In the past, defining political risk was relatively straightforward. Today, however, it can arise from a variety of sources, including citizens making videos on cell phones, city officials passing ordinances, terrorists, cybercriminals and more. Our supply chains are longer, more vulnerable (as we have witnessed since COVID started); the geopolitical environment is more crowded and uncertain.
While political risk is hard to predict, that is not to say you can’t prepare for it. Effective risk management is still straightforward. Companies that excel at it are strong at understanding the four main effects that political factors bring to modern businesses: Economic Impact, Regulation Changes, Political Stability, and Risk Mitigation (more on this later).
What external environmental factors exist?
There are many external environmental factors that can affect your business. Managers are accustomed to assessing each of these factors closely to provide better decision making. Companies also consider legal, ethical, and demographic factors when pursuing risk mitigation.
The government's policy toward business often affects business in several ways. Because all businesses must follow the law, owners and managers must know how upcoming legislation will have an impact on their activities. After all, it is a responsibility of the business to operate legally, or face the consequences.
Politics can affect business organizations in many ways and could pose many different types of risk or even compromise the organization's profitability and survival. Businesses should be prepared to deal with local and global outcomes of external/environmental factors directly impacting their organization or industry.
The political factors potentially affecting your business are influenced by changes in the government policy, which can be economic, legal, social, or a mix of these factors.
Increasing or decreasing a tax rate is an example of a political element. The government might raise taxes on some businesses and lower taxes on others. Obviously, decisions like these will have a direct impact on your business. Therefore, you must stay aware of such political factors since government actions, such as shifts in interest rates, can influence demand patterns in your industry.
Political decisions can also affect or influence the economy, the socio-cultural landscape of your region or country, availability of new technologies, and even the acceptance of these new technologies amongst the greater population.
For example, corruption hinders economic development in many countries. Some companies are only able to thrive by offering bribes to government officials. They succeed despite not providing value to consumers. On the other hand, many companies cannot afford bribes and are therefore left in the lurches.
Think about common political factors that may affect your business. Here are a few examples and scenarios to consider when modeling your risk mitigation:
1. Property tax increases
2. Minimum wage increases
3. Reduction in program spending
4. War and civil unrest
5. Trade losses due to embargoes
6. Environmentally influences
7. Trade disruptions
8. Insurance costs increase because of reduction of law
How to model for risk mitigation of political factors.
There are four main effects that stem from these (and other) political factors on business organizations:
- Economic Impact
- Regulation Changes
- Political Stability
- Risk Mitigation
The economic settings of a country affect its political situation. The environment in which the business exists influences the business performance.
There are major differences between Democratic and Republican policies in the US, affecting taxes and government spending, and ultimately affecting the economy. Where your business is located, and which party is in the majority, affects your business’s situation.
For example, in a time of economic hardship, foreign governments or central banks may decide to restrict or prohibit the exchange of local currency for hard currency or will likely prevent hard currency leaving the country.
At almost any point in time, governments can alter their rules and regulations, and this could affect your businesses. For example, social environments urge changes to make public companies more liable and accountable for their actions.
Foreign governments could even seize, confiscate, or otherwise expropriate a company's investment for no reason or without justification. It can even affect a firm's overseas investments or assets if they adopt measures that have as effect of expropriation.
Political instability negatively affects companies that offer international services. Terrorism, war, civil strife, and other forms of political violence can destroy a company’s assets and prevent it from conducting operations crucial to its success.
An example is an aggressive takeover that might overthrow a government leading to riots, looting and general disorder. These disrupt business operations. Unfortunately, we are continuing to see this daily in some countries.
Companies with global operations can choose to purchase political risk insurance. This way, they can manage political risk and keep their risk exposure at a minimum to continue operating effectively with minimal interruptions. A good example of this is the index of economic freedom, which ranks countries based on how politics impacts business decisions there.
Why it's important to observe the political environment.
Firms need to assess their political environment because it can affect business strategy. Changes in the political environment affect business strategy in more ways than one.
Because there are so many potential political factors beyond the control of a business’s leadership, there are almost infinite ways that shifts in the political environment can impact your business strategy.
Considering these changes, and how they may impact your business or industry, is one of the key steps towards modeling risk mitigation.
For example, the stability of a political system can affect the appeal of a particular local market. Governments also view business organizations as a critical vehicle for social reform. They would be able to pass legislation impacting the relationship between your business and its customers, suppliers, and other companies, based on the reform they think is necessary.
Because the government is liable for protecting the public interest, this may not always align with the views or values of your organization. But government actions influence the economic environment, and your business must be prepared to adapt at a moment’s notice to survive. Something that many business owners never consider is the fact that the government is also a major consumer of goods and services. Getting (or losing) a government contract can be a huge game-changer for some companies.
How to prepare your company against political risk.
The impact of any one of these events on a business may not be isolated or short-lived, and may turn into a very serious problem, affecting the whole organization and even extending all the way back to your headquarters.
So, what can companies do to prepare for sudden, unexpected political risks?
The most important foundation of an emerging market business strategy is perhaps the combination of due diligence, ongoing research and political risk analysis.
It is crucial you have a clear and current political risk mitigation plan tailored to the “what ifs” in your market. Know how you’ll handle various types of risks ahead of time.
Communicate with your key external stakeholders about your contingency plans for dealing with unexpected political risks, where appropriate, and if it makes sense coordinate your response.
The recovery process is likely to be smoother and faster if you prepare for the event ahead of time and coordinate your response with your most influential stakeholders. Owing to the unpredictability of external environmental factors, it is important to have a detailed plan and a risk mitigation strategy to minimize risk.
In a world where political risk is rising to new levels, driven by a series of long-term and ongoing geopolitical events, comprehensive management of political risk can help protect company value and increase growth opportunities.
As a financial and business advisor, you can provide this value to your customers by passing on your expert knowledge of risk mitigation strategies and forecasting software.
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