Emphasis on political risk has declined recently, relegated to the confines of specialty consultancies and research organizations. It was believed globalization and economic liberalization had ushered in an era of investment-friendly policy and technologies that afforded firms flexibility to sidestep operational disruptions caused by violence. The financial crisis and evolving global architecture has proven that instability still exists and dismissing political risk was premature.
Too often firms discount political risks to their strategies, costs, and returns. Events in Egypt help underscore the potential downfall of such miscalculations. These so-called “fat tails” are low probability high impact events. Egypt was once a stable, promising market, given the stability secured by President Hosni Mubarak and the country’s overall orientation. The Egyptian stock exchange, for example, was a top performer regionally, averaging five percent growth during the downturn, and according to the Financial Times, nearly $127 billion in direct investment flowed into Egypt since 2002, reflecting positive investor sentiment.
The difference could not be more different now that Egypt is destabilizing both politically and economically, and lacks certainty going forward. Ironically, it was Mr. Mubarak’s regime that set the stage for today’s instability, and the effects are being felt in all areas of business and finance.
For two weeks, Egypt’s economy has been paralyzed, costing businesses an estimated $310 million dollars daily. Its stock exchange, the EGX, has been closed since late-January, prohibiting portfolio investors from selling their securities and repatriating the proceeds. The EGX 100 dropped 16 percent for the week ending January 27, and will surely continue its selloff after reopening. Similarly, Egyptian banks have been closed amid concerns over bank runs. Investors and domestic depositors are withdrawing funds in search of safer havens. This banking shutdown makes it virtually impossible to conduct monetary transactions within Egypt or across its borders and it has even been speculated that the inability to withdraw cash for food and basic services has compounded Egyptian looting.
Meanwhile, foreign direct investment is at even greater risk. For instance, the crisis could escalate into more widespread political violence that damages on-the-ground assets, cuts into business income, and undermines operations with strikes, transportation disruptions, and telecommunications blackouts. The instability also damages Egypt’s economic outlook and returns on investment, and any regime change raises questions about the investment climate and future policy continuity.
Finally, there are export risks in play, including potential transportation disruptions, as well as counterparty risks should Egyptian firms be unable to fulfill their financial commitments to exporters. Many Egyptian ports have ground to a halt during the crisis, and while the Suez Canal remains open, circumstances are fluid. If the Suez were to close, the impact on global trade could be monumental, as the corridor is a major transshipment point for cargo travelling from the Middle East and South Asia through the Mediterranean. A shutdown would increase transportation costs and agitate oil markets, further raising input costs for producers worldwide.
These events demonstrate how political developments can cascade into international commerce. By providing a contextual example, Egypt should sound the alarm that political risk is still relevant, and perhaps even more so than before. Political risk may have been discounted, but in reality understanding the nexus of politics and business in the global economy is vital to protecting commercial viability.
Corporate risk management practices typically include a greater focus on operational or financial risks, not political uncertainty. According to a 2006 PricewaterhouseCoopers report, managers at many multinationals were not concerned about political risk. 73 percent of respondents stated they either lacked a fundamental grasp of the concept or felt their company’s political risk management processes were inadequate. Political risk must assume a larger role in how firms gauge market opportunities during strategic planning and operational phases, and prepare themselves in case of an unforeseen event.
Organizations that underestimate political risk do so at their own peril. Internationalization of global commerce means political risk is more important than ever before because businesses rely heavily on emerging market growth for trade, portfolio and direct investments, and banking. It is estimated that emerging markets account for almost 50 percent of world GDP, but these markets, while offering opportunities for growth, have unique political risks due to their instability and institutional weaknesses. Government intervention, social unrest, extremism, and coming conflicts over climate change, food prices, and resources are just a few trends positioning political risk as a key driver.
Firms would be well-advised to develop organizational structures and in-house processes that facilitate the gathering of environmental intelligence to identify, evaluate, and monitor political risk in the planning stages and as projects go operational. They also need to evaluate their preparedness to mitigate political risk using strategic flexibility to adjust operations, stakeholder management principles, and risk hedging facilities such as trade credit and political risk insurance. As uncertainty grows, due diligence and proper accounting of political risks will yield better, more secure results for multinational firms of the future.
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