Risk Formation and Management in International Business

Tilburg University

Risk Formation and Management in International Business

van Wyk, J.J.

Publication date:

2006

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Link to publication in Tilburg University Research Portal

Citation for published version (APA):

van Wyk, J. J. (2006). Risk Formation and Management in International Business. [n.n.].

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Take down policy

4,

1

Risk Formation

and

_Management

in International

Business

Risk Formation

and

_Management

_{in International}

Business

Proefschrift

ter verkrijging vandegraad vandoctor

aan deUniversiteitvan_Tilburg,

op gezag vande_{rector magnificus, prof.dr. F.A. van der DuynSchouten.}

inhet openbaar te verdedigen ten overstaan van

een door het_{college voor promotiesaangewezencommissie in de Ruth First zaal} vandeUniversiteit

op woensdag8november 2006 om 10.15 uur door

Jacobus Johannes van Wyk

.:

Promotores: Prof.dr.F.A.L.Caeldries

Prof.dr.ir. M.H. Corbey

1

Acknowledgements

I would liketoexpressmy gratitude forthe encouragement and support Ireceivedduring the

research and_{writing ofthis project to Mary Custy,FilipCaeldries.Michael Corbey. Neil}

Contents

Introduction 1

Chapter 1

Political

Sources

of International

Business Risk 5

Chapter

2

HIWAIDS

as

Business Risk:

A

South

African

Case

_{Study 58}

Chapter

3

External

Risks and the

_{Global Supply Chain in the}

Chemicals

_Industry

105

Chapter 4 Risk and FDI

Flows to

_{Developing Countries}

150

Chapter 5 The Impact o

f Institutional

Change

on

Political Risk in

Developing Countries

185

Chapter

6

Conclusion

232

Endnotes

241

Introduction

InternationalBusinessischaracterized by its JanusFace: representing both negative and

positivedevelopments.Risk reflectsthenegativefacetofInternationalBusiness. and

internationaltrade and investmentsreflect opportunities orthepositivefacet

of

International Business. Intheglobalizedeconomy.risks broadly refer tothoseactivities thatareharmful to businessprofitability. WestandHamel₍₂₀₀₅₎describe the last decade asaperiod of flux for the

international investmentcommunity.Onecouldarguethateconomic slumps,political instability

andfinancialcrisesdefine theera. _{Major financial}crisesin Mexico, EastAsia. Russia and

Argentina inhibitedthe_growthofthe _globaleconomy and deterred investorsfrom venturing into

some emergingmarkets.International conflict. such astheterrorist attacks in NewYork.Madrid

and London as well as the IraqWar. eroded consumerconfidenceandeconomic growth. World

oil priceshaverisen steadily since the endofthefirst Gulf War in 1991.butspikedrecently. partly duetopoliticalinstability in suppliercountries suchasNigeria.SaudiArabia and

Venezuela.The scourge

of

HIV/AIDS andthethreat

of

loomingpandemics. e.g. SARS. Bird

Flu,exposedinternationalbusinesses to loss ofintellectualcapital and other operationsrisks.

The positive side ofthe Janus-Face is represented by the businessopportunities in a

globalizedeconomy. Theglobalization

of

markets andproduction. stimulated by the

liberalizationoftradeandinvestment regulations.hasfostered increasedinternationaltrade and cross-border investments. (He. Elahee,Engle. Nehrt& Sadrieh,2007)These developments were

particularly fueled by high growthrates in the_{US economy and the emergence}ofChina as a

fast-growingeconomy.Institutional developments. such as the WTO. EU.NAFTAandother

free_{trade agreements. have generatedglobal "rules-of-the-game". This}accommodated the

ideology in countries whichwereformerlysubjectedto commandeconomiesorexcessive state

intervention.

Despitethe_{opportunities}forincreased_{profitability.}international firmsmaystill

encounteran_array

of

environmental risks which

will

impose unanticipatedcostsand reduced

expectedprofits.Such risks entail

(1) the deepening

of

regulatoryregimes due todomesticpressurefor protectionismthat plagues

developing as well asdevelopedcountries:

(2) unpredictable policychanges inunconsolidateddemocracies where renewedgovernment

intervention inthe economy comes at the expenseofprivatizationandmarketentryfor foreign

firms: and

(3) tlie growingdispute betweendevelopinganddevelopedcountriesover piracy

of

intellectual

property rights intheformerandprotectionism oftheagriculturalsector in the latter.

The Janus-Face analogy represents thecontext of riskininternationalbusiness and

ofthe

five essays inthis study. Thefiveessays arealsoplaced inaresearch context.Almostthree

decades ago.Kobrin (1979). inhisseminalwork.posedfiveresearchchallenges forthestudy of

political risk. Hecalled for

1. empiricalanalysis oftheconditionsunderwhich. andthe processthrough which.political

eventsaffectbusinesses.

2. more data onthe effects themselves.

3. additional and more systematic studiesoftlieassessment andevaluation ofthepolitical

environment

of

multinational firms.

4. in-depthcasestudies. and

Thefiveessays inthisanalysis address many

of

Kobrin'schallenges. Chapter 1 sets the

stageby investigatingthe_political sourcesofinternationalbusiness risk.This_essayoutlines

a sequential flow of theformationofbusinessriskembedded ina_{macro-system's analysis of}

politics. The analysisisinterdisciplinarysinceitintegrates. ina single framework.

management theories of risk andriskmanagementwith political sciencetheories of the politicalsystem.

The essay in Chapter 2.HIV/AIDS asabusiness risk in SouthAfrica.embraces the

Kobrin_{challenge morefully.}Theframeworkof_{analysis developed}in _{Chapter 1} isutilized

foran_in-depthcase_{study of the pandemic as}abusiness risk in SouthAfrica. This is an

appropriatecasesince SouthAfrica isthecountry withthehighestHIV/AIDSprevalence in

the world.Thepoliticization oftheepidemic inthe SouthAfrican politicalsystem exposed

the businesscommunity.bothdomesticandforeign. toarange of newandchallengingrisks.

In Chapter3.anothercase _{study isexplored. which deals with}theimpactofexternalrisks

on the_{globalsupply chain of the chemicalsindustry.}Thelevel

of

_analysisutilized is industry-specific, global inlocationand focuses onanessential businessfunction.i.e. supply chain management. The essays in thefirstthree chaptershighlighttheimportanceofthe

effectofrisks. i.e. loss_{ofprofitability.}The_{importance of riskmanagement is also}

emphasized.Riskmanagement choicesaretaken on the strategiclevel. i.e. make-or-buy. and

on thepolicy level.i.e. decisionchoicestomitigaterisks.

In Chapters 4 and 5. thefocus is. in line withKobrin's_{challenge. onempiricism and}

interdisciplinaryanalysis. Empirically. thetwo studiesutilize multivariate polynomial

theories which cover management. politicalandsocial sciences. andmacroeconomic

theories. However.theissuesaddressed in Chapters 4 and5differ.Chapter 4 analyzes the

impactofexplanatory variables. including risk.onforeign direct investment. Thisstudy represents the Janus-Face

of

internationalbusiness bydealing with both riskandopportunity. In Chapter 5.theimpactofvariousinstitutionalchanges onpolitical riskis_{investigated. This}

is compatible tothe processes.conditionsandenvironments of risk formationtowhich

Kobrinreferstoabove.

References

He. X.. Elahee.M. Engle, R..Nehrt, C..& Sadrieh. F.(2007). Globalization and international business: livingevercloser together.Garfield Heights. Ohio: NorthCoastPublishers. Inc. Kobrin. S.J. ( 1979). Political risk:areview andareconsideration. ./Otti7ial of International

Bi,si,iess Sti,dies, 10: 67-80.

West. G.T.&Hamel. K. (2005). Witherthe_politicalriskinsuranceindustry?In Moran. T.M. & West. G.T. (eds.)Internationalpoliticalriskmanagement:looking tothefuture.

Chapter 1: Political

Sources

of

International

Business Risk

Theconceptual literaturestreamof political risk (PR) iswellendowedwith definitions as

wellaseffortstodistinguish PRfromrelated.

if

over-lapping.concepts suchasinstability and

uncertainty.(Brewer. 19838:_Fitzpatrick.1983;Kobrin. 1979)The_empiricalstream of PR

literaturehasextensively investigatedtherelationshipsbetweenpolitical risk andavariety of

other business risks suchas_{exchange rate}fluctuations(Cosset. 1985:Siokis& Kapopoulos,

2003).private investmentin_{developing country infrastructure (Doh}

&

Ramamurti. 2003).

strategicrisk (Slywatzky, 2004; Noy

&

Ellis.2003), modes

of

_{entry into foreign}markets

(Ahmed. Mohamad. Tan&Johnson. 2002).portfolioinvestments (Cosset&_{Suret. 1995).}

industryandmacro-risks_{(Jones. 1984).}international_{stock exchangelistings (Cheung & Shum.}

1995), andforeign directinvestments (Chase&Walther. 1988).

Given the poor predictability ofPRassessments._{often as part}ofcountry risk. Brewer

( 1983b)haschallenged scholarstoexploremorefullythepoliticalcontext of PR.Auseful approach isto explorethepoliticalsources

of

international business risk that

will

bypass the

artificial separation of PR fromother business risks suchasfinancial. macroeconomic and

operationalrisks. Suchanapproach topoliticalsourcesofbusiness riskalso raises theissue of

causality.Cause-and-effect is oneofthemostintriguing dilemmasofthesocial sciences.

(Dessler, 1991) Evena_{cursory analysis of}PRdefinitionsreveals cause-effect_{relationships. Such}

causes_{include ' discontinuities: -political}events"._{"unpredictable change". and "political} decisions. eventsor conditions". Effectsfocusonadverse_{impacts on the firmor industry such as}

will

loosemoney or not make asmuch money astheyexpected when theinvestment was made".

(Robock. 1971: Root. 1972:Howell. 1992)

The analysis ofthesources of PR lies inthe nexus betweenpolitical science and management science. Inthisanalysis. thepoliticalscience concept

ofpolitical

system may be

fused withthe management scienceconcepts of risk and riskmanagementto explore causality in

internationalbusiness risk. The argumentinvestigated isthat businessrisk formation is a

sequential process that evolvesthroughthefunctioning ofthepoliticalsystem as aninput-output model.

This studyisorganized intothree parts. Thefirst part outlinesthenotionof political

system asa conceptualframework fortheanalysis ofthepolitical sources

of

international business risk.The second partillustrates thatthevarious functions ofapoliticalsystem are

inexorably linked tothe process

of

businessrisk formation. Thisprocess may be viewed as a

number

of

sequentialsteps.Thethirdpart suggestsvarious policy options available to the

international firmto managerisks emanating frompoliticalsources.Anumber

of

propositions

are deduced fromthediscussions_{in parts two}and threefor_{future investigation.}

Sources andImpacts: APolitical SvstemAnalvsis

The concept

of

politicalsystemrefers tothepoliticalactivitiesand processes of a

society.2Theconcept is notconstrained bythe legaland institutional content

of

terms such as state.nation orgovernment. Thedistinctive functional characteristic ofthepoliticalSystem

includes all interactions thataffect the useorthreat of useoflegitimate physical coercion.Easton (1953) speaks

of

"authoritative allocation

of

values" and Dahl (1963)

of

"power, rule and

system. it willnotsolely relyon force orcompulsion toset miles

of

society. Inpoliticalsystems

withhighlevelslegitimacy.thegovernment will rule withtheconsent oftheruled.

Thevariousfunctional parts ofapoliticalsystemareinterdependent. Interdependence means that when theproperties ofonecomponent ofasystem changeinmagnitudeor quality.

the othersaresubject to strain and totransformation:the system changes itspattern of

performance.the_unrulycomponentis_{disciplinedby regulatorymechanisms. or the system may}

suffer_{from dysfunctionalities if}itscopingmechanismsare_{inadequate. Inpolitical systems. for}

example. the successful emergenceofnewforces. such asacompetitivemarket economy, mass

politicalparties and freedom

of

political_{communications.}

_will

change theperformance of all the

structures of the system and. thereby.influence thegeneralcapabilities ofthesystem in its

domesticandforeignem ironments. Such systemtransformation may takeawhile to consolidate

sincenew_{politicalstructures may}co-existwith_existingstructures.

The_{politicalsystem} isembedded in itsenvironmentwith_penetrableboundaries. A

politicalsystemhasboundariestoward othersystems:social, cultural.economic. otherpolitical

systems. andregional. internationaland_{globalsystems. Due to manyboundary-crossing}

activities.theboundaries ofapoliticalsystemaresubject torelativelylargefluctuations. For

example, inanelection.boundaries_greatlyextend.asvoters become_{politicians for a day.}

OrganizationalAspects of thePoliticalSystem

Role andStructure

The concepts roleandstructureareimportant in understanding boundary-crossing

activities. Roleandstructure.rather thanofficeor institution.are_preferredbecause

of

their

processesarereferred toaspoliticalroles suchasvoter. lobbyist. party activist or legislator. Individuals performroles ina_variety

of

_{systems other than the}politicalsystem such asbusiness manager. consumer. church member orparent ina_family.Aparticular set

of

roles that are

related toperformaparticularfunction isastructure.Thus.judgeship is a role andacourt is a structureofroles.

Froma_{business perspective. roles such}asconsumer andsupplier mayhavepolitical

relevance.Theintroductionofprotectionistmeasures bygovernmentin response to the demand

oflocal _producersfor_{protectionagainstforeign competitors is. in}essence.a_politicalaction.

This

will

impactondomestic consumerswhowililikely pay more fortheprotected products or

services. and whose choices

will

likely be limited.3 A firm may alsoberegarded asastructure.4

Fromashareholderperspective. a firm isa_privateand_{non-political}structure. However. from a

stakeholder perspective. a firm may have manyconstituencies oftenwithdefinite_political

involvement. such asNGOs.laborunions andgovernment agencies. State-owned enterprises

(SOEs).in contrasttopubliclytradedor_privately ownedfirms.are_{overtly instruments of}

government policy. SOEsareoftenmonopolies which eliminateor constraincompetition thereby

limitingprice competition andthe choices

of

consumers and suppliers.

Structures may cross theboundaries ofthe_politicalsystem ifthey pursuepoliticalgoals.

For instance. i fatrade association or afirmundertakeslobbying.itcrossesthe_{boundary from} theeconomicenvironment intothepoliticalsystem. Related andinteractingstructuresrefer to a

subsystem.forexample. thevariouscommittees ofalegislature.Amultinational corporation

maybe_{regarded as}a_{subsystem. The}subsidiaries of MNCsoperate in the businessenvironment

of

variouspoliticalsystems. In addition.thesegmentation ofaMNC's value-creation chain may

countries. For the MNCtocoordinateallthesefunctions. itoperates asasubsystemcutting

across theboundaries ofmanypoliticalsystems.in short.political systemsarecharacterized by

ever-changing roleandstructural differentiation.

Political Culture

The actual performance orbehavior ofthepoliticalsystemhasunderlying psychological

propertiescalled thepoliticalculture._{(Almond & Verba, 1963)}Itconsistsofattitudes.beliefs.

values andskills thatarecurrent inanentirepopulation. Political culturealso capturesnotions of

political and_{economic ideologies regarding}the desired nature_{ofgovernment and/or the} economy.Althoughtheimpact

of

cultural differences oninternational business is well

established. thepolitical dimensionsofculture havebeen_{under emphasized. Hofstede's (1994)}

seminal workon_{comparative cultural dimensions}focuseson_{important structural levels of}

analysis(family,school.work place)andorientational levelsofanalysis(individualism. collectivism). However. he didnot analyze theimpact

of

culture onthepoliticalsystem. This

analysis aims torectifythatomission.

Political culturerefers toasenseofnationalidentity or. in the case

of

transitional

societies. the process

of

secularizationtodevelop suchanidentity. Secularizationmeans that a

setof_{codified. specifically political and universalistic rules}has_{eclipsedrigid.}ascribed and

diffusedcustomsofsocial interactions.For international firms. secularizationenhances transparency.predictability and low risk: conditions conduciveto trade andinvestment.

AlmondandVerba(1963) distinguishthreebroadtypes

ofpolitical

culture: parochial,

subject andparticipant. In parochialsystems.individuals manifest marginalawareness or

participation in nationalpoliticallife. Otherassociations(ethnicgroups. regions.local

identificationhinders thedevelopment

of

secularizationandnational identity. Insubjectpolitical

cultures. individualshave awareness of thepoliticalculture andtheimpact which itsoutputs may

haveupontheirlives. but they are not oriented to participateintheir input structures. For

instance. incontemporaryRussia. thegrowing concentration

of

economicandpoliticalpower in

theexecutivebranch

of

governmenthasdilutedthe advances inpoliticalandeconomic

liberalization. The resulthasinhibited inputofdemands inthepoliticalsystem. InChina, the past

decade haswitnessed advances in thesecularization of theeconomy and the business

environment: however,thepoliticalsystem remains entrenched inauthoritarianism andasubject

political culture.6 Inaparticipantpoliticalculture. individualsareoriented totheinputstructures

and processes ofthepolitical system.Individualsengage in. orviewthemselvesas_potentially

engaging in.thearticulation

of

demands and themaking

of

decisions. This is more in line with

orientationsin_{developed countries where choices in}political.economicandsociallifeunderpin the behavior

of

roles andstructures.

Politicalculture. froma_{business perspective.}refers tothe_{political-economic}ideology of

acountry.particularly.theinvolvement ofthepoliticalsystem inasociety's economic life.

Politicalandeconomic life maybedifferentiated ortheboundariesbetween_{politics and}

economics may be diffused. In the case of differentiation.afree market ideology will more likely

prevail. In the case

of

diffusion. the politicalsystemspenetrationoftheeconomy may be

pervasive asin centrally plannedeconomies orpredatory dictatorships. Onthis

differentiated-diffused continuum. various permutations ofamixed economy maybefound. Indeveloped

countries.thependulumswings moretowards differentiation and. indeveloping countries. it

swings moretowardsdiffusion. However.theimpact

of

globalizationhasoften stimulated

contrast, the pressures

of

globalizationarepowerful drivers

of

tradeliberalization inthose

developing_{countries that endeavor tomaintain ortoimprove comparativeadvantage in an}

increasingly competiti\'e global marketplace.

Asubculture refers to thepsychological orientation

of

distinctivegroupswithin the population suchasethnic_{groups. social}classesand_{religious affiliations.} Some societies_display fragmentedpoliticalcultureswhenvarious_{groups dispute the desiredproperties of}the_political

culture.often_{resulting in competing}orhostilesubcultures.

Functional_{Aspects of the}PoliticalSystem

Thepoliticalsystemhasvariousfunctionalprocesses:inputs. conversion.system

Boundary

INPUTS CONVERSION

OUTPUTS

interest Articulation

Regulative

Demands

Interest Aggregation _Extractive

Political

Distributive

Supports

Communication

D D -7

Environment _Responsive

Regime & Political

Symbolic

Authorities

Rule Making _Destructive Rule Application

Rule Adjudication •

SYSTEM MAINTENAP CE & ADAPTATION

/1 1

m.

Political Socialization/PoliticalCulture

2/

Political

Recruitment

a.

-i

Inputs

Thus far.thepoliticalsystem hasbeendescribedasconsisting

of

interacting roles. structures and subsystems. andanunderlying political culturethataffectstheseinteractions. Thefirstfunctional

processis_{inputs. Inputs mayoriginate fromother systems present in theenvironment or from}

withinthe_{politicalsystemitself. Twotypesof}

inputs maybeidentified: demandsand_supports.

A variety

of

demands may be made upon_{thepoliticalsystemincludingdemandsforgoods and}

services. demands for theregulation

of

behavior.demandsforparticipation inthepolitical

system. and demandsforcommunicationforinformationandaffirmation ofnorms. The

realization of_{demands depends uponsupports suchasresources}

(payment oftaxes).

participation (voting). andthelegitimacyofthe politicalsystem.Generallyspeaking. demands

influencethepolicies orgoals of thepoliticalsystemwhilesupportsprovidethe means to effectuate its goals.

ConversionProcess

Theconversionprocessinvolvestheconversion

of

inputs intooutputs.Anumber of

distinct functions maybeidentified.Thefirst conversion_{process is}interestarticulationwhich

represents the processwherebypressure groups.lobbies and NGOsmake demands on the

political system. Various kindsof_{interest groups may}be_{distinguished: anomic interest groups}

suchasriots. demonstrationsand consumerboycotts: non-associationalinterest groups based on

ethnic.class andkinshipties:institutionalinterest groups suchaslegislativecommittees. bureaucratic agencies and themilitary:andassociational interest_{groups such}astrade associations and_{professionalbodies. Successful interestarticulationis predicatedon}

appropriate

accessto decision-makers._{The foreignness}

of

international firms inhost countries isaninhibiter

personalcontactswithelites and (2)the_development

of

_{networks. especially}the_{sharing of}

informationwithdecision-makersand interest groupswithcommon_goals.

The secondconversion_{process is}interestaggregation whichcombinesdemands into

alternative policiesbypoliticalpartiesor movements competingfor politicalpower. The

businessorientationsoftheruling party and_oppositionparties(potential rulers)are_powerful

clues to the natureofthebusinessenvironment whichexists or maypotentiallyemerge in a host country.Therefore.theinterestarticulation efforts

of

trade or business associationsareoften directedatpoliticalparties topromote favorablebusinessconditions ortomitigate potential

business risks.

Thethird conversionprocess entails thosefunctions normally associated with

governments,i.e.authoritativerulesareformulated (rule-making),rulesareappliedandenforced (rule-application).and these rulesare_{adjudicated in individual}cases_{(rule-adjudication). The}

threerule functionsrefer_{to government functions performed}bylegislatures.executives.

bureaucracies and thejudiciary.respectively. For therulefunctions. itisimportant to distinguish

between_regimeand_{political authorities.}(Easton. 1965)Aregimerefers to basic procedures andrules.regularizedmethodsfor orderingpoliticalrelations andastructure

of

_{authority in a}

politicalsystem.Ultimately. fortheoutputs ofthepoliticalsystem tobeacceptedasbinding.

members ofasociety(polity)must accept some basic procedures and rulesrelated tothe means

throughwhichcontroversyoverdemands is regulated and settlements forged.Aregime

embracesvalues. normsandstructuresofauthority.Valuesreflect principles. rights and

ideologies. Fromavalue perspective. regimes maybeclassifiedasdemocratic. authoritarian.

modernizing autocratic.and_{military.Regime}normsrefer_{to procedures that}are_{expected and}

structure

of

_authorityrefers to thedivisionandorganization

of

power.forexampleaworkable

constitution,independentjudiciary. etc. Thegeneral acceptanceofregime values. norms and

structures by society conferslegitimacy onaregime. Regimes that fail to meetsuch expectations

or supportare_illegitimatein nature.Political authoritiesrefer tothecurrentincumbentsofroles in therule-makingstructures. suchasparliaments.ofthesystem. For example.Italy had 18 changesofgovernment(politicalauthorities)between 1970 and 1995. but that hadlittle_impact

on businessriskbecausethe_{countrysregime (rulesofthe politicalgame) remained}intact. The

Italian_{political systemdisplayed high legitimacy characterized by anopenconversionprocess}

andpoliticalparticipationthatfacilitatedthetransformation

of

inputsintooutputs.(Maher. 2005)

In contrast. changesinpoliticalautlioritiesin Venezuela.whetherbyelections or

unconstitutionalmeans(coup_d'etats).unleashedactions to create a new regime (such as a

constitution). Incountries suchasVenezuela. there is no cleardistinctionbetweenpolitical

authorities andthe regime. Suchpolitical systems have not resolvedlegitimacy problems.

Politicalsystems with low legitimacy

will

oftenblockinputs and frustrate the demand process

(gate keeping). Insuch systems. opponentsoftheincumbent_politicalauthorities_mayrevert to

conflictorcivilstrifetocompeteforpower. Theresultisunpredictablepoliticalprocesses.

politicalinstability andeven systemfailure. Therefore. it isno surprise thatforeignfirmsdoing

businessinVenezuelaoften encounter breachofcontracts since a_{new incumbent government}

maynot recognizecontracts signed bya_{previous government. (Makhija. 1993)}

Thefourth distinct conversion_{process ispolitical}communications. This functionoccurs

when allthe abovefunctionsarecommunicatedbothwithinthepoliticalsystem and between the

political system and itsvarious environments. Indemocracies.thisprocess may be open when

prescription. Political communicationin democracies istherefore conducive tothefree-flow of

information ina_competitivesociety. Inauthoritariansystems.politicalcommunications are

controlledbypoliticalauthoritiesandoften manipulatedforpropaganda purposes.

System MaintenanceandAdaptation

Another function ofthe_politicalsystemissystem maintenance and adaptation conducted

through

political

recruitmentandpoliticalsocialization.Political recruitmentrefers to the

functionbywhichtheroles ofpoliticalsystemsarefilledorvacated.Fillingtheroles

of

political

authoritiesis_{particularly crucial}since they havea_{strong stakein power or}theauthoritative

allocation ofvalues. Recruitment may bebased uponuniversalistic criteria. suchasdemocratic elections. orbaseduponparticularistic criteria. suchas_{group membership}orpatronage in

authoritariansystems.Political socialization isthe processwhereby incumbentsofvariousroles

(legislator.partyactivist.tax_official)learn how to performsuchroles.Political socialization is closely related tothe nature

of

politicalculture inasociety.

Output Functions

The final function ofthepoliticalsystem describes itsoverallperformance in its

environmentand refers to the outputsor capabilities ofthe_politicalsystem.A politicalsystem has_{regulative. extractive. distributive.}responsive andsymbolic capabilities.Regulative capabilityrefers tothepoliticalsystemsexercise

of

control over behavior

of

individuals and organizations. This isthedistinguishingcapability ofthepoliticalsystem. i.e. theemployment of

legitimatecoercionor_persuasionto control behavior. Thespectrumofgovernment regulations

may covermany businessactivities including competition. pricing. productliability.human

resource management andenvironmental protection. The_{extractive capability}entails the range

internationalenvironments.Forfirms. thisentails the payment

of

corporate taxes.licensing fees.

duties and otherformsoftaxation.The_paymentof_{bribes may also}be_{regarded as a form of}

extraction.The_{distributive capability}refers totheallocation ofgoods.services and

opportunitiestoindividuals_{and groups}withina_{society. For}firms.corporate social

responsibility (CSR) isapowerful toolto strengthenrelationswith stakeholders in a host country

through distributionofjobs.infrastructure developmentandcommunity service. Inits extreme

form. CSRmay become a risk as thefirmbecomesanobject

of

societaldemand. This is

especially prevalent inhostcountrieswheretheoutputsofthe politicalsystem fail tomeetinput

demands.International firms withastrong resource base then becomeasurrogate for the

politicalsystem in theprovision

of

public goods. The cost ofsuchdistributive output of the firm

may erode expectedreturns and profitability.6 The responsivecapabilityrefers toasituation

whereinoutputsareaffected by inputs

of

demandsfrom groups inthepolitical system.

Democraciesaregenerally consideredashavingahigherresponsivecapabilitythanauthoritarian

systems. Responsiveness mayreduce risk. i.e. _{when governments heed}domestic demands for

economicliberalization. Responsive may increase risk. i.e. when governmentssuccumb to

domesticdemandfor_{protectionism.}

Thecapabilities mentioned thus far are all tangibleoutputs. However.symbolic

capabilitiesare_{important for}a_{political system to reaffirmvalues and to tapinto popular beliefs,}

attitudesandaspirations that flow fromthepoliticalsystemintosociety and theinternational

community. Government policy statements about itscommitment tofreemarket_{principles. i.e.}

currencystability.trade_{deficits, protectionism.free trade agreement.}are_examples

of

_symbolic

Outputs. Suchpolicystatementsmay impact on the predictability of the business environment.

distributedamongcompetinginterests.Incontrast.asymmetricaloutputs mean that some

participants willbewinnersand others losers.Asymmetricaloutputsgenerally result in more adversarial interactions.

Afeedbackresponse occurs whenoutputs donotsatisfydemandinput expectations or

when new conditionschange theutility

of

outputs;whereupon,political structures may activate

new demands.

Puttine Politics Back into Political Risk

Thepoliticalsources of riskdevelop asa sequential process. Thenotion that risk is the result of asequential process iswellestablished invariousmanagementliteraturestreams such

asbusinesscontinuity planning andscenarioplanning.AccordingtoZsidisin.Ragatz and

Melnyk(2005).businesscontinuity planningfocuses onmultipledriversofthreats and

vulnerabilities.theimpact ofsuchthreats in the form of risk exposure of the firm: and

managerial policies to mitigate risk suchasawarenesscreation. prevention. remediation. and

knowledgemanagement. Scenarioplanningcreatesplots exploringpossiblefutures. By

combining factualdata. experienceandcreativity.managers may identifythe emergence ofrisks

and_{opportunities}withinscenarios (Schoemaker. 1991: Schoemaker, 1993).Miller and Waller

(2003) combinescenario_{planning with}realoptions. Theyargue that scenarioplanning may help

managers identify.categorize andtrack uncertainties such asrisk throughthe scanning of a

continuum

of

environmentalcontingencies.7Howell(2002) identifiesthreesteps in risk

formation:sources. events and losses.The sources have somesimilarity tothe systems

embedded intheenvironmentofthe politicalsystem.Hisnotionoflosses maybecompared with

andconversionprocesses of thepolitical systemprovideto understand the sequentialprocess of risk formation.

In Figure 2.a_{basic sequential}flowmodel of risk formationisoutlined. Asdemonstrated

below.thesequential flow

of

risksisclosely linked tothevariousprocesses and relatedfunctions

ofthe_{political system.}

The sequential flow ofthe_{politicalsources of risk may}bebroken down intoa_process

that movesfrom conditionsto events to threats and.finally.results in risk.Thefinal element of

the sequential flow is how firmsmanage the entirerisk formationprocess.Theformation

ofrisk

has atimeline. Firmsthat understand the processesofthe politicalsystem will haveawindow of

opportunityto developviable andtimelyresponses to theformationprocess before

it

actually

becomesabusiness

risk:

Figure2_{Simple Flow Model of Risk Formation}

Conditions Events + Threats + Risk _Management

6 +

Time

---,

Conditions

Riskstypicallyemergefrom conditions which brewprimarily inthepoliticalsystem of the host countrywhich maybeunfavorableto internationalbusiness. Increasingly.suchconditions also

exist inthepolitical systemofthehome country. Theseconditionsareessentiallyantecedents

andthefirst step inaprocess that may lead to the appearance

of

eventual PR. Conditions which

perspective

of

InternationalBusiness,risks that germinate inthepoliticalsystems of the host and

home countries.andtheir context environments.aredominant. Risk emanating fromthe_regional.

internationalandglobal environmentsareimportant. butmay seldombeenforced due to the lack

of power

of

these systems. Thethrust

ofthis

analysis isthereforefocused on thepolitical

systemsofthe host andhomecountrieswhile inputs fromtheinternational, regionaland_global

environmentsare_regardedas_secondary.albeit important.inputs. Inputs fromtheinternational.

regionalandglobal environments onlybecome relevant once they cross the boundariesofthe

politicalsystem.

Conditionsinside thepoliticalsystem:Oneconditionofconcernis_political

socialization. i.e.the process

of

learningpoliticalvalues.Political socializationmay generate

ideologies aliento free enterprise that may generatepotential risksforfirms. Theemergence and

popularity ofanti-businessideologiescreate thepsychological climate from which hostile

actions_againstfirmsmay arise. Theseideologies include anti-globalism. radicalism. socialism,

economic nationalismand greaterstateintervention inmixed economies orevenpredominately

freemarketeconomies. Governments.politicalparties,NGOs. regionaltrade groupings and even

transnational organizationsmaypromotethese_ideologies.

Asecondconditionofconcern is_{political recruitment.}the process bywhichpolitical

systemsfillrule-makingroles and structures.which mayalso createrisk-generating circumstances._Replacement

of

politicalauthorities favorable tofree enterprisewiththose

embracinganti-businessideologieswillindicate worsening conditions for internationalbusiness.

More seriously. countrieswith politicalsystems that lack regimelegitimacy will. ataminimum,

stimulate unpredictabilityand opaqueness and. atamaximum. fosterconflict. civil strife and

goods and will tendto extract resourcesfor redistribution purposes fromthe business

community. Attheworst.as_{Howell (2002)observed.MNEs operating insuch countries may}

become objectsofregimesupport. i.e.a_{surrogatefor government in}the_{provisionof public}

goods and services.

A thirdcondition

of

concern is thepolitical culture in ahostcountry. If the

political cultureespouses values suchas_{religious fundamentalism. parochialism and/or}

nationalism.thesecularorientation ofbusiness maybeundermined. This. in turn.may foster

suspicion.skepticism oreven oppositiontoforeign investment or trade. Insuch circumstances.

international firms maybeviewedasorganizationsthatunfairlyexploit national wealth or

promote consumerism whichruns countertoestablished values.

Proposition 1: The more intense the opposition to,free mcirket ideas/MNCs, the i,iore likely that conditionsfor riskfonnation ivill be activated.

Conditions external to the politicalsystem: Contextually.thepoliticalsystem. both of

the host and homecountries.is embedded inanenvironmentwhichencompasses other systems.

Fromafunctionalviewpoint.theseinclude economic.social.cultural. technologicalandnatural

systems. Froma_{level-of-analysisperspective.international. regional}andglobal systems may be

distinguished. Conditions inthe_{complex environmentofthe politicalsystem may generate}

issuesandactivitieswhich couldserveasstimuli orsourcesofeventual PR.9

Theinternational environmentisconcerned withtheimpact

of

foreign policy behavior

and interstate war on the businessenvironment oftheinternationalfirm.10

Tallman's ( 1988)

findings showthatcooperative foreign policy behaviorbetween host and homecountries is

strongly associated with FDIinflows_{in developed countries.} Conflictualbehavior has a_negative

apart fromthedestructionofphysicalfacilities. war disrupts global supplychains anddiverts

resources fromthe economy towarusage.Theregionalenvironment mayalso generate sources

of PR suchastradediversioninsteadoftradecreationactivities

of

freetrade agreements and

protectionist regulationsofregionaleconomic organizations. AccordingtoHowellandChaddick

( 1994). badneighboringstates haveacontagious impact resulting inlossestofirms in host

countries.11 Theglobal environmentincorporates those developmentsthattranscendnational boundaries.Factors suchasinternational financial systeminstability,oilprice fluctuations and

worldwiderecession may adverselyimpact onthepoliticalsystems of host and home countries.

12

The activities

of

politicalstructures. such as anti-globalization NGOsandterroristgroups. may cross the boundaryfrom globaltonationalsystems and expose international firms to risk such as

asset_{impairment and}the_disruptionofproductionoperations.(Teegen. Doh&Vachani. 2004:

Held & MeGrew. 2002) Transnational organizations. such as the UN. WTO. IMFandWorld

Bank.may often producesymbolicoutputs thatinfluencetheenvironment

of

international

business.Although the WTO may fine memberstatesfor protectionism.thelattermay accept

retaliatory tariffsrather than alienatedomesticproducers and consumers.13

Theseoutputs are

usuallycodes

of

conduct guidelines onCSRregardinghumanrights. laborarrangements. health

pandemics.thephysical environment. protection

of

intellectualproperty and transparency.

(Christmann.2004: Hartman&Wokutch.2003: Wrage&Wrage. 2005)

Proposition 2: Hostile relationships betiveen host and home coimtries ivill ge,terate

co,iditions fo,* riskformation that will likely increase the risk exposure offoreigi,jinits.

Risk mayalsooriginatein other systems. This isabroad area

of

inquiry. but some

recent trends maybeidentified. The politicization ofhealth issues. such as AIDS and SARS. has

(Rosen.S..Simon.J., Macleod. W.. Fox. M., Thea, D.&_{Vincent. J.R.. 2003). The rise of}

populist ideologiesand_{property ownership disputes. particularly}inLatin AmericaandAfrica.

have increasedinternationalfirms' _exposureto extractiveand_{redistribution policies of host} countries. Theexpropriation

of

private property bythe Chavez government in Venezuela is a current example

of

populism inaction.14The culturaltolerance

of

briberyandintellectual

property piracy has also hadanadverseimpact ontheprofitability

of

internationalfirms.Finally,

changes in thetechnological environmenthaveshiftedthepower from MNEs to host

governments. For example,IBM'stechnologicalleadershipinitiallycompelled governments in

emerging markets toyield tothefirm'sdemand_{for wholly}ownedsubsidiaries. However. the

emergence

of

competitivetechnologies hasstrengthened the hand ofhost governments to demandjointventures instead_{(Wells. 2005).}

Proposition 3. There is a positive correlation behveen the politicization of,1011-political

issues and the emergence of conditions conducive to riskforniation. Events

The secondstageofthedevelopmentofrisksmoves fromtheperceptual or dispositional level tothebehavioral level.i.e.conditions aretransformedintoevents. This may

be regarded as thepoliticization ofan_{issue by}a_politicalstructure such asaninterest_group,

politicalparty, parliamentary factionor_{bureaucratic agency. In thisstage, demands are made on} thepoliticalsystem and support resourcesaresought inaneffortto convertaninput into an

output.The conversionprocess is goal seekingthroughpoliticalaction. The eventor behavioral

phasemayoccur due to boundary-crossingactivity or withinputs. Boundary-crossingactivity

occurs whena_politicalstructure embracesa_{non-political}issueandtransforms it intoademand

issues, suchas_povertyandunemployment. andasocial issue. suchaclass_{disparities, into an} aggregateddemand fortheredistribution

of

wealthandopportunity.Such demand will seek

outputs such as theextractionofresources(taxes) ortheredistributionofassetownershipfrom

MNEs.

With inputsaredemandsthat_emergeinsidethe boundariesofthe politicalsystem. For

example.interest groups. suchastrade associations andlabor unions in ahost country, may

demand thatthe governmentintroduce protectionist regulations to save jobs in the face

of

strong

competition from international firms(Kobrin. 1979).15 NGOs in the homecountry of a firm may

demand that such afirmdivest fromits businessoperations in ahostcountry withan unsavory human_rightsrecord.Actionsmayinclude protestmarches. consumerboycotts andevenlegal

action. This formof_{interest aggregation may}also gathersupport from NGOs operating in the

international or global environments.Finally,change

of

government(politicalauthorities) may

bringchanges inpolicy_(i.e.regulations. taxation. compensation) due tothe demands and

influence

of

institutional interestgroups. These events may heighten concerns about

environmental uncertaintyamong businesses. Even

of

greater concernareregimechanges that

place governmentsin powerwithnegative viewsofforeign firms. Such eventswilllikely lead to

demandsforadverse_{policies including}assetseizure and contractrepudiation. thereby elevating risk_exposure.(Chubik. 1983)

Proposition 4: When demands are widerpi,med by appropriate support, the likelihood of

risk fon,iation (conditions transforn, into events) i,icreases.

Threats

Thethird stage of risk development is whentheactions

of

politicalstructures pose a

politicallybasedthreats may exposeasense

of

uncertaintyamong businesses. The term uncertainty. as used in strategic management andorganizational theory.refers to theaffect of

unpredictability

of

environmental or organizational variablesthatnegatively impacton corporate

performance. It mayalsorefer to_{the inadequacy}ofinformationoftheseconditions._{(Miles &}

Snow. 1978)Athreat may beviewed asan_expressionof_{intention by}a_politicalstructure to

inflict

_{damage or harm on}abusiness firmasretributionor_punishmentfor_{something done or left}

undone. Inthis stage oftheconversion processofthe politicalsystem.there will bemany early

warningsignals thatpoliticalstructures haveharmful intentions towardcompaniesorindustries.

Indicators ofthe_{probability of riskmay}include(1)publicstatements

of

intent_bypolitical

structures such asspeeches.threatsforindustrialaction suchasstrikes.messagesandblogs

posted on websites;(2)media reports on theprobability of harm: and (3)the introduction

of

bills

in thelegislaturetoinhibitbusiness operations.

Changes in the styleofinterestarticulation_{and aggregation may alsoprovide}clues that

politicizedeventshave degeneratedintothreats_(Almond

&

Powell. 1966):

• A change fromlatent tomanifest behavior: moodclues suchasvaguegrumblings

changetoexplicitdemandclaimsfor action

• A changefrom diffusedtospecific behavior: dissatisfaction without specific

means

of

correction (i.e. MNEs arebad) changes tospecificrequestfor legislation

(i.e. limitson_{foreign ownership}ofnationalmineral_resources)

• A change fromgeneral toparticular behavior:general demands couched inclass

orassociational_groupterms (i.e. reformlarge estates)whileparticulardemands

• A change from affectivetoinstrumental behavior: affective behavior in the form

of averbal_{expression (i.e. anger.}disappointment. hope) ofaninterestgroup may

changeinto instrumentaldemand such asathreat

of

withdrawal

of

support (i.e.

finance.vote) contingent ona_{particular action}(i.e. acceptance

of

legislation)

A threat may alsobeviewed asafailure of thehostgovernment'spolicytocreate or to sustainaviablebusinessenvironment.Suchpolicyfailuresmayincludeadeterioration of

infrastructureand_{macroeconomic policies}that increaseinflation.currencyinstability and poor

management

of

foreigndebt repayment.

Scenarioplanners that routinely scantheenvironment forearlywarningsignalsepitomize

the benchmark forthreatrecognition. In SWOTanalysis. weakness and threataresimilar to the

way threat is used here.Forbusinessrisk managers. this is the timetodistinguish. in the view of

Kobrin(1979).between_subjectiveand_{objective uncertainty. Decision-makers}shouldmonitor

unfoldingevents to makejudgments regarding themostimportantoutcomes and the likelihood

of

theoccurrence

of

disruptiveandharmfulevents.Oftenthreats have along timeline which

provide firms withadequate time to respond. Forexample. since its election in 1998. the Chavez

government inVenezuelahasthreatenedtoseizeidle_plants.However. whenthegovernment

seized sucha_{plant from}foodproducerHJHeinz& Company in 2005.the company expressed shock that it had notbeennotified. Thiswasdespite the fact thatthegovernmenthadpreviously

seizedother_plants.(Maher. 2005: Wall Street Joi,rnalAVS.0.September 7. 2005. A14)Threats

(demands)backedbysupport(government power) shouldberegardedascrediblethreats.

Proposition 5: Tlie higher thefreqi,ency and intensity of threats, the,itore likely Stich

Business Risk

Thecriticalcomponentthatchangesathreat into a risk isthatrisksbecome actions bypoliticalstructures._{notably governments, which}willadz·ersely impact ona_foreign

firm's profitability.International business risk in thisregardissimilarto strategic_{risk. (Simons.}

2000: Slywotsky. 2004) Tlie underpinning ofthreateningdemands by appropriatesupport

(physicalresources,political commitment)makesthreatscredibleandconverts them into

harmfulactions. Asoutlined above. businessriskoccurs whenafirm's profitabilityis adversely

affected_bypolitics.A firm'sprofits should notbeviewedinisolation. butrelative tothe_activity

or investment requiredto generate suchprofits.Profitability isameasure ofafirm'soverall performance onarelativebasis

of

relating variousmeasures

of

profittoeithersales or

investment (Lewellen. Halloran

&

Lanser. 2000).Risk exposure.therefore.meansvariability in profitabilitythatfallsshortof_{expected returns such as ROI and}ROA(Butler & Joaquin. 1998:

Click.2005). Table 1 outlinesataxonomy

of

harmfulactionsoroutcomes. withrealworld

Risk

_Description

Cases

• _PhysicalDamage to Assets Miningcompany Sector Capital Corp. suffereddamageworth $78OK

due tovariouscivilstrife activities in Colombia.

In tlie9/11terroristattack ontile WorldTrade Center. thebrokerage finn

• Harm toHumanResources

Cantor Fitzgerald lost 658 of its 1000 employees

FreeportMcMoRan'scopperproduction in Jaya, Indonesia disrupted

• Disruption of Production/Value-added for three days duetocivil strife&ethnictensions.

Damage to Assets

_• Processes&Sales

LargeScaleTheft_{of Inventory} Shell reported71casesofbunkering (illegally siphonilig oilfrompipelines)

by organizedcritne gangs in 2004 &88cases in 2003 in Nigeria. Tlieft of

10OKbpd occurred.

• Sabotageof InformationSystems UNITY, a radical Islamic website, downed Israeli ISPs & e-commerce_sites causing an 8% dip in the Israeli Stock Exchange in 2001.

• _{Nationalization, Confiscation,} in the mid-199(Is SaudiArabia, Kuwait &Venezuelanationalized

Expropriation ofAssets/Resources theiroil industries

Indian gov-t expropriated assets of GE EFS IndiaHoldings&BechtelIndia

• Limitationsof_ForeignOwnership of

Ownership Restrictions

Business

Power Investments worth $2OMinpower industry

• _{Ownership Restricted}inCertain Foreignownershipofairlines inUSrestricted to 25% or less

Sectors In Indonesia, foreign ownership of private or specialbroadcast

institutionsisprohibited.Foreign investors areprohibited from

investing in film production. technical filming services. export or

import of movies, film distributionand screening as well as film or videodistributionvia subsidiaries.

• Restrictions on Gov't Procurement Gov'tslikeBrazil that are not signatories to the WrO Government Procurement Agreement are more likelytodiscriminate against

• Restrictionson_HiringForeign foreign suppliers._{Microsoftseverely constrained to recruit}highly skilled foreignworkers due Personnel _{to H-1 visapolicy ofUSgov't.}

• Corruption of Gov't Officials A GallopsurveyofUS_{companies commissioned by the American}

Operations Restrictions

ChamberofCommerce of the Philippines foundthatcorruption was the greatest impediment tobusiness in theASEAN region.

• Efficiency of Transportation & According to the ElU. the poorinfrastructuresofNigena.Indonesia.

/1 _{Kenya. Kazakhstan,}Pakistan&Nicaragua pose thehighest risk toforeign

<3\

Amway Corp & Avon Productstoalterbusiness_{models by operating r'l} retail stores

Taxation Discrimination

• Formal & InformalTaxPoliciesthat UKtaxedBritishcompanies' foreign earnings at higher rate than

lead to Bias againstInt'lBusiness domestic earningsasincentiveforhigher domestic investments French gov't singled out airline tickets for taxto financeUN'sprogram againstglobal poverty

• Formal& Informal_{Rules regarding} In SouthAfrica,foreignfirms with gov'tcontracts > $1OM must invest

the RepatriationofProfits,Dividends at least 30%in local black owned companies. For defense contracts,

&InvestmentCapital local investment increases to 50%.

Remittance Restrictions

_{In 1993. Japan's}

National Tax Administration filed claimsagainst 50

• RestrictionsonTransfer_{Pricing foreign finns, allegingunderpayment of $492,nin}

Japanesetaxes due to

improperlycalculated transfer prices.

• Gov't Interference withTermsof Chavez_gov'tinVenezuelaunilaterallychangedcontractswith major Contracts oil NINEs.

Breach

of

Contract

• _{inadequate Enforcementof Contract US State Del)artinetit issues background note onUkraine stating that while} Law foreign trade & investment are encouraged. complex laws & regulations

andweak enforcement of contract law by courtscontinuetostymie FDI.

• Formal Policies &InformalPractices USgraincompany, ContinentalGrain.incurred losses of $2m due to

that Inhibit ConvertingLocal inconvertibility ofBrazilian Real in 1992.

Inconvertibility

USMNEs, Philip Morris. Citibank&ChaseManhattan Bank.sufferlosses

Currency to Foreign Currency

of $6.Sm due to inconvertibility of Dominican Republic m 1980s

(normallyafirm's home currency) _US

energy company, Philippine Geothermal, sufferslosses of $1.32m

due to war damage in the Philippines in 1987.

• _{PermissiveEnvironmentforTheftof} Worldwide violationsofpatentrightscost_{computer softwareindustry} Patents,Trademarks,Copyrights an est. $13.08bnin revenues in 2002.

Piracy

of intellectual

US industry estiniates that in 2003-2004 lostsalesresultedfrom piracy iii

Property

_{computer programs}india o f US motion pictures, sound recordings. musical compositions._{&bookstotaled approx. $50()m}

• Lackof_{Legal Protection, Poor Law International Intellectual Property Association findsthat}

while

Enforcement Romaniahasstrong laws to protect IP, poor enforcementofthose laws

remainsaserious_problem.

WorldIntellectual PropertyOrganization notes that while Chinahasadded tough new laws & regulations andhasallocated more resources tocriminal

enforcement, poor enforcemetit combined with weak punishmetit ineatis thatIPRviolations remain rampant.

Country Markets

• Other_RegulationsthatRestrict HongKongbasedEsquel Company,world'slargestmanufacturer of

Imports suchas_{Ouotas, Licensing &} mens'cotton shirts, frequentlymovedproductionfacilities to

AdministrativePolicies circumvent US & ED import quotas. The firm moved facilities from

Other Import Barriers

Hong Kong to China, Malaysia,Mauritius,Maldives&Jamaica.

• Gov't Subsidies for Local Industry Localagriculturalindustriesreceivelargegov'tsubsidiesas_protection

againstforeign competition: in2002,$43bn in EU&5180bnin USA.

Payment

Delays

- Punctuality with which Gov't & In Nigeria. two-thirds of all payment delays are owed by

state_gov'ts

PrivateImportersPayForeign Constrained capital expenditures are duetomappropriate infrastructure

Creditorsbased onGov'tPolicy developmentprojects andcorrupttendering procedures

Corporate

Social

• Gov't Policy &_{Firmsto Provide Public Goods to}Political Pressureon Subjectcompelled to set up chartersto "moral-suasion" bytoSouthfurtherAfrican gov't.blackeconomic powerindustries have beenwithin a

Responsibility

giventimeframe Firms mustmeet quotasforblackequityownership.

Employees&Communities _{executivecontrol, employment.andaffirmativeprocurement&supply} Firms also must mcrease spending on the transfer ofskills.corporate social investmentsin_{disadvantaged}communities & thedevelopmentofblack entrepreneurship

• Fines for_{Legal Transgressions} BaxterInt'lfined $6.6mforviolating theUSAnti-boycott Law in 1993.

o Extraterritorial Laws Largestinvestor in OwlSecurities&Investments. Ltd fined $60K &

imprisonedunder the FCPAfor paying $1M bribe toCosta RicanOfficials

to obtain land for a developmentproject

Legal Liabilities

o Human Rights Abuse Doe vs.courts by humanUnocal, suits filed under the ATCA inrightsgroups and15individualsUSfederal and statealleging that the

multinationalenergycorporationUnocalusedBurmese villagers as

slave labor in thepipeline Yadana Project.After8yearsof litigation.

settledfor undisclosed amounL

Sources: EIU.2004.2005:Griffin &Pushtay. 2005:Hill.2006: Howell.2002: Howell &Chaddick. 1994:O'Sullivan.2005: Political

RiskServices.2005:Trendle. 2002: Van Wyk

&

Custy.2004: Van Wyk.Dahmer

&

Custy.2004: WTO.2003: World Watch.2005:

Footwear News. 01/12/04: Managing Intellectual Property. 04/01/05: PhilippineDaily Inquirer, 06/30/05: US Fed News. 08/01/05:

Vanguard(Nigeria). 08/20/05:WSJ.08/18/05.08/29/05.08/30/05.01/30/06: Washington Times. 04/28/05: www.ummah.net/unity:

Simon ( 1984) madeavaluablecontributionbyindicating that the flow ofthepolitical

sources of risk_{may emerge}from different environments and_mayfollowadirector indirect

sequential pathuntiladverselyimpacting on a firmorindustry'sprofitability.One suspects that

such flow may bemoremultifaceted than a mere oneor two-step process due to theglobalized

natureofinternationalbusiness and theinternationalizationofdomestic_{politics. Hypothetically.}

for_{example. damage to business assets by}an_{Islamic terrorist group may. onthe surface. appears}

to beaone-step event. However.closerexamination suggestsanintricate. multidimensional

process may be atwork: terroristsreceivemoralandsymbolicsupportthroughthepolitical

communications

of

state-ownedmassmedia intheIslamicworld:they receivefinancialsupport

from Islamic nonprofit organizations: theyreceivematerialsupport (arms.training facilities. intelligence._{safe havens)}fromgovernments that actaspatrons of terrorism: theyaresocialized

in Madrassas andMosques intheJiliad-ideology: and theyarerecruitedand socialized byother terrorist organizationsand_politicalmovementswith_{operations on}a_globallevel._{(Nayyar &} Salim.2003: Gannon. 2005;WSJ.8/19/05:All:8/24/05: A9) Areal_{world example is the}

introduction o

f

tariff

andnontariffbarriers by governments to protect domesticfirmsagainst

foreign competition and to save jobs from outsourcing. Suchregulatory outputis usually an

In Simons (2000).thenature

of

strategicbusinessrisksaresimilar to Porter's analysis of

thestrategicbusiness-makingenvironment. Thepoliticalenvironment (Simons' term is

regulators)is somewhat underdeveloped.AlmondandPowell's (1966)analysis oftheoutputs of

thepoliticalsystem. although it didnot address PR perse.offersgreateranalytical utility. The

category

of

risks. outlinedinTable 1 anddiscussedbelow.overlapsconsiderably with the

Simons' classifications as well as thatofAlmond and Powell.

Damageofassets is in line withwhatSimonscalledthephysical impairmentofassets.

i.e. thephysical destruction ofkeyprocessingorproduction facilities. Politicalsystem outputs

did notaddress suchrisk. However. anomic behavior. whichmayoccur duringtheconversion

process. dealswith destructioncaused bycivilstrife, internal war.protests andboycotts.

Ownership restrictionshavereference toanumber

of

system outputs. For example. nationalization is a form

of

redistribution. Restrictionson_{foreign ownership}

of

strategic

industries arearegulativeoutput or evenanoutputresponsive to domestic demands to keep

national wealthandassets in the hands

of

citizens. Withsomelatitude. ownership restrictions

mayberegarded asa_{competitive risk in Simons' analysis. This}isparticularly relevantsince

governmentsmaychangecompetitive regulationstoprotectlocal industries or SOEs.

Operations restrictionsaresimilar to Simons'operationsrisk. Although he did not

explore government restrictions.apartfrom productliabilityon business_operations.Simons. is

cognizant ofthe_{unanticipated}costsof_systemdown-timeand unexpected varianceascauses of

operations risk. Asasystemsoutput. itisclear thatoperationsrestrictionsarerelated to the

regulative capabilities ofthepoliticalsystem.

Taxationdiscriminationis_clearlyanextractive capabilityofthe politicalsystem.

and inconvertibility are bothregulativeoutputs of thepoliticalsystem. From Simons strategic

risk perspective. they arebothformsofasset_{impairment, particularly financial impairment. In}

thissense.inconvertibility maybeviewed asasovereign risk.

Breachofcontract asa_{strategic risk is a form}ofasset_{impairment. particularly a}

counterpart risk. 1nacounterpart risk.theotherparty to the agreement may beunable tohonor

itscontractual obligations. Froma systemsviewpoint.breach

of

contract may be theresult of poor regulativecapability. i.e. thejudiciary may lack resources_{to uphold contract law. The}

motivationforcontract breach maybepoliticallymotivated: that is.incountries withlowregime

legitimacy. a new government may nothonorcontractsbetween MNCsand_previous

governments.

Piracy

of

intellectual propertyalsoindicates a lack

of

_{regulative capability}

(adjudication) ofthe_{political system. In somepoliticalsystems, the demand}for_{protection for}

patents and brand names may be low due toa_{permissivepolitical}culture._Accordingto Simons.

impairment

of

intellectual property is a form

of

assetimpairment. Simonspoints out that the

market value

of

_{software and drug}manufacturers is notafunctionofthesize

oftheir

balance

sheets,butratherreflectsthe estimated value

of

futurecash flowsrelated totheir intangible intellectualresources.

Fromastrategicriskperspective.tradebarriers are a form

of

competitive risk.Simons

refers particularly to recent regulatorychangesintrade. As asystemsoutput.tariffsandother

administrativefeesleviedagainstforeigncompanies are a tax oranextractivecapability. Often

such_{extractions result from the government'sresponsiveness to demandsfor protectionism.}

Accordingto Simons.legal liabilitiesarefranchiseriskswhich include pending lawsuits

(products. brandnames. corporateimage) of a firmisviewed unfavorably bystakeholders such

asthemedia.customers or thegovernment. Asa_systemsoutput.legal liability is a form of

regulativeoutputs.

Finally. corporatesocial responsibility (CSR) may be influenced by outputs of the politicalsystemwhich

will

co-opt international firmstodistributegoods and services. Such

distribution may not onlytarget stakeholders. but also otherconstituents inthepoliticalsystem in

the form

of

health care. education andinfrastructuredevelopment. The inadequacy of the

politicalsystem toconvertinputdemandsintooutputs maysetinternational firms up to act as

surrogates forthedistribution

of

publicgoods and services. Simons did notaddress CSR per se

as a strategic risk.

Finally. the list

of

risks outlined in Table 1 has bothanupside(opportunity) and a downside (further deterioration).Thecontraction of riskindicatesan_{upside in the form of new}

opportunities. Thisisoftenbroughtabout byanincrease in theliberalizationandtransparency of

the businessenvironmentand ascendance topowerby pro-business governments.For example.

Chineseregulatorsareconsideringraisingthepermitted levels of FD1 inChinese banks above

20% forasingle investorandabove 25% forallforeignshareholders. (WSJ.09/15/05: A18)

Improved protection

of

intellectual property bythe Chinese government has led tofinesagainst

Chinesefirmsfor trademarkandcounterfeitpiracy.16 Thedownsideisusually in the form of deterioration that

will

resultinincreasedriskexposure.Many conditions

will

stimulate a

downside movement in risk, notably domesticdemandsfor protectionism. new

boundary-crossingevents.deterioration

of

political legitimacyandoutput failure.Anexample of such

strategic_{industries that will exclude M+A activities from foreign firms.}(WSJ.08/30/05: A3: 09/01/05: A12)

Proposition 6: The higher the deniand for protectionis,it in a host cotmt,y, the higher the

probability that international jir,its ,vill be Subject to business risks.

Proposition 7: The ireaker the legitimacy of the political syste,ii of the host cotintry, tile higlier

the probability that international jinns will be subject to business risks.

Risk Management

Risk management maybeviewed from bothstrategic andpolicylevels.

Strategic Level

On the strategiclevel.thedynamics of riskmanagement face themake-or-buydecision.

International firms_{may treat}risk_{management as}avalue creation_{activity performed in-house or}

may outsource itto anotherentity. Themake decision has thefollowingadvantages: cost

efficiency.i.e. utilizingexistingresources: specializedinvestmentsinresourcesunique to a firm orindustrysvalue_{proposition. i.e.}the_{developmentofpropriety} risk_managementsoftware: and

organizational integration of all activities related to risk_{management. The advantages of the buy} decision(outsourcing) includestrategicflexibility to dealwithdiverserisk environments in

differentmarkets:lowercosts due_{to suppliers which}haveefficientand_{proven riskmanagement}

products available;and offsets. i.e.outsourcing tohost countries may enhancelocation

networking and may also pave the way for newmarkets andnew product offerings.17

The_{buy-or-make decision may}belinked toafirm's_{global strategy.Bartlett.}Ghoshal

and Birkinshaw (2004) distinguishamongmulti-domestic. internationalandtransnational

strategies. Firmswith multi-domesticstrategies havesuperior intelligenceabout hostcountries

and. thus.arebetterpositionedtoconductriskmanagementin-house.However.suchfirms may