changes the expected value of an investment outcome — should be a key factor in your strategic investment decisions. This is especially important in certain emerging markets, where investors can come up against opaque and personalised governance, corruption, state capitalism, inequality and social unrest. Governments determine the degree to which they welcome foreign direct investment (FDI), and the stability of the regulatory and taxation environment for businesses operating in their country. These policies — and their efficiency and transparency — determine how much time and capital it requires to invest in a market and how onerous it is to maintain operations there.

Often more important than a static analysis of these issues, though, are the potential business risks arising from future policy changes. Many political, regulatory and tax risks are predictable. Such market-moving decisions are usually made by government officials with identifiable political motivations or known limitations on their authority. However, even unpredictable risks can be managed. Risk managers cannot always know when social upheaval will occur, but an analysis of political risks can predict which markets are more vulnerable to such shocks and how governments are likely to respond when they do hit.

Political risks can be measured, both qualitatively and quantitatively. Qualitative analysis relies on the knowledge and opinion of subject matter experts, while quantitative analysis is based on social, economic and political data to compare risks across countries. Static analysis examines the current political and policy environment in a country, while a trajectory analysis predicts the most likely future direction of these issues and how they will affect the sustainability of investments. In this article, we explore each of these types of political risk analysis. Your board-level decisions are likely to benefit from integrating analysis of these political risk assessments into your long-term growth strategies, helping you to mitigate risks today as well as those around the corner.

The impact of political risk

Political risk can take a variety of different forms. One of the classic examples of political risk is also one of the most draconian: government expropriation of business assets, as seen in the case of Repsol’s assets in Argentina. There is also a variety of other less extreme and less direct forms of political risk that can affect the business environment. For instance, government elections can create political and policy uncertainty in both developed countries (such as the presidential elections in France) and developing countries (such as the fractious election process in Egypt). In addition, broad-based social unrest can inhibit business operations, as seen during the Arab Spring demonstrations that began in early 2011. More localised social unrest directed against a particular industry can also affect investment returns, an example of which was the Chilean mining strikes in the summer of 2011.

One of the most direct political risks affecting a company’s foreign investment prospects is the government’s policy and regulatory environment for foreign direct investment. Some governments have implemented policies to attract foreign investment to bolster growth. In contrast, other governments have promoted investment by domestic companies or have burdensome and opaque policy and regulatory environments that inhibit foreign investment. Regardless of the macroeconomic conditions, markets in which governments have chosen the latter policies are likely to present foreign investors with more risks than the countries with more welcoming and transparent policy environments. Companies operating in markets with high-risk policy environments often face longer time frames to start a business; complex and often convoluted tax policies; and weaker property and intellectual property rights.

Sustainable investment decisions should therefore include an evaluation of political and policy risks in addition to the risks and opportunities stemming from countries’ economic growth trajectories and other relevant business and market factors. As shown in Figure 1, Eurasia Group has developed a simple yet robust framework for managing country risk by identifying and assessing threats and opportunities in growth markets. Figure 1 outlines a straightforward way to assess a comparative level of risk in high-growth markets, allowing strategic planners to assess the relative ease of operating in markets with similar growth potential. Some of these growth markets are more hospitable to foreign investment, and constraints on or barriers to economic activity are lower. We measure the ease of operating in particular markets with the policy environment risk index, incorporating data on policy stability, the regulatory environment, the government’s attitude toward foreign investment, capital movement risk and the protection of property rights. By identifying country positions within Figure 1, the framework provides strategic planners with a tool to evaluate the business risks and opportunities in each country.

Figure 1: Assessing economic growth and policy environment risk

Static analysis

The upper-left quadrant of Figure 1, ‘Forge ahead’, includes markets that are growing strongly and that have governments with policies and regulations that are favourable to foreign investment. For instance, Thailand has one of the best regulatory environments among Southeast Asian emerging markets, and the bureaucracy works hard to attract foreign investment, particularly in the manufacturing sectors. After severe flooding in the country last autumn, the government earmarked 350 billion baht (US$11 billion) for implementing a master plan on integrated water management to prevent future flooding and encourage foreign firms to remain in the country. In Australia, which is currently benefiting from a natural resources boom, the government welcomes foreign investment without restrictions on local content or local hiring. In November 2011 there was a clear example of this open door when the government approved the acquisition of brewer Foster’s by SABMiller.

In the upper-right quadrant, ‘Develop strategies’, robust economic growth creates business opportunities, but these governments may favour domestic over foreign investment as a means to promote growth. Depending on the severity of the government’s policies, foreign investors may face higher costs of market entry than domestic firms or may be barred from investing in the country altogether. Such policy conditions pose risks to investors, but the strong economic growth also creates opportunities for firms that are able to successfully navigate the policy environment. A potential solution is for foreign companies to partner with domestic firms when investing in such countries.

A similarly mixed investment outlook characterises markets in the lower-left quadrant, ‘Seek opportunities’. Countries that fall into this category currently have slow economic growth or are contracting, so their domestic demand is likely to be weak. On the other hand, these governments are implementing policies that are favourable to foreign investors. If they attract enough investment, their internal demand prospects could improve. Such markets could provide an opportunity to make relatively inexpensive investments or acquisitions now, allowing your business to establish a base of operations for future growth. Alternatively, these markets may be favourable sourcing locations, as the policy environment is welcoming and labour and other inputs may be relatively inexpensive. For instance, ongoing tax and labour market reforms in countries such as Spain and Italy are likely to reduce the costs of doing business in those markets.

Finally, the lower-right quadrant, ‘Proceed with caution’, encompasses countries in which economic growth is weak and the government’s policies are largely unfavourable to foreign investors. Investing in such markets involves taking on a high degree of risk. Although such markets may offer only limited opportunities to foreign investors in the short- or medium-term, there may be strategic reasons for attempting to enter them now to set up long-term opportunities. In Egypt, the political situation is volatile as the country continues to deal with the ousting of Hosni Mubarak and as it fitfully attempts to move toward democracy. Despite this ongoing uncertainty about the political environment — and the resulting policy environment for foreign investors — there are still opportunities in this market. For instance, small oil exploration and production firms have made a number of deals and discoveries in Egypt in the past year. The recent political unrest is likely to prompt the exit of some companies, presenting opportunities for established players — for instance, Apache — to consolidate their holdings or for new players to enter.

Trend and trajectory analysis

In addition to a static analysis of these issues, it is important to understand the recent trends and likely future trajectories of policies in individual markets in order to anticipate changes in the business environment. For instance, China has made considerable efforts in recent years to move toward a rule-based strategy to attract investors and improve laws and regulations regarding FDI. Although investors still come up against challenges such as weak protection of intellectual property rights and a lack of regulatory transparency, the business environment is likely to remain stable until the leadership transition is completed in 2013. In contrast, Hungary’s government made a number of anti-market moves in the last year, including the introduction of a number of so-called crisis taxes levied against the banking, telecommunications, retail and energy sectors, and the de-facto nationalisation of the country’s private pension funds.

In Brazil, the government is open to foreign investment, but protectionist policies in some sectors, such as oil and gas, will limit the opportunities for private investment. Corruption and bureaucratic hurdles can be a burden on companies when navigating the numerous federal, state and local agencies that issue licences required for project approval. Brazil’s policy environment for FDI is expected to improve in the long term, albeit slowly, as the government introduces incremental changes to increase economic efficiency. Foreign firms may also find it difficult to enter the Indian market due to the collage of regulations, licences and permits required to operate. Although the government is likely to adopt more positive regulations in the long term, it is making only small steps toward that goal in the short term. For instance, in January the government removed the FDI cap on single-brand retailers, but a similar regulatory reform for multi-brand retailers is unlikely to follow soon.

Sustaining investment in the long term

Businesses are looking further afield as they strive to sustain long-term growth. Increasingly, this means operating in diverse markets around the world, which requires an assessment of the various risks and opportunities. The sustainability of investments depends not only on near-term economic growth, but also on other factors that make an investment sustainable in the long term, including broad political risks and the policy and regulatory environment. As businesses seek growth in new markets, many executives focus on market-entry risks, but underestimate the risks that come with sustained market presence. The political, economic, social, security and policy environment can change rapidly, so decision makers must constantly monitor political risks and assess how business practices should evolve to profit from the changes underway in markets around the world. As such, your organisation should incorporate an analysis of political risks in key markets into your investment strategy framework in order to ensure that business decisions made today remain sustainable tomorrow.

Will economic reform continue in China?

James Chang’s view

China’s economic development has achieved remarkable success, averaging double-digit GDP growth over the last three decades as a result of a ‘reform and openness’ policy adopted by the central government in the late 1970s. However, the reform, to a larger extent, maintained a command-and-control political system, evidenced by a direct role of government in allocating resources and deciding business affairs, and significant state ownership stakes in key sectors and enterprises.

To address the increasing social and economic inequities and at the same time keep the economy growing, some Chinese leaders are calling for some reform of the political system, which signals political volatility ahead. Within the Communist party, there is an increasingly visible divide over how to handle these new challenges. On the one hand, the conservatives support a strengthening of China’s socialist roots and the use of state intervention to redistribute wealth, the so-called big government and small society. On the other hand, the pro-reformers advocate more opening up through administrative transparency, political diversity, market economy and public participation, or big society and small government.

We have seen a series of recent developments indicating that the country’s pro-market leaders and reformers are gaining some momentum ahead of the critical once-a-decade leadership transition later this year. If successful, the breakthroughs will cement the foundations of a market-oriented economy and promote completion critical to China’s efforts to achieve sustainable and innovation-driven growth of enterprises and the financial system.

One milestone was the recent release of the China 2030 report before the annual two meetings, jointly issued by the World Bank and the Development Research Center, a government think tank under the State Council, China’s top executive body. Subsequent speeches by government officials and leaders have confirmed the reform agenda, including controversial moves to limit the scope of state-owned enterprises and a wide array of financial-sector reforms, including expediting interest-rate liberalisation and the lifting of controls on international capital flows in the near future.

Another example was the announcement of a recently approved plan by the central government to set up a pilot zone in the eastern coastal city Wenzhou, known as the nation’s private financing hub, to regulate and develop private financing activities, encourage individual funds to set up rural banks or small lending companies, as well as allow individual investors to make direct overseas investment. The plan signals the central government’s willingness and determination to boost the private sector, promote a more versatile and competitive financial sector, and loosen control of the capital account and foreign currency policy.

As China gets close to the leadership change, the country has reached another turning point. The upcoming transition represents a rebalancing of power between two competing factions, and each side has consolidated an impressive amount of power and developed personal strongholds in the state, party and military over the past decade. It will be difficult for the party to apportion power neatly between the internal political divides, as evidenced by different personalities, conflicting reform agendas and different perspectives on the challenges China faces. The politics of determining which side will control the the Politburo Standing Committee is unsettling the preparations for the new leadership generation. Ultimately, whoever ‘wins’ will shape whether China will further economic reform or will take a harder stance, and inevitably will have a significant financial and economic impact on the nation.

Nick Consonery’s view

Investors should not conclude that recent political maneuverings in Beijing, including high-level discussion of economic reform and the ouster of the once high-flying politician Bo Xilai, suggest the relative rise of economic reform as a priority within the Chinese government. Indeed, the reform trajectory in China remains very much unsettled.

The good news is that it appears that reform-minded officials in the government have recently launched a concerted campaign to influence the policies of the next administration, which comes to power in March 2013. Coming amid this important political transition, the recent spate of reform rhetoric is a major sign of life among liberal officials and thinkers in China, who are pushing back against advancing state involvement in the economy and pervasive ‘reform fatigue’ over the last several years.

The push for reform was best embodied by a recent major policy paper jointly published by the World Bank and the Development Research Center of the State Council. That well-publicized report called for a vast array of economic and political reforms in China, many of which are already contained in China’s 12th Five-Year Plan. The report sets a framework for China to avoid the ‘middle-income trap’ that has bedeviled many developing countries; it is an effort to nudge the Chinese leadership, amid a political transition, past the politics of status quo.

But it is precisely because of the ongoing political transition that any bold reform actions will be deferred. Stability is the overriding objective for top leaders this year, and major reform undertakings would risk that mandate. Instead, over the next year Beijing will continue to muddle through with marginal economic adjustments and hope to keep the economy above the 7.5% growth target set by the government for 2012.

Why is reform so challenging? In China, the notion of ‘reform’ means different things to different people, many of whom find certain changes detrimental. Indeed, the political and bureaucratic constraints in China are so severe that reform will become the work of a generation. And the risk is that China’s political environment could defeat many elements of the reform agenda.

Given the current political climate of caution, proceeding timidly is the most likely outcome for now. Beyond 2013, the success of reform will rest largely with the next generation of leaders. Yet the reality is that change will be borne of economic and political urgency, and China’s leadership does not appear to be facing either at the current juncture. Overcoming such hurdles will be the key determinant of how successful China will be in transforming its growth model over the next decade.


1 International Monetary Fund: World Economic Outlook (Copyright (c) 2012 by International Monetary Fund. All Rights Reserved.), published on 17.04.12
2 1,250 CEOs from 60 countries were polled at the end of 2011 as part of PwC’s 15th Annual Global CEO Survey, published on 25.01.12