SM4008/LD4008/AT7016 - International Business: Contexts and Challenges

Political Risk in International Business

Student’s Name

Student’s ID

Word Count: 3304

Table of Contents
1
Introduction..................................................................................................................................................3
Part 1: Literature Review.............................................................................................................................3
Political risk.............................................................................................................................................3
Political system and stability....................................................................................................................4
Corruption and lobbying...........................................................................................................................6
Policies for international business............................................................................................................7
Bureaucracy..............................................................................................................................................8
Part 2: Example of a Country in which foreign direct investors may be subject to political risk..................9
Internal and external conflicts..................................................................................................................9
Corruption..............................................................................................................................................10
Policies...................................................................................................................................................11
Terrorism................................................................................................................................................11
Political stability.....................................................................................................................................12
Recommendations......................................................................................................................................12
Conclusion.................................................................................................................................................14
References..................................................................................................................................................14

2
Introduction

As the world continues to become globalised, foreign direct investment (FDI) becomes the major

concept used to drive economic growth, especially in developing countries. FDI is associated

with several benefits such as generating revenues for the government, creating employment

opportunities, increasing competitiveness and improving the balance of trade (Samimi et al.,

2011). Despite the promising benefits of FDI, political risks in the host country are likely to

discourage foreign investment. For instance, political instability in a host country is harmful to

FDI because it increases volatility due to frequent changes in policies. Most of the political risks

are common in developing countries which are characterised by corruption and unstable

governments. The paper aims to discuss the political risk in international business. It is divided

into two parts where part 1 review the literature on the concept of political risk and part 2

discusses a country where foreign direct investors are likely to be affected by political risk. The

paper will also recommend mitigation strategies for political risks.

Part 1: Literature Review

Political risk

Political risk refers to the negative consequences that government actions are likely to have on an

international company’s cash flows (Bekaert et al., 2012). Political risks have been described also

as uncertainties associated with political events such as political violence, coups, revolutions, and

regime changes; as well as discriminatory actions by host countries such as unfair compensation,

export restrictions, corruption, or labour restrictions among other things (Chang et al., 2018). The

concept of political risk in international business is widely researched. Change et al. (2018)

investigated the strategies that can be used to manage political risks in international construction

3
projects. Through this study, the authors identified multiple strategies such as making correct

decision related to selecting the correct entry mode, establishing relationships with the host

country, and conducting market research among other things.

Political risk is also an important determinant of foreign direct investment and the effectiveness

of multinational companies. This is because an effective FDI requires a conducive environment

for investors. As such, there is evidence that supports the importance of conducting a political

risk assessment. Mshelia and Anchor (2019) suggested that conducting a political risk analysis

identify the reason why some firms have invested in some markets despite high political risks.

The authors also revealed that different firms perform the analysis using qualitative and

quantitative strategies. It has been established that previous exposure to political risk and political

capabilities influence international strategy adopted by MNCs (Jiménez et al., 2014). These

authors established that exposure and experience enable firms to understand and implement

various political actions such as litigation, lobbying, bargaining mode of entry, and decreasing

transaction costs among other things. In another article by Aguiar et al. (2012), multinational

companies require high rates of return in FDI to invest in politically risky countries. The authors

also identified that the policy environment of home countries facilitates a negative relationship

between risk and FDI. This implies that firms from countries with low political risk are likely to

invest in countries with lower levels of political risks.

The concept of political risk in international business can be divided into the following areas:

Political system and stability

The role of the political system and stability in international business (IB) is widely researched.

Political stability is one of the key requirements for a country to be competitive. As such,

4
investors use the political stability of the host country to make their investment decisions. In

other words, the political stability of a country determines the number of foreign investors.

According to Shenkar (2014), countries that experience civil wars, ethnic, or civil conflicts

experience economic regress, with the minority willing to invest in productive activities. In other

words, political instability reduces the likelihood of multinational companies investing in such

countries. On the other hand, countries with political stability attract more foreign investors.

Samimi et al. (2011) noted that political instability is a serious issue that is injurious to economic

performance because it affects the collection of capital.

Studies have also indicated that political instability has negative impacts on foreign direct

investment (FDI). Bekaert et al. (2012) claimed that democratic countries have higher rates of

FDI inflows. Khan and Akbar (2013) argued that political instability causes economic uncertainty

and reduces the motivations of investors to invest in the host country. Samimi et al. (2011)

established that there is a direct relationship between political stability and FDI and to improve

foreign direct investment, political instability must be reduced. Said (2013) argued that factors

such as political instability affect investment climate and governments should create favourable

climates to attract FDI. Another study by Shahzad and Al-swidi (2013) established that political

stability is important for a country’s both domestic and foreign investment. This is because

political stability moderates the gross domestic growth (GDP) rate and the balance of payment

which play a significant role in determining the inflows of FDI. Jewel (2015) established that a

harsh business environment and a high level of political instability reduce FDI inflows in a

country.

5
Corruption and lobbying

Corruption and lobbying are the other forms of political risk affecting international businesses.

Khan and Akbar (2013) stated that corruption is a measure of political risk. Bahoo et al. studied

the impact of corruption in international business. These authors defied public corruption as an

illegal activity involving a politician, bureaucrat, or government official. This definition indicates

that there is a link between the political environment and corruption because the legal activity is

carried out by a political representative. They conducted a review of the literature and they

established that corruption has several negative impacts on international business. For instance,

corruption has a negative on FDI and operational efficiency. The authors argued that companies

from countries with a high level of corruptions are likely to invest in host countries with high

corruption rates and vice versa. Overall, corruption has negative effects on FDI because it

increases the risk and uncertainty experienced by the prospective investors (Khan & Akbar,

2013).

Keig et al. (2015) studied the impact of corruption environment on social irresponsibility of

multinational enterprise (MNE). The authors were interested in determining whether the

environments that MNEs operate influence their ability to practice corporate social responsibility.

They studied this relationship using the informal and formal dimensions of corruption. Through

this studied, they concluded that higher institutional corruption portfolios (formal and informal)

increase the risk of corporate social irresponsibility. This means that MNEs operating in

environments with high levels of formal and informal corruptions are likely to have higher levels

of corporate social irresponsibility.

The impact of corruption on the profitability of multinational companies is also studied in the

literature. Lee and Hong examined the effects of corruption levels on the profitability of MNCs in

6
the US. Through this study, these authors established that lower levels of corruption by host

countries impact the profitability of MNCs positively. One of the possible explanation for this

observation is that lower levels of corruption in a host country mean that government officials or

politicians are less likely to demand bribes from MNCs. Lobbying refers to an attempt to have

direct control over government actions or legislation or to affect the political process (Kerr et al.,

2014). For instance, businesses use lobbying to protect against foreign competition through

tariffs. It has been established that fraudulent firms spend more resources on lobbying than non-

fraudulent firms (Yu & Yu, 2011). In other words, lobbying is used to promote fraudulent

activities in business organisations.

Policies for international business

The political climate also influences the policies for international business. This is because the

political system of a country plays an important role in developing and governing the policies that

support FDI. Governments are in charge of enacting and enforcing policies that influence

international investment. Aithal (2017) argued that governments have developed several

strategies and policies to promote international business. At the same time, governments can also

develop strategies that discourage international business. Aithal (2017) noted that exports of

specific materials to subsidiary companies might be banned by the home country through tariffs,

quotas, or limiting FDI flows. Evidence also shows that sanctions are used in different countries

as political tools to encourage compliance. Fetzer and Schwarz (2021) claims that sanctions

increase the probability of leadership change.

Tax policies for international businesses are determined by the political climate of a country.

Recent evidence shows that most foreign direct investment (FDI) and global operations are

subjected to tax biasness (Contractor, 2017). According to Contractor (2017), most multinational

7
companies take advantage of tax loopholes created by government policies. For instance, the tax

policies on the US multinationals allow deferral of foreign affiliate income provided that those

profits are not remitted back to the US. Other countries levy high taxes on MNCs and this

reduced their profitability.

Evidence in the literature also shows that policies influence corruption in international business.

Pathak (2013) provided insights into the concept of corruption and whether compliance is higher

with anti-corruption laws or with corruption itself. Through this exploration, the author learned

that most people across the world are living in ignorance concerning the issues of corruption and

that anti-corruption laws are not effective because of ignorance. This shows that government in

different parts of the world especially the developing countries have created anti-corruption laws

but have not educated the public about them.

Bureaucracy

Bureaucracy is another political risk that influences international business. Evidence shows a link

between bureaucracy and corruption especially in developing countries (Fredriksson, 2014).

Tiwari (2012) studied the relationship between corruption, democracy, and bureaucracy. The

findings of the study indicated that democracy, rule of law, and control over corruption reduces

the level of corruption. Bureaucracy is linked to corruption because it allows discretional power

which is abused by politicians for personal gain. Bureaucracy is common in developing countries

and this explains why levels of corruptions are high in those countries.

The effect of bureaucracy on the attraction of FDI has been studied in the literature. Frâncu

(2015) studied the role of Romania’s bureaucratic system in attracting foreign investors. The

author identified some negative impacts of bureaucracy on FDI such as lack of transparency in

8
public organisations, prolonged problem-solving, inadequate infrastructure, and corruption.

These bureaucratic factors act as barriers to FDI as well as suppressants of economic growth.

This means that countries such as Romania are less competitive compared to other less

bureaucratic countries.

Despite the negative impacts that have been associated between bureaucracy and international

business, some studies identified positive impacts of bureaucracy. A study by Nawaz (2015)

indicated that bureaucracy has a positive impact on economic growth in both developed and

developing countries. This means that bureaucracy facilitates economic growth which in return

attracts FDI. Similar observations were made by Dahlström et al. (2011) who argued that a strong

and well-organised bureaucracy leads to economic growth.

Part 2: Example of a Country in which foreign direct investors may be subject to political

risk

Foreign direct investment (FDI) is seen as one of the strategies for promoting economic growth,

especially in developing countries. However, political risks in various countries limit the inflow

of FDI. Rafat and Farahani (2017) argued that political and institutional risks are the main issues

affecting foreign investors, particularly in non-developed countries.

Iran is one of the countries that foreign direct investors are likely to experience political risk. Iran

is characterized by several factors that increase its political risks and they include the following.

Internal and external conflicts

Iran has suffered multiple conflicts internally and externally. One of the major external conflicts

that have affected Iran is the conflicts with the Gulf Arab States. According to Nuruzzaman

(2012), the conflicts between Iran and the Gulf Arab States were ignited when the US invaded

9
Iraq in 2003. This is because the US and Iran have conflicted over nuclear weapons. External

conflicts between these countries are mainly religious in nature. For instance, the Islamic

sectarian divide has been the source of conflicts between the Shiite and Sunni in the country. Iran

has also engaged in territorial conflicts with its neighbours. Nuclear conflicts between Iran,

Israel, and Saudi Arabia are other sources of conflicts for the country. The religious tensions,

ethnic wars, and unstable politics also cause internal instability (Nuruzzaman, 2012).

According to Rafat and Farahani (2017), conflicts, especially external conflicts have adverse

effects on foreign investment in terms of restrictions on trade operations, violent change in

societal structure, and lack of transparency in the allocation of resources. The conflicts in Iran

seem to have discouraged investors because evidence shows that the Persian Gulf economic

system is characterised by low levels of investment (Nuruzzaman, 2012).

Corruption

The other political risk that might influence direct foreign investors in Iran is corruption. Iran is

usually ranked top among the countries with the highest index of corruption. A recent ranking by

Transparency International’s corruption perception index ranked Iran among the top two-third of

the countries with the highest perception of corruption (Azadi, 2020). Iran has been accused of

different forms of corruptions such as money laundering, bribery, extortion, and favouritism.

Iran’s financial system tops the world in terms of money laundering and drug trafficking is also

the main sources of funds in the country. Favouritism in Iran promotes nepotism where benefits

are given based on relation. Corruption associated with professional activities is also common in

Iran. For instance, favourable media coverage and analysis of the state of the economy are done

for the government (Azadi, 2020). Corruption is a threat to foreign investment because it distorts

the economical and financial environment. Corruption also affects the efficiency of governments

10
and business leadership because people will acquire power through corruption instead of

experience and qualification (Rafat & Farahani, 2017). As such, foreign investors interested in

Iran might be discouraged by corruption problems in the country.

Policies

Another measure of political risk in Iran relates to policies. Policies can promote or discourage

foreign investment. Just like any country, business policies are established by the Iranian

government. However, research shows that the Iranian economy is characterised by high tariff

and non-tariff barriers, unfavourable foreign exchange rate, and challenges in collecting

payments for exports. These challenges are associated with government dimensions such as

restrictive rules and regulations, bureaucratic needs, and inadequate help from the government

(Jalali, 2012). These factors reduce the suitability for foreign investment in the country.

According to Rafat and Farahani (2017), foreign investors are interested in a country with few

trade barriers to allow the free flow of goods and services.

Terrorism

Iran is usually linked to terrorism and this affects its political climate. Research shows that Iran is

one of the countries sponsoring terrorism around the world despite international condemnation

(Manni, 2012). The country also admits its involvement in the French Revolution and this makes

the state central to terrorism (Ansari, 2020). Iran has continued to support terrorism since the

Islamic Revolution in 1979 in the Middle East, Central Asia, and South America. The active

sponsorship of terrorism activities does not only affect the economic stability of the Gulf region,

but also the economic growth of the country. For instance, the country has experienced

international sanctions through the United Nations as a way of pushing Iran to adopt new

policies. However, the sanctions have not been successful because Iran receives backing from

11
other countries such as China and Russia (Manni, 2012). Terrorism does not only scare potential

foreign investors buts also create a bad reputation for the country.

Political stability

Iran is one of the countries in the world with the unstable political system. The main source of

instability in the country relates to democracy issues. Lack of democracy in the country has

ignited multiple protests, especially from the opposition. The political instability in the country is

also caused by various conflicts that the country has experienced. Political instability is a threat to

foreign direct investment because it increases policy volatility. This means that policies related to

international business will change from time to time due to instability. Protests also can lead to

violence which interferes with business operations.

Recommendations

Based on the political risks in Iran discussed above, several recommendations are available for

mitigating political risks in the future. One of the recommendations for international business is

to acquire political risk insurance (PRI). Foreign investors or businesses can acquire political

insurance to control future risks. Stiller (2015) argued that different agencies offer political risk

insurance and they vary from country to country. For instance, the UK Export Finance (UKEF)

are the providers of insurance. The political insurance will mitigate damages and eligible parties

can make claims (Stiller, 2015). PRI protects against the negative impacts of the actions of

government or political groups on business investments. For example, it protects against damages

caused by political violence and wars, restrictions on remittances, and breach of contract among

other things (Mayer, 2018).

12
The other recommendation for mitigating political risk is the joint venture with a local company.

This tool of the joint venture is mainly used by companies investing in developing countries.

According to Iftinchi and Hurduzeu (2018), 24% of MNCs opt for a joint venture with a local

enterprise as the best risk mitigation tool compared to others. Using a joint venture as a risk

mitigation tool has several benefits. One of the benefits is that it brings a better understanding of

the business environment of the host country. It also helps MNCs to develop a good relationship

with political stakeholders through local network connections. Establishing good relationships

with the government will allow companies to get good treatment from the government. Joint

ventures can be voluntary or forced but they help to reduce exposure to political risk.

The other recommended strategy for mitigating political risk is through the investment protection

agreement between the investors and the host country’s legal system. Stiller (2015) argued that

the national legal system of the host country provides a reasonable level of legal protection. Some

countries have protection treaties such as bilateral investment treaties (BIT) for private investors.

As such, MNCs should investigate to determine if the host country provide such treaties.

Investment treaties provide protection such as equitable treatment, protection against

expropriation, transfer guarantees, and security (Stiller, 2015). The other recommendation for

mitigating political risk is by adopting policies and ensuring compliance. For instance, the

political risk of corruption can be prevented through ant-corruption policies. The governments

should educate the public on corruption and its consequences. This will bring a better

understanding and compliance to anti-corruption laws. Besides, every country should establish an

ethics commission to reduce political corruption (Crider & Milyo, 2013). Trade policies should

also promote trade liberalisation, elimination of tax biasness, and minimization of tariffs on FDI.

Restrictions on FDI’s capital transactions should be removed.

13
Conclusion

This paper focused on various political risks affecting international business. Iran was discussed

as the country that foreign direct investors are likely to experience political risks. Political risk

refers to actions taken by governments that are likely to impact the cash flows of international

business. The main political risks that might affect international businesses include political

system and stability, corruption, lobbying, policies, bureaucracy, and terrorism. A country with

political stability is likely to experience the inflow of FDI. Political instability on the other hand

limits FDI inflows. Corruption also affects FDI because it alters economic growth and limits the

function of the government as well as organisational leadership. Policies can also promote or

limit international business. For instance, policies that remove trade barriers promote foreign

investment. Bureaucracy involves international business both positively and negatively. Strong

and well-organised bureaucracy promotes economic growth and consequently promotes

international business. Unorganised bureaucracy on the other hand promotes corruption. The

main political risks in Iran include internal and external conflicts, political instability, corruption,

and terrorism. Political risks can be mitigated through political risk insurance, joint venture, and

investment protection agreement.

14
References

Aguiar, S., Aguiar-Conraria, L., Gulamhussen, M.A. and Magalhães, P.C., 2012. Foreign direct

investment and home-country political risk: the case of Brazil. Latin American Research Review,

pp.144-165.

Aithal, P.S., 2017. Impact of Domestic, Foreign, and Global Environments on International

Business Decisions of Multinational Firms: A Systematic Study. International Journal of

Management, Technology, and Social Sciences (IJMTS), 2(2), pp.93-104.

Ansari, A.M., 2020. The state and terrorism in Iran. In Non-Western responses to terrorism.

Manchester University Press.

Azadi, P., 2020. The Structure of Corruption in Iran.

Bahoo, S., Alon, I. and Paltrinieri, A., 2020. Corruption in international business: A review and

research agenda. International Business Review, 29(4), p.101660.

Bekaert, G., Harvey, C.R., Lundblad, C.T. and Siegel, S., 2016. Political risk and international

valuation. Journal of Corporate Finance, 37, pp.1-23.

Bekaert, G., Harvey, C.R., Lundblad, C.T. and Siegel, S., 2016. Political risk and international

valuation. Journal of Corporate Finance, 37, pp.1-23.

Chang, T., Hwang, B.G., Deng, X. and Zhao, X., 2018. Identifying political risk management

strategies in international construction projects. Advances in Civil Engineering, 2018.

Contractor, F.J., 2016. Tax avoidance by multinational companies: Methods, policies, and ethics.

Rutgers Business Review, 1(1).

Crider, K. and Milyo, J., 2013. Do state ethics commissions reduce political corruption: An

exploratory investigation. UC Irvine L. Rev., 3, p.717.

15
Dahlström, C., Lapuente, V. and Teorell, J., 2011. Dimensions of bureaucracy II: A cross-

national dataset on the structure and behaviour of public administration. QoG Working Paper

Series, 6.

Fetzer, T. and Schwarz, C., 2021. Tariffs and politics: evidence from Trump’s trade wars. The

Economic Journal, 131(636), pp.1717-1741.

Frâncu, L.G., 2015. The impact of bureaucracy over the foreign direct investments in Romania.

Theoretical and Applied Economics, 22(Special (I)), pp.33-38.

Fredriksson, A., 2014. Bureaucracy intermediaries, corruption and red tape. Journal of

Development Economics, 108, pp.256-273.

Iftinchi, V. and Hurduzeu, G., 2018. The Pros and Cons of Using Joint Ventures as a Tool to

Mitigate Political Risks in Developing Countries. Romanian Economic Journal, 21(67), pp.193-

199.

Jalali, S., 2015. Export barriers and export performance: empirical evidence from the commercial

relationship between Greece and Iran. South-Eastern Europe Journal of Economics, 10(1).

Jewel, F.R., 2015. Political Stability, foreign direct investment and remittance inflow in

Bangladesh: An empirical Analysis.

Jiménez, A., Luis-Rico, I. and Benito-Osorio, D., 2014. The influence of political risk on the

scope of internationalization of regulated companies: Insights from a Spanish sample. Journal of

World Business, 49(3), pp.301-311.

Keig, D.L., Brouthers, L.E. and Marshall, V.B., 2015. Formal and informal corruption

environments and multinational enterprise social irresponsibility. Journal of Management

Studies, 52(1), pp.89-116.

Kerr, W.R., Lincoln, W.F. and Mishra, P., 2014. The dynamics of firm lobbying. American

Economic Journal: Economic Policy, 6(4), pp.343-79.

16
Khan, M.M. and Akbar, M.I., 2013. The impact of political risk on foreign direct investment.

Lee, S.H. and Hong, S.J., 2012. Corruption and subsidiary profitability: US MNC subsidiaries in

the Asia Pacific region. Asia Pacific Journal of Management, 29(4), pp.949-964.

Manni, N.F., 2012. Iran's Proxies: State Sponsored Terrorism in the Middle East. Global Security

Studies, 3(3).

Mayer, H., 2018. Political risk insurance and its effectiveness in supporting private sector

investment in fragile states. Commission on State Frazility, Growth and Development.

Mshelia, J.B. and Anchor, J.R., 2019. Political risk assessment by multinational corporations in

African markets: A Nigerian perspective. Thunderbird International Business Review, 61(2),

pp.133-142.

Nawaz, S., 2015. Growth effects of institutions: A disaggregated analysis. Economic Modelling,

45, pp.118-126.

Nuruzzaman, M., 2012. Conflicts between Iran and the Gulf Arab States: an economic

evaluation. Strategic Analysis, 36(4), pp.542-553.

Pathak, H., 2013. Corruption and compliance: preventive legislations and policies in international

business projects. Tribuna Juridică, 3(06), pp.136-151.

Rafat, M. and Farahani, M., 2019. The country risks and foreign direct investment (FDI). Iranian

Economic Review, 23(1), pp.235-260.

Saidi, Y., Ochi, A. and Ghadri, H., 2013. Governance and FDI attractiveness: Some evidence

from developing and developed countries. Global Journal of Management and Business

Research.

Samimi, A.J., Moghaddasi, R. and Azizi, K., 2011. Political stability and FDI in OIC countries.

Journal of Social and Development Sciences, 1(1), pp.18-23.

17
Shahzad, A. and Al-Swidi, A.K., 2013. Effect of macroeconomic variables on the FDI inflows:

The moderating role of political stability: An evidence from Pakistan. Asian Social Science, 9(9),

p.270.

Shenkar, O., Luo, Y. and Chi, T., 2014. International business. Routledge.

Stiller, D.F., 2015. Political risks: How to effectively mitigate political risks, deal structure,

financing and political risk insurance. Journal of Airport Management, 9(2), pp.133-143.

Yu, F. and Yu, X., 2011. Corporate lobbying and fraud detection. Journal of Financial and

Quantitative Analysis, pp.1865-1891.

18