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POLITICALRISK:A REVIEWAND RECONSIDERATION

STEPHEN . KOBRIN*

Massachusetts Institute f Technology

Abstract. This paper has three objectives: First, to review the literaturedealing with theassessment and evaluation of political risk by managers in internationalfirms. Second, tobuild

uponthis literature

by extendingand more

precisely defining the concept in a mannerthat facilitates integration into the planning or decision-making process. Last, the paperattempts to suggest fruitfuldirections for future research.

Whenyou enter an endeavorunsuccessfullythen the planningwas incorrect.The riskwasabove the gains and you stumblealong the way... Sagacity, ingenuity,planning. it in-volves muchweighing,odds againstfailure,odds againstgain.

(Doc Graham nTerkel 60])

* While there has been increasing academic interest in the intersection of politics and INTRODUCTION

international business, it is still a relatively new and loosely defined field. It would ap-

pear worthwhile to review and summarize what has been accomplished thus far and to

look toward future needs. This paper will attempt to serve that end by focusing uponone of the more salient issue areas: the political risk associated with foreign invest-

ment. Ithas three specific objectives: to review the existing literature,to build upon thisliterature by attempting to define more precisely the concept of political risk, and to

suggest fruitfuldirections for future research.

Although the term "politicalrisk"occurs frequently in the international business litera- POLITICALture, agreement about its meaning is limited to an implication of unwanted conse- RISK

quences of political activity. It is most commonly conceived of in terms of (usually host)

government interference with business operations. Weston and Sorge's [64] definition

is representative: "[P]oliticalrisks arise from the actions of national governments which

interfere with or prevent business transactions, or change the terms of agreements, or

cause the confiscation of wholly or partiallyforeign owned business property" (p. 60).

Similarly,Aliber [2], Baglini [4], Carlson [11], Eiteman and Stonehill [16], Greene [23],The Journal of Commerce [28], Lloyd [41], and Smith [56] all explicitly or implicitly

define political risk as governmental or sovereign interference with business operations.This rather widespread conception of political risk in terms of government interferencewith private investment has important normative implications which will be discussed in

the next section.

A second major cluster of authors defines political risk in terms of events-either politi-cal acts, constraints imposed upon the firm, or some combination of both. While there

are differences among them, Greene [19, 20], Hershbarger and Noerager [27], Nehrt

[44], Rodriguez and Carter [47], Van Agtmael [62], and Zink [66] all equate politicalrisk with either environmental factors such as instability and direct violence or con-straints on operations such as expropriation, discriminatorytaxation, public sector com-

petition, and the like. Others-such as, Daniels [13], Dymsza [14], and Brooke andRemmers [9]-do not explicitly define the concept but rather note that the political

environment (or the environment in general) is a source of business risk for the firm.Robock, Root, and Haendel and West have considered the concept of political risk in

considerable detail. Robock [46] suggests the following operational definition:

... political isk n internationalusiness exists (1) whendiscontinuities ccurinthe business

*StephenJ. Kobrins Associate Professorof Managementat the Sloan Schoolof ManagementatM.I.T.His research interests nvolve he relationship etween international usiness and the politi-cal and social environment.

The author would like to thank Gene Carter,Joseph LaPolombara,DonaldLessard, BernardMennis,StewartMyers,DavidParker,FranklinRoot,and GeraldWest as well as several anony-mous referees fortheir criticism f his ideas and earlierdrafts of this paper.He suspects, that inmore than one instance, they would consider theirefforts less than successful. This articleisdrawn froma longer workingpaper whichcontainsa considerablymore detailed review of the

literature. 67



environment, 2) when they are difficult o anticipateand (3) when they resultfrompoliticalchange. To constitutea 'risk' hese changes in the business environmentmust have the

potential orsignificantly ffecting he profit r othergoals of a particular nterprise. p. 7)

The concepts of discontinuity and direct effects on the enterprise are central to

Robock's definition. He notes that while all politicalenvironments are dynamic, changeswhich are gradual and progressive and are neither unexpected nor difficult o anticipatedo not constitute political risk. He then clearly differentiates between political instability

and political risk: "... political fluctuations which do not change the business environ-ment significantly do not represent risk for international business .... Political instabil-

ity, depending upon how it is defined, is a separate although related phenomenon from

that of political risk" (p. 8). Robock also distinguishes between "macro risk" where

political events result in constraints on all foreign enterprise (for example, Cuba in

1959-1960) and "micro risk" which affects only "selected fields of business activity or

foreign enterprises with specific characteristics" (p. 9).

Root [50] defines political risk in terms of the:

... possible occurrenceof a political vent of any kind(such as war, revolution, oup d'etat,

expropriation,axation,devaluation,exchange controls and importrestrictions) t home orabroad that can cause a loss of profitpotentialand/orassets in an international usiness

operation"p. 355).

Root emphasizes the difference between uncertainty and risk (drawing both normativeand positive implications), attempts to separate political from other environmental risks,and develops several useful taxonomies. In a second paper [51] Root concludes that

the distinction between political and economic risks breaks down at the experientiallevel as a result of the "... interdependence of economic and political phenomena: [p.

3]. Still, an attempt at that distinction is made; [A]n uncertainty is political if it relates to

(a) a potential government act. . ., or (b) general instability in the political/social sys-tem" (p. 4).

Root also categorizes political uncertainties in terms of the manner in which they affect

the firm:(1) transfer-uncertainty about flows of capital, payments, technology, people,

etc.; (2) operational-uncertainties about policies that directly constrain local opera-

tions; and (3) ownership/control-uncertainties about policies relating to ownership or

managerial control (p. 357). He suggests that transfer and operations uncertainties flowprimarily rom political/economic events and ownership/control from political/social.

Haendel and West [24] focus upon a distinction between risk and uncertainty:between

"the probability of occurrence of an undesired political event[s] and the uncertainty

generated by inadequate information concerning the occurrence of such an event[s]"

(p. 44). Thus, political risk is defined as the "risk or probabilityof occurrence of some

political event[s] that will change the prospects for the profitabilityof a given invest-

ment" (p. xi). (They later note explicitly that political risk is both investor and investment

specific.)

The crux of their argument is that information-in this case informationabout the politi-cal environment-can help bridge the gap; it can enable investors to convert uncer-

tainty to risk that is, at least potentially, "measurable, insurable and avoidable" (p. 46).

POLITICALISK: One of the conclusions of this paper is that most managers' understanding of the con-

A RECON- cept of political risk, their assessment and evaluation of politics, and the manner inSIDERATIONwhich they integrate political information into decision making are all rather general,

subjective, and superficial. We would argue that while the literature reflects substantial

progress in a relatively short period of time, it still does not provide an analytic

framework which can adequately contribute-in either a taxonomic or an operationalsense-to improved practice.

As noted above, many authors simply view political risk in terms of an event occurring

either in the environment (for example, instability)or at the junction of environment and

68 enterprise (for example, a nationalization), typically associated with an act of govern-



mentthathas unfavorable onsequences for the firm.Scholarswho have exploredthe

issue in moredepth[24, 44, 46, 50] clearlydistinguishbetween the political vent1and

the actual loss or gain to the firm.They note that the consequences of any givenpoliticalevent for the foreign investordepend upon its nature,the conditionsunder

whichitoccurs, and the characteristicsof the specific investment nquestion.

However,the existing state of the art limitsoperationalizationn the context of the

investment(orreinvestment)decision process. First, he phenomenonis not defined in

a mannerthat allows for unambiguousclassificationof environmental vents: that is,which are of concern and whichare not. Second, while all of these authorsdeal with

uncertaintyntermsof bothenvironmental rocesses (continuousversus discontinuous

change) and decision makers'perceptions (uncertainty ersus risk), he two processesare not explicitly inked n a manner hat facilitates ntegrationnto investmentdecision

making.Third,the concentrationon discontinuouschange or uncertainty imits un-

necessarilythe scope of politicalanalysis. Last,the emphasis on the negative conse-

quences of government ntervention ntails an implicitnormativeassumptionthat maynot be universallyvalid.

Root is correct when he claims that the analyticaldistinctionsof the social scientist ThePolitical

break down at the experiential evel; society exists in the entirety.This most certainly Environmentapplies to economics and politics.Gilpin 17], among others [8, 40], has argued thatthe relationshipbetween the two is not at all distinct,but rather nteractiveand recip-rocal. Lindblom40] goes so faras to suggest that differencesmay be entirelypercep-tual.

It appears reasonable to ask whether there is any cause to consider the politicalenvironmentseparately-to distinguishbetween sources of business risk. There ap-

pearto be very pragmatic easons fordoingso. Economicsand politicsare sufficientlydistinct,both as abstractphenomena and in terms of their impact upon the firm,to

require eparate analysis and managerialresponse. Forexample, itshouldbe obviousthat a Japanese producer'sresponse to the U.S. impositionof steel triggerprices in

1977 would be quitedifferentfanalysis indicated hat the primarymotivationortrigger

prices was the need to preventthe alienation of importantdomestic interestgroupsrather han strict balance of paymentsconcerns.

Definingpolitics nterms of poweror authority elationshipsexercised in the contextof

society at large [15, 39] can usefullydistinguish t from economics. This paper is con-

cerned withevents, whetherthey appear to be politicalor economic (thatis, directlyconcerned with the productionand distribution f wealth), that are motivatedby at-

temptsto gain, maintain,or increase powerat the state level, "toinfluencesignificantlythe kindof authoritative olicyadoptedforsociety"[15, p. 127].

Althoughwe can distinguishbetween economic and politicaldeterminantsof events,

they are obviouslyinterrelated.First,at least in the short run,"politics argelydeter-mines the frameworkof economic activity" 17]. A change in regime can result in a

change froma market o a socialist economy (Cuba in 1959) or the reverse (Chilein

1973). Second, and following romthe first,politicalor powerconcerns often influenceeconomic policy.The converse is, of course, equallytrue.The production nd distribu-tion of wealth directlyaffect the distribution f power; however, the distinction hasheuristicvalue and can be appliedin practice.We wouldnot, forexample,consider a strike,or even a general strike,a political ventif its motivationresults from dissatisfactionover work-related ssues. However,wide-scale strikes in Nicaragua nJanuary1978 protesting he Somoza regimewere clearlypolitical.Similarly,a general strikein Tunisat aboutthe same time began as an eco-nomic event-a protestagainst wage restraints-and ended as a fullchallenge to the

Bourguibagovernment.

69



TheEnvironmentThe firmexists as a system withinan environment.How do political vents, whichoccurand the Firm: in the environment,affect the firm?The answer depends, to a large extent, on the

Perceptions nd nature of the worldfacing the firm.Three states of affairs-in terms of managerialImpact perceptionsof events and outcomes-are of interest.

If a single outcome can be unambiguouslyassociated with a given event, certaintyexists. The distinctionbetween the second and thirdstates, whichKnight 34] calledrisk and uncertainty,depends upon whetherprobabilities an be associated without-comes. Inthe former,one has perfect knowledgeof both all possible outcomes as-sociated withan event and the probabilityf theiroccurrence,either"through alcula-tion a priorior from statistics of past experience"[34 p. 233]. In the latter,neither

knowledgeof all possible outcomes nor "objective"probabilities in the sense used

earlier)exist. However,uncertaintys, followingShackle [54], bounded.Decision mak-ers can make judgmentsaboutmost of the important utcomes and theirlikelihoodofoccurrence. (Completeuncertaintys not of interest;it entails what Shackle calls a

"powerlessdecision.")To avoidsemantic confusion(for example, political isk,business risk,systematic risk)the firststate may be called certainty;he second, objectiveuncertainty;nd the third,subjectiveuncertainty.The distinctionbetween objectiveand subjective uncertaintys

quite important,particularlyn international usiness. Uncertaintys subjective in the

sense thatopinionsabout the relative ikelihood f events are based uponperceptionsthat are a functionof the available information, revious experience, and individual

cognitive processes whichsynthesize bothinto an imaginedfuture.

Itis clear that forvirtually ll business decisions of the type discussed here both cer-

taintyand objectiveuncertainty re ideal constructs. As the decisions can neitherbe

repeatednordivided-that is, treatedas one of a series of experimentsand pooled (ascan both deaths and auto accidents)-they are uniqueevents. Perhaps,more impor-tantly, he decisions are made by humanbeings in a very complexenvironmentwhichmakes it difficulto specify all possible, or even all important, lternatives.Since deci-sions are taken inthe present,possibleoutcomes must be imaginedoutcomes, existingsubjectively n the mindof the decision maker;however, both certaintyand objectiveuncertainty an be approximated.

Certainty an be approximatedby situationswhen one outcome dominates all others.

Thus,the probabilityhat the next Presidentof the United States willbe selected by aconstitutionalprocess and that he (or she) will not institutea programof broadscalenationalization f industry s so high as to be virtually ertain.Certaintymay also be

approximatedn situationsthat Robock[46] described as gradualchange, which onecan anticipate,based uponcurrent rends.Objectiveuncertainty an be approximatedby situationswhere, whileone outcome does not dominate,all feasible outcomes are

known, information s readilyavailable,and all (or almost all) observers agree uponprobabilities.Again,an examplewouldbe the outcome of most U.S. presidential lec-tions.

We can now return o the question of the impactof politics upon the firm.Several

preliminary ointsare in order.First,one can say only that politicaleventsmay

affectthe firm;whetherthey do so is a functionof bothenvironmental onditionsand industry-andfirm-specificactors.Acoup, forexample, mayplace a radical ocialistgovernmentin powerwhichexpropriatesall foreign-owned irms(as in Ethiopia);t may resultin aconservativegovernmentwhichactuallyreturnsexpropriatedproperty as in Chile in

1973), or itmaysimplyreplacegoverningelites withoutaffecting oreign nvestorsat all.

Furthermore,s manyauthors have noted (forexample, [46] and [50]), vulnerabilitysa functionof enterprise-specific haracteristics.Naturalresource-based investment is

generallymorevulnerable,ceteris paribus, han are manufacturingirmsproducing s-sential products.

Second, one must clearlydistinguishbetween the environmentand the firm.Instabilityis a propertyof the environmentand riskof the firm. It is the possible variationof a

~~70~firm-specific ariable(forexample, returns) rom ts expected value thatcan be caused



by environmental events. Last, risk may imply positive as well as negative variation

about the mean; it can result in gains as well as losses. The distinction between pure

risk, which involves only a chance of loss or no loss (for example, a fire or fraud), and

speculative risk, which involves the possibility of both gain and loss [31], is useful.

Given certainty, the firmdoes not face business risk; both outcomes of events and their

impact upon the firmare known; however, political events can still affect returns. As an

example, assume it is absolutely certain that a new government will come to power in

one month and that it will force a firm to divest 100 percent of equity in five years at

present book value. Although the political event will reduce the value of future returns, it

will not in any way contribute to their variation. There is no business risk associated

with the change in government.

However, once uncertainty is introduced, political events can both affect the expectedvalue of returns and contribute to their variation. Political events are now a source of

business risk. Whereas their impact upon the value of returns is not dependent uponwhether the uncertainty is objective or subjective, the nature and extent of their contri-

bution to risk clearly is. If uncertainty is objective, the contribution of political events to

business risk is a function of only the events themselves. Risk, then, is the distribution

of probable returns which is, ceteris paribus, a function of the probable impacts of

political events on operations.

If uncertainty is subjective, the contribution of business risk is a function of both the

events themselves and the fact that decision makers' perceptions of those events are

inherently subjective-distorted by past experience, cognitive processes and the nature

of the organization. This subjectivity factor is particularlyimportant in international busi-

ness operations where decisions are often taken in one sociopolitical environment

based upon stimuli arising in another. As will be discussed later, the survey data indi-

cate that managerial evaluations of political risk are typically subjective and ethnocen-

tric.

A better understanding of the political process in general, the political environment in

the country in question, and the potential impact of politics upon the firm's operationscan thus obviously reduce risk by reducing the uncertainty about the actual probabilitydistribution. However, the crucial point, one which forces us to take issue with the

existing literature (for example, Haendel and West [24]), is that while better informationcan help eliminate misconceptions about both the political environment and its impact

upon the firm, it can seldom convert uncertainty into risk or what we have called objec-tive uncertainty. Opinions formed about future events (and particularlyevents which will

take place in another culture) are inherently subjective. Hannah Arendt [3] put it well:

The worldappears in the mode of it-seems-to-me,dependingon particular erspectivesde-terminedby location nthe worldas well as by particular rgans of perception.Notonlydoes

this produceerror,whichI can correctby changingmy location,drawingcloser to what ap-

pears, or by improvingmy imaginationo take otherperspectives intoaccount; t also givesbirth o true semblances-that is truedeceptive appearances, whichIcannot correct ike anerror pp. 108-109).

The term "political risk" thus appears overly constrained from both an analytical and

operational viewpoint. What we are, or should be, concerned with is the impact ofevents which are political in the sense that they arise from power or authority relation-

ships and which affect (or have the potential to affect) the firm's operations. Not the

events, qua events, but their potential manifestation as constraints upon foreign inves-

tors should be of concern. Furthermore, although the same constraint (for example,restrictions on profit repatriations or a forced divestment of ownership) could be moti-

vated by economic as well as political factors (or both) depending upon the circum-

stances, the two may be differentiated to facilitate analysis and response. Last, politicalevents may affect only the value of returns, or they may also contribute to business risk

depending upon whether outcomes are evaluated under conditions approximating cer-

tainty or uncertainty. If that uncertainty is subjective, as it is likely to be in an in-

ternational business decision, the contribution to risk will be greater because one is

uncertain about both outcomes and the probabilities associated with them. Integration71



of the assessment of politicalrisk into the investment decision process will be dis-cussed next.

Integrationnto The integration f politicalassessments into decision making s not a subjectthat hasDecisionMaking been widelydiscussed. The literatureocuses typicallyupon derivingprobabilisticsti-

mates of politicalevents and theirimpact uponthe firmrather han howthe estimates

are utilized; his studyconforms o that tradition.Most authors who have considered the problemassume that decision makers willutilizepoliticalanalysisto adjusteithercash flowsorthe discountrate.Robock 46], for

example, shows how riskanalysis can be used to determine he political iskslikely oarise duringspecific time periods and then suggests that "the present value of ex-

pected cash flows, or the internal ate of return romthe investmentprojectundercon-siderationcan be adjustedto reflect the timingand magnitudeof riskprobabilities"p.17). (Inthe example thatfollows, however,onlycash flows are adjusted.)

Afterreviewingevidence showinghow most firmsanalyze political ndeconomicstabil-

ity,Stobaugh [57] suggests two more "sophisticated echniques":range of estimatesand riskanalysis. However,while both provideprobability istributions s well as ex-

pected values of cash flows, Stobaugh's examples entail only the adjustmentof the

level of cash flows.Stonehilland Nathanson[58] objectto simplediscountrateadjustments o reflectpolit-ical and foreignexchange uncertainties.They suggest that "A betterway to allowfor

uncertaintynthe multinationalase would be to chargeeach period's ncremental ash

flows the cost of a program f uncertainty bsorption or thatperiod,whetheror not the

programwas actuallyundertaken"p. 46). The programof uncertainty bsorption ouldentail the purchaseof additional nformation,nsurance(including nvestmentguaran-tees), hedging,and the like.They, in essence, recommendusing a market-determined

approximationf a certainty quivalent.

Shapiro[55] deals withpoliticaland economic risk,and specificallywithexpropriation,inthe context of the capitalbudgetingprocess. He notes that neitherof two methods(ahigherdiscountrate or a shorterpayback period)commonlyused to accountforpoliti-cal or economic risk "lends itself to a careful evaluation of a particular isk's actualimpacton investmentreturns.A thoroughriskanalysis requiresan assessment of the

magnitudeof the risk'seffect on cash flowsas well as an estimate of the truepatternofthe risk" p. 6).

Shapiro then develops sophisticated techniques for adjustingcash flows given the

probability f expropriation t a pointin the future.However,he assumes that 1) the

assumptionsof the CapitalAsset PricingModel are relevant;and 2) the risksin ques-tion are nonsystematic n nature.Thus, the cash flowadjustmentsreflectonlychangesin expected values resulting romthe impactof a given risk.

Althoughagreeing withShapirothat, in evaluating he impactof the politicalenviron-ment on the firm,boththe effect uponthe magnitudeof cash flows andon theirdistribu-

tion (thatis, risk)must be taken intoaccount,we would like to avoidenteringthe lists

on the questionof whether he firm hould be viewedas a social organization eflectingmanagerialutilities and riskpreferences)or as an agent of the stockholders.Instead,we suggest that the potentialeffect of politicsbe evaluated in terms of the continuum

discussed earlier. Underconditionsgivingriseto risk,whether one actuallyadjuststhediscountrate or not will be determinedby one's judgmentas to 1) the applicability fthe CapitalAsset PricingModeland 2) whether he riskis systematicor not.

Underconditionsapproximatingertainty,decision makersshould be concerned onlywithdetermining he effect of politicalevents on the magnitudeof cash flows. Risk,

clearlyis not a relevantconcern;however,politicalassessment and evaluation s still

necessary. Certainoutcomes are not inherently bvious;they are certain,given suffi-cient information bout the environmentandthe firm.

Under conditionsapproximating bjective uncertainty, he decision maker must con-2



sider the impactof politicson boththe expected value of cash flows and theirdistribu-tion (or business risk).The estimate of the contributiono riskwillflowsolely from thedistribution f the jointprobability f a politicalevent taking place and affectingcashflows.Last,underconditionsof subjectiveuncertainty,he decision maker s again con-cerned withthe effect of political vents uponbothexpected values and risk.However,in this instance risk is increased because one is uncertain about the shape of the

probability istribution.nfact one knows one's esimate is inherentlydistorteddue to

subjectivefactors and thatthe distortion an never be completelyeliminated.One additionalpointentails an implicitnormativeassumptionwhichis counterproduc-tive interms of the veryissue of concern:2Thetendencyto view political isk ntermsof

government nterferencewithone's operations.Much of the discussion of politicalriskappears to assume that governmentalrestric-tions on FDI-such as, partialdivestment or local content regulations-involve eco-

nomically nefficientand perhapseven irrationalamperingwithflows of direct invest-ment thatprovidenet benefits to theirrecipients.Itis obvious thatthisviewpoint s lessthanuniversally ccepted and that whatappearsas economic nationalism3o an inves-tormaybe regardedas an attempt o implementa policyof indigenous ndustrialization

by the host. In short, company and host countryobjectives differ and neither has a

monopolyon goodness and light.A perception o the contrary,whetherexplicitor im-

plicit,maywell increase the riskone is attemptingo evaluate.

A numberof empirical tudies have attempted o analyze the relationshipbetween FDIand environmental actors-typically measures of political nstabilityand market sizeand potential.Withsome relativelyminorexceptions the results are consistent. The

overwhelminglymportant eterminant f manufacturingnvestment is the size and po-tential of the market[20], [35], [61]. A director simple relationship annot be foundbetween a general notion of instability nd stocks or flows of FDI[7], [19], [20], [35].Forexample, inan early studyGreen[7] regressed stocks of U.S. FDI nmanufacturingand trade on an index of politicalnstabilitywhilecontrollingorgross nationalproductper capitaacross 46 countries. He concluded that political nstability id not affect theoverallallocation of U.S. marketingFDI. Ina 62-countrycross-sectional study Kobrin

[35] analyzed the relationshipbetween flows of U.S. manufacturingFDIand sevenindicatorsof economic, social, and political actors. While the environmental actorsaccountedfor 64 percentof the varianceof FDI,onlymarketsize, growth,and a meas-ure of priorU.S. export nvolvementwere significant.Therehave been several exceptions to the overallpatternof results. Green and Smith[22] established a weak butstatistically ignificantrelationshipbetween profitabilityfU.S. FDIand instability.However,methodologicalproblemscloud interpretationf theresults. Root and Ahmed[52] used discriminant nalysis to attempt o account fordif-ferences between three groups of countries based upon per capita inflowsof nonex-tractive FDI. While regularexecutive transfers was found to be a significantdis-

criminator,t was the fifthvariableselected by the stepwise procedure (the other fivewere marketrelated),and its explanatorypower,therefore,appearsweak. Last,Knick-

erbocker [33], in his study of oligopolisticreaction, found a significantrelationshipbetween a measure of entryconcentration ndan indexof stabilityacross 21 countries.He concluded that "oligopolistswere not inclined to make defensive investments inunstablemarkets" p. 184).At least two studies suggest a complex and indirectrelationshipbetween FDIand in-

stability.Thunell[61], in a longitudinal tudy, attempted o analyze the relationshipbe-tween major"trend"hanges inthe flow of FDI thesecond derivative)anda numberofindicatorsof elite and mass stability.An asymmetricalrelationshipwas observed. A

high level of mass violence precedes negativetrendchanges, whereas ittakes both alow level of violence and a governmenttransfer(whichThunellspeculates implies ashiftin policy) o generate a positivechange. Itshouldbe notedthat,although nterest-

ing,Thunell'sresults must be regardedas quitetentative due to problemsof compara-

bilityand the absence

(withone exception)of statisticalanalysis.

POLITICAL

EVENTSANDFOREIGNDIRECT

INVESTMENT

73



Ina studyof 48 countries,Kobrin36] founda significantrelationshipbetween flows ofFDI(controllingor market-relatedactors)and one dimensionof intrastate onflict: o-cused antiregimeviolence. The relationships intensifiedat higherlevels of develop-ment and when host countryadministrativeapacity is strong. Thatstudy concludedthatpolitical onflict has the highest probabilityf affectingforeigninvestors when it isof a natureand occurs underconditionswhichare likely o motivaterelevantchanges in

governmentpolicy.

Itwould thus appear that political actors are not a majordeterminantof FDI. To theextent that a relationshipdoes exist, it is rathercomplexand depends uponthe proba-bility hatinstability r conflictwillresult nchanges inpolicyrather hanindirecteffects

uponinvestors.

Itshould be obvious that all of the studies summarizedhave several glaringdefects.

First, hey all focus upon instabilitywhen it is clear that political nstabilitys neithera

necessary nora sufficient ondition orchanges in policyrelevant o foreign nvestment.

Second, they all utilize aggregate (typicallycross-national)analysis when the risk

posed by politicsis markedlyaffected by industry, irm,and even project-specificac-tors. (Thisproblem s somewhat alleviatedby the focus of most of the studies on the

manufacturingector.) Last,all the studies entailmajordata and methodologicalprob-lems ranging rom he use of compositeindices of instabilityo the almostuniversaluse

(withone exception) of cross-sectional techniques to investigatewhat is obviouslyalongitudinal henomenon.Insummary,while the resultsare usefuland interesting,heymust be taken as tentative.

THE POLITICALENVIRONMENT:

ASSESSMENTANDRESPONSE

Surveys of managerialassessment and evaluationof the politicalenvironment onsis-

tentlyreveal an interestingparadox.Withveryfew exceptions, managersratepoliticalinstability or politicalrisk)as one of the major nfluences on the foreigninvestmentdecision. Yet, again withveryfew exceptions,the same surveys report he absence of

any formalor even rigorousand systematicassessment of politicalenvironmentsandtheirpotential mpactuponthe firm.

Twoearlystudies-those of Aharoni 1] and Basi [5]-found thatpolitical r economic

stabilitywas the first factorconsidered in the foreigninvestment decision. A second

conclusion of Aharoni'sdescribed the assessment process: "Risk s not described interms of the impacton a specific investment.Itis, rather,described in general termsand stems fromignorance,generalizations,projection f U.S. cultureand standardstoother countries and on unqualified eduction rom some general indicator o a specificinvestment"(p. 94). As we shall see, little can be found in reportsof more recent

surveys to supporta challengeto Aharoni's onclusions.

Several other importanttudies were conducted(or reported) nthe late 1960s. In two

separate studies [48 and49], Rootsurveyedexecutives in a largenumberof U.S. firms

selected fromthe Fortune500 list. He reported hatwhile executives indicatedpoliticalrisks and marketopportunities re "the dominant actors in most (foreign) nvestment

decisions... no executive offeredany evidence of a systematicevaluationof political

risks, involvingtheir identification, heir likely incidence, and their specific conse-quences forcompany operations" 49 p. 75]. Furthermore,t is quiteclear that execu-

tives' subjectiveperceptionsof political nstabilitywere highlyinstrumentaln shapingtheir attitudes oward he safety and profitabilityf investmentclimates.

A 1967-1968 ConferenceBoardsurveyof investorsin twelve countries[43] confirmed

the earlier indings.First,estimates of political iskwere typicallybased uponsubjective

perceptions:"Thestudymakes it clear that obstacles to investmentexist in the mindof

the investor . certaincountriesare dismissed from considerationas investmentsites

on the basis of informationhatis incomplete,outdatedor in some cases even errone-

ous" (p. 2). Second, politics s perceivedas an important eterminant f foreign nvest-

ment,and a commonresponse to perceivedpolitical isk s avoidance.Studiesreportedinthe early 1970s-[45], [59], and [66]-added littlenew information.Whilepolitical r

quasi-political actors continued to be of majorconcern to investors, few U.S. com-4



panies had as yet developed techniques for assessing the politicalenvironmentor

evaluating ts impact upon operations.

The most recent studies reportedare monotonouslyconsistent withpreviousfindings.Intwo Conference Boardreports[37 and 38] LaPalombaraand Blank conclude that

whilesome sort of environmental nalysisexists inmostfirms, tis typically ather ooseand casual, developingand utilizing subjective"feel for the political ituation."Duringthe course of the study,variousplanningmaterialsand documents were reviewed. The

conclusiondrawn s to the point:"Moreoften thannot,the few paragraphsdevoted to ahost country'ssocial and politicaldynamicsis not betterthan one might indin leadingparentcountrynewspapers" (p. 65).

Drawingon his experience as a Vice Presidentof a majorbank, Van Agtmael [62]concluded that even large and active MNCsdo not analyze politicalrisk in a verysophisticatedmanner;and he agrees withother authorsthat the typical response to

politicalrisk is avoidance, "Even those corporationswhich have made commitments

overseas, by and large,tryto avoidpolitical iskby investing n 'safe'countries" p. 26).There remains one, somewhat specialized, area of the politicalenvironmentassess-ment literature-that dealing with the sovereign (or country)risk inherentin privatebanklendingto LDCs. Rather han extend what is alreadya rather engthypaper,thereadermay be referred o the following:Goodman[18], Mueller42], VanAgtmael 63],

and Yassukouich[65].Last,a briefreviewof the findingsof the literature n managers'sources of informationaboutpoliticsshows thatthe earliestfindingsstill stand. Ina classic study,which while

dealingprimarily ith radecertainlyhas broader mplications,Bauer,de Sola Pool, andDexter[6] concludedthat,to businessmen, knowledgeof the "outsideworld" ame ina

numberof ways:Itcame npart hroughheprinted ord, utwhat ame hatwaywassurprisinglyeneral ndunfocused.Ourrespondentsread Time,Business Week,The WallStreetJournal,The New

YorkTimes,andother uchjournals. heyreada greatdeal.Theyalso read radepapers.But,nmakingpecificbusinessdecisions,heydidnotdo researchnpublishedources....

Knowledgef foreign conomic ffairs ameeither romhe mostgeneralnews sourcesor,morevividly,rom orrespondencendpersonal xperiencep.470).

Zink 66] found thatmanagers'majorsources of political nformationwere reports romhost countryemployees, generalnews sources, and financial nstitutionsinthatorder).

Only 23 percent of respondents considered internalpoliticalstaff as an importantsource, and only 9 percent so rated outside consultants on a continuous retainer.

Keegan [30] concludedthat his studyof managersat MNCHeadquarters mphasized"how little he systematicmethods of informationcanning have become a partof the

way in whichexecutives learnabouttheirbusiness environments"p. 420). Executivesstationedabroad(butnot lower evel employees), banks,and the publicpress were themost importantources of informationorheadquartersmanagers.

The findingsreviewedhere are impressivelyconsistent. First, t is clear thatmanagersconsiderpolitical nstability r politicalrisk,typicallyquite loosely defined,to be an im-

portantactorinthe foreign nvestmentdecision.Second, it is justas clear thatrigorous

and systematic assessment and evaluationof the politicalenvironments exceptional.Most politicalanalysis is superficialand subjective, not integratedformally nto the

decision-makingprocess and assumes that instability nd risk are one and the same.The response frequentlys avoidance;firmssimplydo not get involved n countries,oreven regions, that they perceive to be risky. Last, managers appear to rely forenvironmental nformation rimarilyn sources internal o the firm.Whenthey lookforoutside data, they are most likelyto go to their banks or the general and businessmedia.

Existingscreening models fitintotwo general categories:those aggregatingsubjective ENVIRON-assessments (typically ia a Delphi method)and those relyingon quantifiedndicators MENTAL

of economic, social, and political actors. (A "soft/hard" istinction s not appropriate.) ASSESSMENT

The best known examples of the former are Haner's "Business EnvironmentalRisk METHODOL-5

OGIES4



Index" r BERI 25 and26] and the Business Internationalndexof Environmental isk

[10]. Bothattempt o assess the general investmentclimate n a numberof countriesbyusingthe Delphi echniqueto polla panel of experts. Haner[26] states that the objec-tive of BERI s to assess the business environmentn a country rom he viewpointof a

foreign nvestor six months to one year inthe future.

BERI'spanel assesses fifteen environmental actors quarterly forexample, politicalstability,attitude oward oreign nvestors,and economic growth).Eachpanelistscores

each factor and the responses are then aggregated with the factors not equallyweighted. The aggregate index and political,operations,and financialsubindices areavailable.The BIsystem is quitesimilar.

Whilebothindicesattempt o screen the environmentystematically, heirusefulness issomewhat limited.First, hey provideholisticrankingswhichare inherentlyndependentof firmor industryactors. More mportantly,hey relyon a panelwho maydifferwidelynot only in terms of rankings,but in how they conceptualize the phenomena beingevaluated. Last, while panel members are non-U.S. nationals,they also tend to be

employees of industrial irmsor financial nstitutions nd theirfundamental iewpointsare not likely o differgreatly rom he users of the service. The net result, is, as Hanerhimselfnotes [25], that the indexcannot forecast sudden changes in the politicalandeconomic environment.Again,however, both indices may be useful for general pre-

screening.A second set of methodologiesutilizesquantitativendices. Several authors[21] and

[56] simplyreviewexistingindicators ormodels)of political nstabilityntermsof their

managerialutility.There have also been attempts o develop moresophisticatedquan-titative ndices of political isk.Forexample, Haendeland West [24] suggest whattheycallthe PoliticalSystem Stabilityndex(PSSI)which s composed of fifteen ndicators f

the system's stability/adaptabilityrouped into three subindices:socioeconomic, gov-ernmentalprocesses, and societal conflict.A score and an estimate of confidence in

thatscore (1-5) are provided or the overallindex and each of the three majorsubin-

dices. Rummeland Heenan[53] suggest integrating ualitativeassessments (such as,relianceon "oldhands,"or Delphitechniques)withquantitativeassessments. As an

example, they utilize multivariate nalysis to predicttwo components of intrastate

conflict-turmoil and rebellion-in Indonesia hrough1980.Juhl [29] compares a numberof environmentalndicators, ncluding ourmeasures of

political nstabilityand BERI.The results are of interest. First,while the relationships(rankordercorrelation)between the various indices are typicallysignificant, hey are

ratherweak. Second, none of them accountfor morethan 25 percentof the varianceof

any of three indices of nationalization.Last,withone exception, the authorcould not

establish a significant elationship etweenthe BERINationalismubindexand flows ofFDI.

Although here are inherent imitsof aggregate quantitative nalysis-as with the Del-

phi techniques, it ignoresindustry ndfirm pecificfactors-it does offera greatdeal of

potentialas a basis for systematic and rigorousassessment of the politicalenviron-ment. (However, hatitcan now,or at any point nthe future,be utilized ndependently

of qualitativejudgments is not suggested.) In spite of the fact that most of themethodologiesdiscussed were developed to aid in internationalirms'assessment of

the political nvironment,hey stillmeasure political nstability ather hanthe potentialimpactof politicsuponthe firm.

The problem ranscendsthatof indexdevelopment.Whilemost authorsreviewedagreethatpolitical nstability nd political iskare distinctphenomena,the fact of the matter sthatenough is not known about how the former and the political nvironmentn gen-

eral)affects the latter o constructreasonablepredictivemodels.

76



Managers use a wide varietyof techniques to reduce and cope with uncertainty n CONCLUSIONS

manyareas of business operations.Mostfirms,forexample, would not even consider

basing a majornew product ntroductionn a generalizedfeel for the market.Rather,

they typicallyutilize a batteryof relatively ophisticatedresearch techniquesto aid in

reachinga judgmentabout both the product'spotentialand how to market t.Yet,judg-ments about the impactof politicsupon operationsappear, at least fromthe sourcesreviewedin this paper,to be rathersuperficialand typicallybased almost entirelyon

subjectiveperceptions.To be absolutely clear, "sophisticatedanalysis"is not equated here witha complexmathematicalmodel, butrather,what is suggested is a systematicand relatively igor-ous approachto data gatheringand problemsolving.Whilestereotypes are admittedlyunfair, he all too typical process, where political nstabilitys equated witha poor in-vestmentclimate and the marketavoided, is a long way fromthat ideal.The literaturereviewedin this paperreflects the substantialgrowthand developmentof a relativelynew area; however,some fairlymajorgaps must be filledif it is to contribute o more

systematic and rigorousassessment and evaluation of politics by managers of in-ternational irmsand to the effective integrationof the information nto the decision-

makingprocess. The lacunae that exist are both conceptual and empirical.We needbetterdefinitionsof the phenomena,a conceptualstructurerelatingpolitics o the firm,

and a greatdeal of information bout the impactof the political nvironment.The threeare, of course, related.

Althoughhis paper representsa preliminary ttempt o redefinethe concept of politicalrisk, much work obviously remains. In fact, the term "politicalrisk"might well be

droppedfromusage. (This suggestion, however, is probablya futileone.) It is overlyconfiningand confusing.Rather, he area of interest should be defined in terms of thecurrentand potential mpact(s)of the politicalenvironmentupon the operationsof thefirmwhere:

1. The politicalenvironment s circumscribedn terms of events which,howevertheyare manifest,are motivatedby or have as theirobjectivethe maintenanceor modifica-tion of poweror authority elationshipsat the governmental evel;

2. The impactof political vents uponthe firm s defined in termsof both effects upon

the magnitudeof cash flows or returnsand uponthe business riskassociated with heminthe context of a specific project.

3. A significant mpacton business operationscannot be assumed to be an inherent

property f any political vent.

Inoperational erms we are concernedwiththe probabilityhatchanges inthe politicalenvironmentwill reduce returnsto the point where the projectwould be no longeracceptable on the basis of ex ante criteria.Changes in the politicalenvironment anaffect returnsdirectly hroughdamage to plantand equipmentand degradationof the

economy as a resultof conflict.Returnscan also be affectedindirectlyhroughchangesin government policysuch as expropriation,ocal content regulations,and restrictionson the remittanceof dividends.

Last,researchmight

be focused on thefollowing

areas:

1. Empiricalanalyses of the conditions underwhich,and the process throughwhich,

politicalevents affect the firm. Furtherwork(boththeoreticaland empirical) s needed

to identify he types of environmental vents likely o affect operations,the conditionsunder which they are most likelyto do so, and the nature of the specific processthroughwhicheffects are transmitted.

2. Moredata on the effects themselves. Aside from some limiteddata on nationaliza-

tion, we reallyknowvery littleabout the relativeimportanceof actual constraintsim-

posed upon firms.Have, for example, pressures for local ownership,exchange con-

trols,directlimitson operations,or restrictions n fees and royaltiesresultedfrompolit-icalchange and how have they affected firms?

3. Additionaland more systematic studies of the assessment and evaluationof the

politicalenvironmentby multinational irms. What factors affect the way the assess-77



ment and evaluation process is organized and executed? Where is it located in the

organization? How is the resulting informationintegrated into decision making? Impor-

tantly, how does the process affect strategic decision making? Are there industrial or

national differences? What affects managers' subjective perceptions or politicalenvironments? How does information act upon them?

4. In depth case studies. Most of the research described in this paper is quantitativeand cross-national. While it has been a valuable aid in mapping out the nature of rela-

tionships between variables, thorough case studies are needed to flesh out the skele-ton. For example, a case study of the impact of a deteriorating political environment

(Argentina in the late 1960s) on foreign investors could aid in understanding the exact

nature of the impact of political events on foreign firms. Case studies could also help

compensate for the lack of time-series data.

5. Interdisciplinary research. Work in this area, by definition, implies that one draw

upon previous efforts in both management and political science; however, it is clear that

efforts involving a number of the social sciences such as economics, organizational

psychology, and anthropology are likely to bear fruit.

1. As Baglini 4] notes, the political vent is a cause of loss or a peril.

2. BernardMennisbroughthis point o my attention.3. For a discussion of "economicnationalism"ee Harry ohnson, "ATheoreticalModelof Eco-nomicNationalism n New and DevelopingStates,"PoliticalScience Quarterly, une 1965, pp.169-185.4. Whileit could not be reviewedinthis paper,the extensive literature n internationalusinessgovernmentrelations s obviouslyrelevant.Forexamplesee: Jack N. Behrman,J. J. Boddewyn,and AshokKapoor, nternational usiness-Government Relations(Lexington:LexingtonBooks,1975) and Business International,orporateExternalAffairs NY:Business International,975).

[1] Aharoni,Yair. The Foreign InvestmentDecision Process. Boston: Divisionof Research,GraduateSchool of Business Administration, arvardUniversity, 966.

[2] Aliber,RobertZ. "ExchangeRisk,PoliticalRiskand InvestorDemands for ExternalCurrencyDeposits."Journalof Money,Credit&Banking,May1975, pp. 161-179.

[3] Arendt,Hannah."ReflectionsThinking-Part I)."

The NewYorker,

21 November1977, pp.65-140.

[4] Baglini,NormanA.RiskManagementn International orporations.NY:RiskStudies Founda-tion,Inc.,1976.

[5] Basi, R. S. Determinantsof UnitedStates Private DirectInvestment n ForeignCountries.Kent:KentState University, 963.

[6] Bauer,RaymondA.,de Sola Poor,Ithiel,andDexter,LewisA.AmericanBusiness and PublicPolicy.2nd Ed. Chicago:Aldine-Atherton,nc.,1972.

[7] Bennett,Peter D., and Green, RobertT. "Politicalnstability s a Determinant f Direct For-eign Investment n Marketing."ournalof Marlting Research, May1972, pp. 182-186.

[8] Bergston,C. Fred, Keohane, Robert0., and Nye, Joseph S. "International conomicsandInternational olitics:A FrameworkorAnalysis."InWorldPoliticsand International conomics,editedby C. FredBergstenand LawrenceB. Krause.Brookings nstitute,Washington,DC,1975,pp. 3-36.

[9] Brooke, Michael,and Remmers,H. Lee. The Strategyof Multinational nterprise.London:LongmanGroupLtd.,1970.

[10] Business International. Y:Business International orporation, 969.

[11] Carlson, Sunne. InternationalFinancial Decisions. Uppsala: The Instituteof BusinessStudies, 1969.

[12] CitiBank.The Multinational orporation:An Environmental nalysis. InvestmentResearchDepartment,NY:unpublished,April1976.

[13] Daniels,John D., Ogram,ErnestW., Jr., and Radebaugh,Lee H. International usiness:Environments nd Operations.Reading:Addison-Wesley, 976.

[14] Dymsza,WilliamA. Multinationalusiness Strategy.NY:McGraw-Hill,972.

[15] Easton,David.ThePoliticalSystem. NY:AlfredA. Knopf,1968 (1953).[16] Eiteman, David K., and Stonehill, ArthurI. MultinationalBusiness Finance. Reading:Addison-Wesley,1973.

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