by Platon Fakas
Until recently, the decision of a multinational corporation (MNC) to expand or invest in a new market was determined by using mainly economic criteria. The dominant rationale was that businesses do business and politicians do politics. Be that as it may, developments in the past years have made this distinction obsolete, with an increasing number of MNCs taking political risk into serious consideration.
Source: Yahoo! Finance
Why Politics Was Left Out of the Conversation
Economic analysis has been essential for investors, capturing the prospects of a country’s economy and producing certain metrics, which is essential considering how much people in business love numbers. By building models, economists can quantify the prospects and potential outcomes of an economy, thus reducing uncertainty.
While economic analysis will most definitely not go away, investors are becoming increasingly anxious about something they historically tried to avoid: politics. The lack of attention to politics by investors can be attributed to two factors. First, politics lies outside the areas of expertise of most people in business, who understandably prefer talking about the Fed’s decision to raise interest rates than the limits of state sovereignty. Second, political analysis is inherently different from economic analysis; it is mostly qualitative, and that makes people from quantitative fields feel uncomfortable. KPMG can forecast a 1.1% growth for the UK economy in 2024, but the Foreign Office cannot say whether the chances for the war in Ukraine to end in 2024 are 10, 30 or 50%.
Political Risk Coming to the Surface
That being said, developments in recent years have shown that ignorance of politics is not a viable option for MNCs that want to be successful in the new global geopolitical environment. According to the Global Risks Report 2023 published by the World Economic Forum (WEF), CEOs think geopolitics poses the third higher risk for global business in the next two years, after the cost of living crisis and natural disasters. Another survey, produced by Oxford Analytica, a leading geopolitical risk consultancy, reports that 9 in 10 businesses faced political risk-related losses in 2022. Out of them, only 20% said the losses were a direct result of the invasion of Ukraine, thus suggesting that the rising significance of politics in global business is a trend, not an one-off incident to a geopolitical crisis.
When talking about political risk for MNCs we generally refer to what Condoleezza Rice, former US State Secretary, defines as “the probability that a political action will significantly affect their business”. The question that reasonably one might ask is, what has changed in the past decade and has led to the spark in the interest of MNCs in politics-associated risks? While much can be written about growing instability in global politics, this article identifies four key parameters that are particularly relevant to global business: US involvement abroad, supply chains, social media, and domestic politics.
The Retreat of US Involvement Abroad
Saying that the US has traditionally been active in the politics of other countries is an understatement (or maybe, for some, a euphemism). After the collapse of the Soviet Union in 1991, international politics was characterised by the dominance of a single power, known as unipolarity in international relations lingo. An implication of that system of international order was that the US had the power to intervene when it deemed it necessary to maintain stability. American corporations operating abroad could be certain that the State Department would ‘never gonna give them up’, in Rick Astley’s words, in case of adversity in foreign lands.
Nevertheless, today’s reality is fundamentally different. Our world is multipolar, with the rise of powers such as the BRICS (Brazil, Russia, India, China, and South Africa). At the same, the failures of US operations in the Middle East, namely Iraq and Afghanistan, have created backlash against interventionism at home, with many American policy-makers being highly sceptical of any further involvement abroad. The election of Donald Trump 2016, who promised to end the operation in Afghanistan verifies this trend. In his influential article on political risk, Why Your Company Needs a Foreign Policy, Sir John Chimpan, CEO of the International Institute for Strategic Studies, argued that these developments mean that the US no longer is the “world policeman” who guaranteed a stable environment for global investment. In case of an unexpected political event, MNCs can no longer count on the US, something with tremendous consequences on how businesses now perceive political risk abroad.
Long Supply Chains and Geopolitical Concerns
One of the central advantages of globalisation has been rapid economic growth. By integrating to the global economy countries with cheap labour (mainly) in Asia, MNCs have managed to cut down their costs of production by relocating from the industrialised West to countries like China. The global production of goods takes place in different countries to minimise costs. A characteristic example is that until a typical H&M t-shirt reaches an American retail shop, different parts of its manufacturing have taken place in India, China, Cambodia, Germany and Sweden.
However, the recent Covid-19 pandemic and rising tensions between China and the West, such as the Sino-American trade war, demonstrate the vulnerability of long supply chains to geopolitical risks. The Oxford Analytica survey discussed above reports that the decoupling from China and economic nationalism pose a serious threat to global business, with 86% of the respondents thinking that de-globalisation will further intensify in the next few years. In this respect, before investing in a country, MNC must pay much closer attention to the relations of that country with its home country and its trading partners. The era of trade liberalisation is over, and companies must perform thorough geopolitical analyses before deciding to invest abroad.
Social Media and Public Opinion
With social media, everyone can now have access to the public for free, from the ease of their home, and within seconds. Effectively, the cost of collective action has fallen enormously. If a company engages in activities that are deemed unethical by the public, it is very easy for social activists to expose such behaviour, and for the company to receive widespread condemnation. In other words, MNCs are under tremendous reputational risk if they act in a way that is considered politically inappropriate.
Mcdonald’s decision to leave Russia after the 2022 invasion of Ukraine constitutes an exemplary case of how big corporations are now particularly cautious of political risk. To comprehend what this decision meant from an economic perspective, Russia was the 8th largest market for the American giant, employing 62,000 people, and grossing a revenue of $2bn in 2021 (9% of its global revenue). Mcdonald’s exit from the Russian market did not occur after an economic analysis, but a political one. As Nigel Gould-Davies puts it, the decision was the product of “a potent mix of geopolitics and ESG, with a dash of Twitterstorm”.
The Domestic Politics of Emerging Markets
The most fundamental axiom of investing is that it involves risk. If there was no risk, then there would be no reward premium. What follows from that is that the riskier an investment (or a market as a whole) is, the higher the returns. That’s why emerging markets have been attractive investment destinations.
The most common way in which investors have traditionally mitigated risk is by following a principle we all learn as kids: don’t put all your eggs in one basket. In the business world, that is called diversification, meaning investing in different and diverse industries to avoid the impact of industry-specific risks. However, a 2015 report by the Eurasia Group and Nikko Asset Management finds that risk in emerging markets becomes less “diversifiable idiosyncratic or stock-specific” and more “non-diversifiable macro-political risk”. Portfolio diversification is ineffective in times of crisis in emerging markets, as asset classes and securities become more correlated. Practically, that means that conventional risk-mitigation methods are incapable of dealing with the new sources of risk, which are political, not economic. The same report identifies as the sources of political risk the institutional capacity of a country to manage shocks, the uncertainty in its domestic politics, and how the government deals with issues of competition. Therefore, it becomes clear that companies interested in investing in emerging markets, and potentially enjoying the high returns offered by such markets, need a deep understanding of the domestic political environment of a country. Otherwise, they might commit the mistake of investing in markets that may be economically attractive, but politically precarious. If that happens, then the outcome of such an investment will be solely determined by the gods of luck.
Conclusion
Doing business and investing abroad comprise the central pillars of the global economy, and this will not change. Nor will the prominence of economic analysis in business and investment decision-making. What is changing, though, is the severity of political risk MNCs and investors are facing. To be successful in global business, it is now necessary to cultivate a thorough knowledge of both the geopolitical developments and the domestic politics of the respective country of interest. Corporations that fail to adapt to this new reality will soon find themselves risking running out business.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.