The Importance of Political Risk

By Robert Broadfoot, PERC, Ltd.

How much do political variables shape the business environments in Asia? Banks and companies invariably spend a large part of their research time and budget trying to understand the economic variables that, in part, define "country risk" (i.e., external environmental risks as opposed to risks that are internal to a particular company). To the extent that such data is available and quantifiable, those responsible for assessing country risk probably feel more comfortable focusing their attention on information they can put into computer spreadsheets and manipulate into specific forecasts. This is only part of the picture, however -- and perhaps not even the most important part. More than numbers, Asia is about people and the systems in which they live. Just as it is much less important to have access to a balance sheet of a typical Asian company than it is to know the dynamics of the families who stand behind these companies, macroeconomic statistics often tell little about the quality of the government that put them together. Yet it is the quality of the government (at the national and local levels) and its policies that often make or break the business environment.

Unfortunately, this type of information is highly subjective and usually very difficult to come by. However, the fact that it is hard to get your arms around social and political risks does not in any way reduce their importance or provide an excuse for not trying to factor them into a company’s strategic analysis and business plans. Yet the latter is exactly what many companies, banks and fund managers do. Just look at your own organization. How much time, money and effort do you spend collecting and analyzing macroeconomic and quantitative market information compared to more subjective information such as political risks, the potential for social unrest, and problems like corruption and nationalism? Do you rely on "gut feel" or do you have a more systematic way of analyzing socio-political variables and their potential impact on your business? Clearly you put in some effort. Your reading this article is proof of that. However, is the effort what it could or should be relative to your financial exposure?

In early 1997, just prior to the onset of the Asian economic crisis, we undertook a survey of US corporate headquarters in which we asked middle and senior managers of these companies with responsibilities for Asia to indicate how much weight they felt should be given to political risks in assessing total risks of a particular country. In other words, if the person was not at all concerned with political risks, the weight given to politics should have been zero, leaving 100% of attention toward analyzing country risks to be devoted to economic variables. On the other hand, if the respondent felt political risks overshadowed everything else, political risks should have received a 100% weighting. If political and economic risks were felt to be of equal concern, the ratio should be 50:50. We received between 25 and 40 responses per country, and we averaged the responses for each country to arrive at a composite score or weight.

Business Risks in Asia -- A US Perspective (October 2, 1998 update of survey originally undertaken in February 1997)

Importance of Degree of difficulty Country political risk of doing business:

               (1)        (2)

1. China 68.55 6.33

2. Hong Kong 62.32 3.61

3. Vietnam 56.54 5.75

4. Philippines 56.32 5.83

5. Taiwan 54.20 4.78

6. South Korea 50.24 5.62

7. Thailand 48.70 5.59

8. Indonesia 48.41 6.27

9. Malaysia 42.00 5.35

10. US 32.19 2.89

11. Japan 31.79 4.97

12. Singapore 27.07 3.50

    (1)  Measured as a percentage (%) of total country risk.

    (2)  Graded on a zero to 10 scale, with zero being the best grade possible, or an extremely hospitable business environment, and a 10 the worst grade possible, or a very difficult business environment.

Businessmen were most concerned about political risks in China and Hong Kong, which was understandable at the time, considering that Hong Kong's transition was less than half a year away and led to a number of questions in minds of many manager. How can you say you are very concerned about political risks in China and not put your concern about risks in Hong Kong on close to the same level? US managers did not yet lump Taiwan in the same boat as Hong Kong, but they may be moving in that direction.

At the other end of the spectrum are Japan and Singapore. Indeed, US corporate managers were more concerned about political risks in the US than they were in these countries. This does not mean that these countries do not face political problems -- certainly not Japan. But it does indicate that these problems, to the extent that they exist, are not perceived to impinge greatly on the operating environment or business development potential of the companies we interviewed. That said, even Singapore -- where concern about political risk was the lowest -- received a political risk weighting of 27%. This is a significant number, implying political risks cannot be taken for granted or completely ignored. Yet how many companies have done just that? Most do not even know what the real political dynamics or issues in Singapore are. How can you say political risks in Singapore are as low as they are when the island is situated beside two of the more volatile countries of Asia, namely, Indonesia and Malaysia, and its economy is very much linked to these two economies.

It is important to stress that these responses are perceptions from a rather limited sampling of companies, and that perceptions and reality are not necessarily the same thing. However, they do serve as a useful reference point of what companies in the West were thinking about political risks and the operating environments in Asia just before the meltdown. Corporate decisions are based on these perceptions. Communications between head offices and field staff in the countries concerned are shaded by them. So are premiums or discounts on such nuts-and-bolts issues as interest rates, forward foreign currency exchange rates, and credit ratings. Asian stock markets can also be jolted by political news, while longer-term political issues such as the kind that exist in Hong Kong can translate into lower p-e ratios for stocks of listed companies relative to markets where political clouds do not hang so heavily.

In some ways, the existence of political risks are good for business. They encourage trading volume on the foreign exchange and stock markets, for example, and the commissions to be earned by banks and brokerages on this higher volume are a major source of revenues for the financial sector. The scales can be tipped too far, however. This does not mean that money cannot be made in a panic situation. To the contrary, that is precisely when fortunes are often made. Unfortunately, it is also often when they are lost. When we undertook this analysis in February 1997, we warned that several countries in Asia could be entering such a period. We certainly cannot take credit for anticipating the intensity of the crisis, however, and the way that problems in one country could so quickly destabilize conditions in another country.

When we surveyed the US companies, we also asked the executives to rate the Asian countries with which they have first-hand experience in terms of their perception of the overall ease or difficulty of doing business. It is interesting to note that although there is some correlation between the weight given to political risks and the perceived degree of difficulty of doing business, the match is not exact. In a few cases, the differences are huge. For example, US managers may have had more political questions about Hong Kong than almost any other country except China, but they continued to find the territory one of the easiest places to conduct business. Taiwan also rated quite favorably. This could be explained by a combination of two factors: first, it is actually easier to do business in Hong Kong and Taiwan than in most other places in Asia and, second, the managers interviewed have more experience in doing business with these economies and, therefore, possess a greater understanding and confidence of how business is done there. From where we sit, the very favorable grade given to the US business environment would indicate that familiarity with an environment has a lot to do with perceptions of difficulty.

If this is so, then the grades describing the business environments in countries where Western business have less experience -- such as Vietnam, China and Indonesia -- might start to decrease over time, as the foreign companies gain more experience and confidence. On the other hand, this casts a very negative light on a country like Korea, where the foreign companies have had experience at least as long as in Taiwan and Hong Kong but still consider the environment to be comparatively difficult. The survey results also showed just how far the Philippines had slipped in many people’s estimation. In early 1997, it would seem to be rivaling Vietnam both in terms of perceived political risks and the degree of difficulty of the operating environment. This latter conclusion is not one we share with the respondents, and the relatively favorable performance of the Philippines economy during the crisis has underscored that the country has some strengths that were not fully appreciated. The Philippines may have slipped, but it is still an easier place for foreign companies to do business than in Vietnam, which is more of an unknown quantity. We are not surprised, however, that the Philippines was being compared more to Vietnam in the minds of many foreign companies. This is what can happen when a country allows its political situation to deteriorate to the extent the Philippines did in the early 1980s. A favorable reputation once lost can be doubly difficult to regain. We believe the Philippines is moving in the right direction again -- probably even faster than in Vietnam -- but it has a ways to go yet before foreign managers change their perceptions of the country’s political stability.

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