Understanding and Managing Political Risk

An International Investor Guide to Political Risk

Tahrir Square - January 25, 2012

 Jonathan Rashad / Getty Images

International investing is a powerful way to diversify and grow a portfolio. However, there is often a higher level of risk than in domestic investing. Many of these risks are unique to international investing and can be caused by conflicts, unrest, changes in international policies between countries, and internal politics.

Political risk is among the most important factors facing international investors. In many emerging and frontier markets, the political situation is affected by more than influences within the country being considered. Conflicts in the Middle East, Chinese debt problems, American policies, and disputes over resources around the globe directly affect international investment opportunities.

What Is Political Risk?

Political risks are risks associated with changes that occur within a country's policies, business laws, or investment regulations. Other influential factors include international relationships and any other situation which may have an influence on the economy of a given country.

A common example of political risk is countries that are in political upheaval. Many countries are experiencing changes in social attitudes and perspectives as of late, causing unrest, changes in politics, and political movements that are disrupting economies.

Relatively new to the scene of political risk is technology. The rise in cell phone ownership allows everyone with a phone to be a photographer, journalist, or source of information. Confidence in investments, companies, and countries can be shattered within a matter of seconds of a video being posted online.

It's important to note that political risks aren't always well-defined—in many cases, the risks may be rumors with little or no substance behind them. International investors must, therefore, keep an eye on the news rather than just looking at just performance data to manage these risks.

The Impact of Political Risk

A rise in political risk has a variety of impacts on a country and companies operating within its borders. While the most noticeable impact is a decline in equity prices, many countries facing higher political risk factors experience reduced foreign direct investment (FDI), which can prove destabilizing.

A reduction in FDI can lead to slower economic growth across the board, as well as potential social issues. Social issues, such as wage gaps, inequality, and corruption, can lower the value of international equities.

These issues may also affect other asset classes. For example, sudden slower economic growth could impact a country or company's ability to repay its debts, which could impact the bond markets.

Slower economic growth or a crisis could also prompt currency-related issues. A decline in a country's currency value could, in turn, lead to slower exports and reduced economic growth.

Managing Political Risk

The first step in managing political risk is understanding that these risks are often worth taking in order to maintain a diversified portfolio. Even if you keep all of your investments in the U.S., you are still exposed to decisions made in Washington D.C.

Investors should maintain a diversified portfolio in order to avoid any specific political risk significantly impacting the overall portfolio. Diversification should include hedging the risk that is inherent to international investments.

International investors can manage risk by hedging their portfolio against future problems. For instance, an investor that senses problems arising in Brazil might decide to buy put options (the option to sell at a set price) on the iShares MSCI Brazil Index ETF (NYSE Arca: EWZ). If your put option is placed at the right value, you could significantly reduce your losses if the index were to fall or create gains elsewhere in your portfolio.

You should monitor your international investments for potential political risks. The CIA World Factbook is a great place to start with a wealth of background information on a country’s government, politics, and economy.

Watch for the Indicators

Some indicators to watch out for in the countries you may invest in are the rise of different or new political parties, upcoming elections, or any new trade agreements affecting a country. It may also be helpful to set up alerts or other automated reminders to keep track of potential political risks in key markets.

This way, you can be alerted early on when problems arise, and then take the necessary actions to reduce exposure to riskier areas. The key is to not overreact to the news but to determine what's truly happening and if it impacts your investments.

Frequently Asked Questions (FAQs)

What are the two types of political risk facing international companies?

Companies that conduct international business may differentiate between macro and micro political risks. A macro risk threatens the country's economic environment more broadly, while a micro political risk might only threaten a single firm. Changes in monetary policy are examples of macro risk. A labor strike over differences in working cultures could be an example of micro risk.

How do you measure political risk?

Measuring political risk isn't an exact science for all economists, but several have attempted to quantify it. "Political risk spreads" are one measurement that economists have come up with that includes factors such as bond liquidity and other country-specific economic indicators. Other economists have worked on firm-level calculations to estimate a company's political risk.

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