I would like to begin with a reflection on the Day of Judgement as seen through the eyes of my Scottish, Calvinist forebears, a stern unforgiving people whose philosophy of life can best be summed up by the proposition that “ we were not put on this earth to enjoy ourselves”. The story goes that on the Day of Judgement all mankind were brought before the Archangel Gabriel to have an assessment made of their conduct while on Earth. And the many who were judged to have been irredeemable sinners were condemned to spend all eternity suffering the torments of Hell. And as the sinners were waiting to be cast down into the everlasting fires, they looked up and saw the face of the Lord and cried out in piteous tones “Lord, Lord, we didna ken, we didna ken” – for those of you unfamiliar with Scottish dialect, that means “We didn’t know, we didn’t know”. And the Lord, in his infinite wisdom and mercy, looked down upon the faces of the poor sinners and said “Yes, well, you know now”. And that I think is a good starting point for a talk on assessing political risk. Ignorance really is no excuse.
Over the past decade we have witnessed, at least in the Anglo-Saxon world, a massive upsurge in what might be termed the risk industry. And here I’m talking about risk in the widest and most generic sense, defined as the probability of something going wrong multiplied by the impact of its doing so, Risk assessment and risk management are now supposed to be at the heart of corporate management culture with risk registers and directors responsible for risk. Much of this approach has been driven by the fallout from major financial scandals such as Enron. But if the recent developments in the US financial sector are anything to go by, it would seem that the risk-based management system is still in need of some refinement. The reality is in fact simpler and more banal. What seems to have happened is that directors of companies in the financial sector simply didn’t and couldn’t understand the risks their companies were running despite being legally liable for these risks. It seems clear that if the financial crisis ever settles down, more thought will need to be given to how a system more fit for purpose can be developed. But that, perhaps fortunately is beyond the scope of this evening’s talk.
The topic this evening is political risk. What do we mean by that? The classic definition is probably that given by Professor Louis t. Wells of the Harvard Business School – “Threats to profitability that are external to the business and which arise from government action or inaction”. That definition still holds good but may not encompass the way in which political risk has developed since Wells produced it. Since the 1980s a sea change in the global economy, in which developing nations moved away from autarky and a focus on import substitution to a policy of actively courting foreign direct investment, combined with declining business opportunities in the developed world, has driven many western companies to move into emerging markets, with accompanying levels of risk much greater than those to which many had been accustomed. Those companies who moved into emerging markets on the presumption that business was business the world over quickly came to grief. “Mr China”, a book written by British investment banker Tim Clissold depicts in graphic terms what can and did go wrong when insufficient account was taken of local political and cultural factors. Since the early days, an approach to political risk which could often be described as pro forma has now become focused and serious – and supported by a huge industry specialising in different aspects of political risk analysis.
Traditionally, political risk has been seen in terms of government risk and instability risk; in essence the risk either that the government of a particular country might expropriate one’s assets, or that a country might suffer a level of internal instability – insurgency or even civil war – which makes the conduct of normal business either difficult or impossible. From the 1950s through to the 1970s, the risk of expropriation was very real as numerous newly independent nations, often following socialist models of development, sought to acquire control of what were then deemed strategic assets. Latterly, this concern has been less salient, although recent developments in countries such as Venezuela, Bolivia and Russia suggest that economic nationalism may be about to make a comeback, a process which might be exacerbated if, as seems increasingly likely, the global economy suffers a prolonged slowdown.
Globalisation of markets has led to the globalisation of political risk. And this has a number of important consequences. Amongst these is the degree to which organisations which might normally be risk-averse and disinclined to venture overseas looking for new business increasingly find that risk comes to them even if they don't go to it. A banker might for example decide not to open a branch office in Russia. But if a high-value Russian client shows up wanting to open an account, the bank in question is brought face to face with Russia political risk
And in this regard, the global preponderance of the USA has had a significant impact as a result both of extraterritoriality and international sanctions as evidenced on the one hand by the extensive application of the Foreign Corrupt Practices Act on the one hand, and the Iran-Libya Sanctions Act and the Iran Proliferation Act on the other. Two years ago, the US arm of a Dutch bank was compelled to pay a $80 million fine for failing to make adequate arrangements to ensure compliance with the Iran-Libya Act.
The final category of political risk to which I would like briefly to refer is reputational and it is here that international civil society, in particular in the form of non-governmental organisations, plays a major role. Anyone who has ever run an organisation will be acutely aware of how fragile reputation can be and how easy it is for one remark or one action to cancel out years of high-quality performance. Examples are legion of how specific organisations have suffered reputation damage due to the way in which third parties, and particular NGOs have taken up, publicised and campaigned against particular behaviours or activities. De Beers and conflict diamonds, Shell and BP in Colombia, Shell and Exxon in Nigeria are some of the better-known examples. The point to note is that although the risk arises in the country of operation, it increasingly manifests itself transnationally, in a virtual arena where the normal rules don’t apply. Most companies now, when confronting investment decisions, will as a matter of course ask where the NGOs stand on that investment and consider how to manage and mitigate their responses.
So if political risk matters, how are we supposed to measure and assess it in ways best calculated to minimise the risk of unexpected shock and unwelcome surprises and optimise our chances of coming out ahead? There are some kinds of risk that lend themselves to quantitative analysis. These risks tend to be the kind that can be defined numerically and which fall within predictable ranges. The insurance industry makes extensive use of such models, as don the major hedge funds whose quantitative analysis models seem, for the time being at least, to bring them out ahead of the markets But I suspect that these models may have their limitations, and that they are unlikely to be able to deal with the Black Swans – an analogy developed by the US writer Nassim Nicholas Taleb to describe events so far removed from the realm of previous experience as to give rise to a paradigm shift. Iit's important to remember that these models are developed by people with similar backgrounds, similar levels of knowledge and similar sets of assumptions. In situations where those assumptions don't apply there has to be some risk that they can represent a kind of electronic group-think, a GPS system for guiding the lemmings over the cliff. So it is important to bear in mind their limitations.
I know that there are many political risk experts and organisations who claim that it is possible to apply at least some aspects of quantitative analysis to political risk. I can’t disprove these assertions. But I am profoundly sceptical, and so as an institution is IISS. I can well understand why people in the business community crave the certainty of hard figures. But if asked to give a percentage probability that, say, the USA might attack Iran in the next two years, I find it impossible to offer a convincing response. 60%? Then why not 59% or 61%? And is the provision of such a figure not actively counter-productive if it provides false comfort and prevents people from thinking about the nuances of the issue? In general, I believe that political risk is better approached using qualitative models such as the scenario-planning approach pioneered by Shell. This approach posits a range of potential outcomes for particular situations, in order both to make judgements about which are most likely and to enable decision makers to consider possible responses to a range of different eventualities. The scenarios are illustrative and don’t purport to predict the future. There are of course many snake-oil merchants who seek to persuade us that they can develop systems which will predict the future if only we pay them enough. My strong recommendation is that if you are faced with such a person, reach for your revolver.
Because when it comes to predicting the future, the picture is quite clear. We simply can’t do it There are too many variables, too many possible combinations and there are the uncertainties that arise from the vagaries of human behaviour. The record of the human race in this regard ought to speak for itself. But if that isn’t sufficiently convincing, there is a body of scientific evidence deriving from detailed experiments which demonstrate the point. There is a book that I would commend to any of you interested in this topic. It's called Expert Political Opinion, by a Canadian academic called Philip Tetlock. It's an excellent read, but not an easy read, especially if you don't enjoy having your reading interspersed with complex algebraic formulae. But its conclusions are compelling and accessible. As a species we are startlingly bad at predicting the future. But there are some people who achieve consistently better results than the average, albeit with low overall percentages, typically in the twenties to low thirties. That's the good news. The bad news is that these are in the main not the sort of people who tend to become senior decision makers. They are cautious, pragmatic people whose instinct is to weigh the evidence carefully and not leap to premature conclusions. In the analogy popularised by Sir Isaiah Berlin, they are foxes, people who know lots of little things and who build pragmatic models to help them make sense of the information they have, rather than hedgehogs, people who know one big thing and tend to look for evidence which supports that. Not, in a word, people well-suited to the sound-bite world we live in. But to the extent their voices can be heard, the quality of political risk analysis is likely to be better than it might otherwise be.
And there are some traps which we ought to be able to avoid so that, if we don't make good judgements, we at least avoid making seriously bad ones. The key pitfalls are;-
- persuading ourselves that some things won't happen even though they could. As a species, we are remarkably good at this. And we're remarkably susceptible to all the Great Lies. You know the ones; the cheque's in the mail; I'll respect you in the morning. And in terms of political risk analysis, the most terrifying of all: this time it'll be different. How many times did I hear that said about Iraq in the latter part of 2002? And about the British economy over the past decade?
- making assumptions that other actors will share our values and desire the same outcomes as ourselves, a common flaw among western politicians who struggle to put themselves into the mindset of leaders from radically different cultures. Again, Iraq demonstrates the dangers. We all thought Saddam Hussein had lost the First Gulf War. Saddam thought he'd won it. We all thought Saddam would be scared of a US invasion. Saddam was much more worried about losing the respect of his immediate neighbours and didn't take the US threat seriously. We all thought that when the invasion started, Saddam would blow the bridges across the Euphrates to stall the American advance. Saddam needed those bridges to move his troops south to suppress Shia rebellions, a much more pressing preoccupation than an American invasion And so on.
The general conclusion I would draw is that in trying to assess risk, the factors most likely to make for success are;-
- A pragmatic, open-minded approach, avoiding ideology or dogma, considering dissenting views and what a former boss of mine called inconvenient information and showing readiness to learn from mistakes.
- An integrated approach. Risk assessment, like security – with which there is a lot of overlap – works best when it becomes part of the corporate culture and is seen as integral to planning processes rather than something retrofitted to a “pure” business plan.
- Avoidance of any approach which seeks to automate risk analysis to the point where decision-makers are left feeling that this is an issue they don't own and don't need to spend time on.
To sum up, I do not believe that there is or ever can be a Holy Grail for assessing political risk, no single methodology so manifestly superior to all the others that it becomes the industry standard. But equally in today’s world we cannot afford to be indifferent to the wider environment in which we operate, and globalisation has made that environment infinitely more complex than it was before. As Tolstoy put it in the open lines of Anna Karenina, “Happy families are all happy in the same way. Unhappy families are each unhappy in their own way” Achieving happiness involves identifying and avoiding multiple sources of risk and failure results in unhappiness the nature of which is defined by the risk that is not avoided. By applying the kind of approach outlined above, we can at least give ourselves some prospect of achieving happiness. But we should also accept that there can be no system which will guarantee it.
