Political risk refers to the potential for an investment’s returns to be adversely affected by political changes or instability within a country. This can include a wide range of events such as changes in government, legislative adjustments, military actions, civil unrest, and policy shifts that may impact the economic environment and, consequently, the investments within that jurisdiction.
Types of Political Risk
Political risks manifest in various forms, influencing investments differently:
Governmental Risks
Changes in government or political leadership can lead to new policies that affect businesses, such as changes in tax laws, regulations, or nationalization of assets.
Economic Risks
Economic decisions based on political motives, such as import/export restrictions, enforcement of embargoes, or changes in monetary policies, can impact businesses and investments.
Social Unrest
Civil disorder, protests, and revolutions can disrupt business activities, damage infrastructure, and reduce investor confidence.
Legal and Regulatory Risks
Evolving laws and regulations, including those related to property rights, labor laws, and environmental regulations, can alter the operating landscape for businesses.
Historical Context
Political risk has been a factor for as long as investments have existed. Historical events such as expropriations of foreign assets in Latin America during the mid-20th century or the impact of the Arab Spring on Middle Eastern economies highlight the significant influence that political events can have on investments.
Examples of Political Risk
- Brexit: The United Kingdom’s decision to leave the European Union created significant uncertainty and volatility in financial markets.
- Venezuela: Nationalization of industries and hyperinflation have severely impacted foreign investments.
- Arab Spring: Widespread protests and regime changes in several countries led to economic instability and risk for foreign investments.
Mitigating Political Risk
Diversification
Investors can spread their investments across multiple countries to reduce exposure to political risks in any single country.
Political Risk Insurance
Insurance products are available to protect against losses due to political events, such as expropriation, nationalization, or political violence.
Due Diligence
Investors should conduct thorough research and analysis of the political environment and its potential impact on investments.
Comparisons and Related Terms
Economic Risk
Economic risk is broader and includes political risk as one of its components. It encompasses risks due to economic downturns, inflation, or currency devaluation.
Sovereign Risk
This type of risk refers specifically to the risk of a country defaulting on its debt obligations, which can be influenced by its political stability.
Market Risk
Market risk pertains to the potential losses due to market movements and is not directly linked to political events, but can be exacerbated by them.
FAQs
What are common indicators of political risk?
How can businesses protect themselves from political risk?
References
- Bekaert, G., Hodrick, R. J., & Zhang, X. (2009). International Financial Management.
- Wells, L. T., & Gleason, E. S. (1995). Is foreign infrastructure investment still risky?
Summary
Political risk is a critical consideration for investors, particularly those with international exposure. Understanding and mitigating this risk can protect investments from adverse effects due to political changes and instability. By employing strategies like diversification, political risk insurance, and thorough due diligence, investors can manage the impact of political risk on their portfolios.
