How Does Political Risk Affect International Business?

Better times: It is what companies seek when opportunities in domestic markets are limited and sales are trending downward. At these times, companies may revise their business models, amend their marketing strategies and seek their fortunes in international markets. But doing so exposes them to new risks, including political risk.

To ensure a successful international strategy, businesses should take steps to understand the causes of political risk and its potential impact on operations and financial results. Businesses should also be aware of issues that influence political risk and how to manage that risk effectively.

Tip

Political risks can impact the value of a company, make it harder to operate normally and make expansion more difficult.

Political risk is an exercise of political power that can affect a company’s value. For example, a government embargo may prohibit trade with a foreign country, which will prevent the sale of a company's products in that country’s markets. A government may also prohibit the departure or arrival of merchant ships to and from its ports, which may prevent the shipment of a company's goods to its customers or the receipt of materials a company needs to manufacture products.

Political risk in international business results from various factors that can negatively affect a company’s income or complicate its business strategy. These factors include macroeconomic issues such as high interest rates and social issues such as civil unrest. Government actions, like confiscating a company's assets, make it difficult to acquire financing, which can affect the ability of a company’s supply chain to support production.

Other political events may mean a company will be unable to convert foreign currency, export or import goods and supplies, or protect in-country assets. According to Aon, a provider of risk management, insurance and reinsurance services, these and other effects of political risk can lead to higher operating costs, factory shutdowns and operating losses.

Companies that launch international operations must be alert to factors that contribute to political risk. For example, a change in a country’s leadership, or the rapid deterioration or improvement in a country’s economic environment, can affect the business environment.

Impending regulatory changes by government agencies, or even the frequent discussion of regulatory changes, are also causes of political risk. The same is true of changes in trade agreements made by multilateral agencies. Finally, current or imminent social unrest poses a major risk to a country's business environment.

Business leaders can manage political risk using a three-step process. First, risk managers must identify political risks — whether they come in the form of higher taxes, terrorist activity or something else — and determine how those issues might affect the company's ability to meet its business objectives. Next, managers must quantify the impact of particular risks on company performance using a financial model, such as discounted cash flow. Managers then connect that impact to a company’s risk tolerance.

For example, assume an international business strategy can increase returns by $1 million but expose a company to a $3 million loss. In this case, a company must decide whether to implement the strategy or forego it. If leaders choose to implement the strategy, they will implement a risk response to manage the risk, such as purchasing property insurance.