Measuring the impact of political risk on investment projects is one of the most vexing issues in international business, but this exercise is doubly important insofar as many of the most compelling growth opportunities reside in countries with weak institutional environments that are plagued by political risk concerns. While there are a number of tools available to help firms manage political risk—including, obviously, insurance—the pricing of political risk continues to frustrate practitioners and academics alike. This challenge has become even more pronounced as our understanding (or lack thereof) of the very nature of political risk realizations is evolving; the degree to which political risk events may be correlated is perhaps more nuanced than earlier appreciated. More on this shortly – first we have to establish some definitions.
Before proceeding, political risk requires a description. I realize that no universal definition exists – indeed, the inability to precisely measure political risk may partially result from a difficulty in coalescing around a precise definition to start. For the purposes of this article (and indeed throughout my own academic research), political risk for a given country is the risk that government actions adversely affect the value of an investment by a foreign firm in that country. This definition encompasses government-initiated seizure of private assets and creeping forms of expropriation such as unexpected taxes or royalties on profits. It also includes the instability of relevant government policies as well as the strength of the legal system, especially with respect to the enforcement of property rights. Finally, internal and external conflicts, such as general strikes, terrorism, and (civil) war are also typically categorized as part of political risk. Applying this definition of political risk, it is clear that the assessment of this category of risk is one of the most important challenges underlying foreign direct investment decisions.
The academic literature has traditionally viewed political risk, much like natural disasters, as country- or region-specific and diversifiable. An example of that type would be the retroactive taxation imposed on Vodafone in India – a largely country-specific event. If true, political risks can be diversified in the context of a portfolio of global corporate investments. While of first order importance for the particular investment under consideration, the impact of any potential political risk realization is limited in the context of a broader investment portfolio. The implications of the traditional academic view for a political risk insurance book are identical: an insurer with a set of potential liabilities spanning many different countries, industries, and project types is quite well-diversified. Similarly, while a natural disaster in one geographic area deeply impacts affected property insurance contracts, the insurer likely has a sizable collection of other contracts that are completely unaffected.
Such a world, if true, still requires multi-national firms to think deeply about the impact of a political risk realization for a proposed project. However, the pricing effect is relatively straightforward insofar as one has to ask what is the potential cash flow impairment (and correspondingly, what is the associated insurance premium that makes actuarial sense). Despite the long-held assumption that political risk is diversifiable and the observation that many political risk events appear country specific, recent academic research has begun to ask a more nuanced question. Specifically, researchers are beginning to explore the degree to which political risk pricing may be more complicated than earlier envisioned. Namely, what would political risk pricing look like in a world where adverse political decision-making may be endogenously associated with bad states of the global economy. In particular, does, say, a global economic slowdown or a commodity price plunge engender incentives among local political actors in weak institutional environments to behave in ways that negatively affect foreign firms’ cash flows?
Under such an assumption, a political risk realization looks less like a one-off natural disaster and instead reflects a degree of cross-event correlation inherited from the underlying global factors that are driving the altered incentive environment, even across potentially geographically disperse countries or regions. Here then, not only should a multinational firm work to get a handle on the degree to which future expected cash flows might be impaired, but an additional valuation discount is required to reflect the fact that such an event is more likely to materialize in precisely those same states of the world when the firm’s shareholders are facing other economic or financial challenges (and, by extension, a political risk insurer is facing multiple, correlated claims). This is the very definition of non-diversifiable, systematic risk, and pricing systematic political risk in such a world would be much more complicated.
This nascent research is thus far largely theoretical, but it is bolstered by some important empirical observations. In a recent article in the Journal of International Business, I (along with my co-authors Geert Bekaert, Campbell Harvey, and Stephan Siegel) have proposed a novel political risk spread that incorporates forward-looking market information to help facilitate pricing. In contrast to available political risk ratings, which are mostly subjective assessments of experts, it is very easy to incorporate our political risk spreads in a quantitative valuation analysis. We illustrate how to use our political risk spreads in project evaluation and how to extract the probability of an adverse political event. These measured political risk spreads do exhibit some cross-country correlations. We also developed a novel “big-data” media-based measure of political risk realizations extracted from a large database of news articles across countries and through time. Interestingly, our news-based political risk realization measures also exhibit a significant degree of cross-country correlation and are, on-balance, elevated during periods of global economic and financial stress. These observations together reinforce the idea that political risk may indeed have a systematic component.
Despite these early findings, it is important to stress that this research is quite young in its development, and one thing we academics who are interested in emerging market finance and political risk analysis suffer from is a dearth of data. For us to move forward to help shed more light on the nature of political risk, we need more and better data and a deeper understanding of how political risk insurers (at the forefront of this difficult pricing landscape) approach these topics. A willingness among this readership to share (with the appropriate non-disclosure agreements, of course) historical political risk insurance pricing data, along with information on insured projects, relevant events, recovery rates, etc., would help academics to dramatically accelerate our understanding of this question that is central to global firms, policy makers, NGOs, and political risk insurers. I welcome any readers to reach out to me (Christian_Lundblad@kenan-flagler.unc.edu) if you are willing to do so, or if you have additional thoughts to share or questions to ask.
Christian Lundblad is the Edward M. O’Herron Distinguished Scholar and Professor of Finance, University of North Carolina at Chapel Hill Kenan-Flagler Business School. His research spans asset pricing and international finance, with a specialization in emerging market development.