Chapter 6

International Business: The New Realities, 5th Global Edition

by
Cavusgil, Knight, and Riesenberger

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 Learning Objectives
6.1 Describe political and legal environments in
international business.
6.2 Understand political systems.
6.3 Understand legal systems.
6.4 Describe the participants in political and legal
6.5 Identify the types of country risk produced by
political systems.
6.6 Identify the types of country risk produced by
legal systems.
6.7 Know about managing country risk.
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 Realities of Doing Business in Russia

• High rate of piracy in software, music, DVDs, other

goods
• Anti-piracy laws and law enforcement are weak.
Obtaining business licenses requires bribing officials.
• SMEs may spend 1/5 of their net income on bribes.
• There is substantial organized crime and killings.
• Criminal raiders may seize independent businesses.
• Conditions in Russia are typical of many emerging
markets and developing economies.

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 What is Country Risk?
Exposure to potential loss or adverse effects on company
operations and profitability caused by developments in a
country’s political and/or legal environments.
• Also known as Example
‘political risk’ Coca-Cola’s business fell off in
Germany when the government
• Each country has enacted a recycling plan. New laws
unique political required consumers to return
and legal systems nonreusable soft drink containers to
that often pose stores for a refund of 0.25 euros.
challenges for Rather than cope with the unwanted
company returns, big supermarket chains
performance pulled Coke from their shelves.
The potential benefits, costs and risks of doing business in a country
are a function of its political, economics, and legal systems. 4
 Political Systems
• Political systems can be assessed according to two
dimensions:
– the degree to which they emphasize collectivism as opposed
to individualism, and
– the degree to which they are democratic or totalitarian.
• Collectivism is an ideology that views the needs of society as
being more important than the needs of individuals.
• Collectivism translates into an advocacy for state intervention in
economic activity and, in the case of communism, a totalitarian
dictatorship.
• Individualism is an ideology that is built on an emphasis of the
primacy of the individual’s freedoms in the political, economic, and
cultural realms.
• Individualism translates into an advocacy for democratic ideals and
free market economics.
Democracy <------------------------------------------> Totalitarianism 5
Dimensions of Country Risk

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Country Risk in Selected Countries

Measured as political stability, legal environment, economic indicators,

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and tax policy.
 Political and Legal Systems

A political system is a set of formal institutions that constitute a

government. It includes legislative bodies, political parties,
lobbying groups, and trade unions. The principal functions of a
political system are to:
• Provide protection from external threats.
• Ensure stability based on laws.
• Govern the allocation of valued resources among the
members of a society.
• Define how a society’s members interact with each other.

Constituents are the people and organizations that support the

political system and receive government resources.

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 Political and Legal Systems

•Understand Political Systems

•Three major types of political systems:
▪ Totalitarianism
▪ Socialism
▪ Democracy

•These categories are not mutually exclusive.

•Many democracies also include some elements of
socialism. Many former authoritarian regimes now
embrace a mix of socialism and democracy.

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 Political and Legal Systems (cont’d)

• Legal system: A system for interpreting and

enforcing laws. The laws, regulations, and rules
establish norms for conduct. It incorporates
institutions and procedures for ensuring order and
resolving disputes in commercial activities, as well
as protecting intellectual property and taxing
economic output.

• Four major types of legal systems:

▪ Common Law
▪ Civil Law
▪ Religious Law
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 Sources of Country Risk

Political System Legal System

•government Laws, regulations, and
•political parties rules that aim to:
•legislative bodies • ensure order in
•lobbying groups commercial activities
•trade unions • resolve disputes
•other political • protect intellectual
institutions property
• tax economic output

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 Political Systems: Totalitarianism

• Government controls all economic and political

matters
• Either theocratic (religion-based) or secular
• A state party is led by a dictator. Membership is
mandatory for those wanting to advance.
• Power is sustained via secret police, propaganda,
and regulation of free discussion and criticism.
• Today: Some countries in the Middle East and Africa;
▪ China (1949–1980s)
Cuba, North Korea. ▪ Germany (1933–1945)
▪ Soviet Union (1918–1991)
• Ex-totalitarian states tend to ▪ Spain (1939–1975)
have much government 12
 Political Systems: Socialism

• Capital is vested in the state and used primarily as

a means of production for use rather than for profit.
• Group welfare outweighs individual welfare.
• Government’s role is to control the basic means of
production, distribution, and commercial activity.
• Socialism occurs in much of the world as social
democracy (e.g., Western Europe, Brazil, India).
• Government intervention in the private sector
• Corporate income tax rates are higher

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 Political Systems: Democracy

• Economic activity occurs freely, as per market forces

• Limited government: The government performs
only essential functions that serve all citizens, such
as national defense, maintaining law and order,
foreign relations, and providing basic infrastructure.
• Private property rights: The ability to own property
and assets and to increase one’s asset base by
accumulating private wealth. Property includes land,
buildings, stocks, contracts, patents. Encourages
initiative, ambition, innovation.
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 Examples of Countries
Under Various Political Systems

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 Relationship Between
Economic and Political Freedom (cont’d)

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 Relationship Between
Economic and Political Freedom (cont’d)

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 Democracy and Openness

• Democracy is associated with ‘openness,’ the lack of

regulation and barriers to the entry of firms in foreign
markets. Example
Since the 1980s, India
• Openness is associated with: steadily lowered entry
▪ Successful market entry barriers to its car market.
▪ Increased market demand Foreign carmakers
entered the market,
▪ Competition on quality, which
greatly increasing the
improves overall product quality.
number of models for
▪ Increased competition, leading sale. Greater competition
to efficiencies and lower prices. increased the quality of
available cars, and car
prices fell. 18
 The Relationship Between Political
Systems and Economic Systems
• Each political system tends to be associated with
a particular type of economic system.
• Generally speaking, authoritarianism is
associated with command economies,
democracy with market economies, and
socialism with mixed economies.
Examples
North Korea
USA
UK
India
China

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 Political and Economic Systems

• Totalitarianism is associated with command

economies, wherein the state makes all decisions on
what to produce, how much to produce, and what
prices to charge.
• Democracy is associated with market economies and
capitalism in which decisions are largely left to market
forces, that is, supply and demand.
• Socialism is associated with mixed economies, which
have features of both market and command
economies, combining state intervention and market
mechanisms (e.g., Sweden, Singapore).
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 The Rule of Law

Existence of a legal system where rules are clear,

publicly disclosed, fairly enforced, and widely respected
by individuals, organizations, and the government.

• Common in the advanced economies.

• The legal system is: (i) applied to all citizens equally;
(ii) issued via recognized government authorities; and
(iii) enforced fairly and systematically by police forces
and formally organized judicial bodies.
• Economic activity suffers and uncertainty increases
when the rule of law is weak.
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 Legal Systems: Common Law

• A legal system that originated in England and spread

to Australia, Canada, USA, and other former
members of the British Commonwealth (also known
as case law).
• The basis of law is tradition, past practices, and legal
precedents set by courts via interpretation of
statutes, legislation, and past rulings.
• Judges have much power to interpret laws based on
the circumstances of individual cases. Thus, common
law is relatively flexible.
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 Legal Systems: Civil Law

• Found in France, Germany, Italy, Japan, Turkey, and

much of Latin America.
• Based on an all-inclusive system of laws that have
been “codified”—clearly written by legislative bodies.
• Laws are more ‘cast in stone’ and not strongly
subject to interpretation by courts.
• A key difference is that common law is mainly judicial
in origin and based on court decisions, whereas civil
law is mainly legislative and based on laws passed
by national and state legislatures.
• 23
 Sampling of Differences
between Common Law and Civil Law

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 Sources of Law

The
Constitution
↓↓↓

Branch of Judicial Legislative Executive

Govt. ↓ ↓ ↓
↓ ↓ ↓

Type of Law Case Law Statutes Regulations

Produced ↓ ↓ ↓
↓ ↓ ↓

Session Laws
Chronological Case Law The Gazette
(Federal
Publication of Reporters of Pakistan
Laws)
Law ↓ ↓
↓
↓ ↓
↓

Publication of
PLD, ScMR Pakistan Gazette
Law By
etc. Code Notifications
Subject

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 Legal Systems: Religious Law
• Strongly influenced by religious beliefs, ethical codes,
and moral values and viewed as mandated by a
supreme being.
• Most important religious legal systems are based on
Hindu, Jewish, and Islamic law.
• Islamic law spells out
norms of behavior
regarding politics,
economics, banking,
contracts, marriage,
and many other social
and business issues. 26
 Legal Systems: Mixed Systems
• Two or more legal systems operating together.
• The contrast between civil and common law has
blurred as countries combine both systems.
• Totalitarianism is most associated with religious law
and socialist law.
• Democracy is associated with common law, civil
law, and mixed systems.
Example
Legal systems in Lebanon, Morocco, and Tunisia share
elements of civil law and Islamic law.
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Dominant Legal Systems in Selected Countries

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 Actors in Political and Legal Systems

• The government, or the ‘public sector,’ operating

at national and local levels.
• International organizations such as the World Bank,
World Trade Organization, and the United Nations
• Regional economic blocs, such as the European
Union, NAFTA, and many others.
• Special interest groups
such as labor unions and
environmental advocates
• Local competing firms,
which oppose foreign
firms.
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Special Interest Groups Typical Issues

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 Country Risk Produced by Political Systems:
Government Takeover of Corporate Assets
• Confiscation: Seizure of corporate assets
without compensation.
• Expropriation: Asset seizure with compensation.
• Nationalization: Takeover of an entire industry,
with or without compensation.
Examples
• In Venezuela, President Hugo Chavez confiscated an
oil field owned by the French petroleum firm Total.
• In Bolivia in 2006, the Bolivian government
nationalized the oil and gas industry.
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 Country Risk Produced by Political Systems:
Creeping Expropriation
• The most common expropriation today.
• The government gradually modifies regulations and
laws after foreign MNEs have made big local
investments in property and plants.
Examples
•Abrupt termination of contracts.
•Creation of laws that favor local firms.
•The governments in Bolivia, Russia,
and Venezuela have modified tax
regimes to extract revenues from
coal, oil, and gas companies.
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 Country Risk Produced by Political Systems:
Embargoes and Sanctions
• Governments may respond to offensive activities of
foreign countries by imposing embargoes and
sanctions.

• Sanctions are bans on international trade, usually

undertaken by a country, or a group of countries,
against another judged to have jeopardized peace and
security.

• Embargoes are bans on exports or imports that forbid

trade in specific goods with specific countries. Example:
The U.S. has enforced embargoes against Cuba, Iran,
and North Korea, labeled as state sponsors of terrorism.
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 Country Risk Produced by Political Systems:
Boycotts against Firms and Nations
• Voluntary refusal to engage in commercial
dealings with a nation or a company

Examples from France

•Citizens boycotted Disneyland Paris to express
opposition to globalization and takeover of French
farmland.
•French farmers boycotted McDonald’s and crashed
a tractor into a shop to vent their anger with
agricultural policies and globalization.
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 Country Risk Produced by Political Systems:
Wars, Insurrection, and Violence

• War and insurrection – Indirect effects can be

disastrous for company activities.
• Terrorism: the threat or actual use of force or
violence to attain a political goal through fear and
intimidation.
• Some terrorism is sponsored by national
governments.
• Terrorism particularly affects certain industries –
tourism, hospitality, aviation, finance, retailing.
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Types of Country Risk Produced by Legal Systems

Country risk arising from the host country legal

environment:
• Foreign investment laws
• Controls on operating forms and practices
• Marketing and distribution laws
• Laws regarding income repatriation
• Environmental laws
• Contract laws
• Inadequate or underdeveloped legal systems
• Internet and e-commerce regulations
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 Country Risk Arising from the Host Country

• Foreign investment laws affect FDI-based entry.

Examples
• Japan – The “large-scale retail store law” restricted
foreigners from opening warehouse-style stores like
Toys’R’Us in favor of smaller Japanese retailers.
• Mexico – Foreign oil companies cannot obtain 100%
ownership of Mexican oil firms.
• United States – Restricts inward investments seen to
affect national security. E.g., the U.S. Congress blocked
Dubai Ports World, a Middle Eastern firm, which sought
a deal to manage U.S. ports.
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Country Risk Arising from the Host Country (cont’d)

• Controls on operating forms and practices are

laws and regulations on how firms can conduct
production, marketing, and distribution activities.

Example
In the telecommunications sector in China, the
Chinese government requires foreign investors to
seek joint ventures with local firms. This ensures
local control of the telecom industry, and China
gains access to foreign capital and technology.

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Country Risk Arising from the Host Country (cont’d)

• Marketing and distribution laws regulate

practices in advertising, promotion, and
distribution.
Examples
• Finland, France, Norway, and New Zealand
prohibit cigarette advertising on television.
• Canada and other countries cap prices in the
pharmaceutical and other industries.

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Country Risk Arising from the Host Country (cont’d)

• Laws on income repatriation limit the amount of net

income or dividends that firms can bring back to the
home country.
• Environmental laws aim to preserve natural
resources, combat pollution, and ensure safety.
• Contract laws affect the sale of goods and services;
intermediary agreements; licensing and franchising;
foreign direct investment; and joint ventures.
Example
In Germany, firms are responsible for recycling product
packaging.
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Country Risk Arising from the Host Country (cont’d)

• Internet and E-Commerce Regulations

Internet and e-commerce regulations are the new frontier in legal systems
and continue to evolve.
Firms that undertake e-commerce in countries with weak laws face
considerable risk.
Many consumer-privacy laws have yet to be enacted, and progress has been
delayed on the development of methods to protect private data from
criminal or competitive eyes.
Protections for online contracting methods have been implemented with the
recent adoption of e-signature laws.
Emergent e-signature laws offer protections for online contracting.

Examples
• In China, for example, the government has developed
legislation to ensure security and privacy due to the rapid
spread of the Internet and e-commerce. 41
Country Risk Arising from the Host Country (cont’d)

• Inadequate or underdeveloped legal systems, or

poor enforcement of existing laws.
• Laws may be weak regarding intellectual property,
pollution, consumer protection, and other areas.
• While the problem is common in developing
economies, it can occur in advanced economies too.
Examples
•In China and Russia, foreign firms sometimes abandon
business ventures due to erratic legal environments.
•The recent global financial crisis was triggered partly by
poor regulation in the United States and Europe.
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Country Risk Produced by Legal Systems (cont’d)

Country risk arising from the home country legal

environment:
• The Foreign Corrupt Practices Act (FCPA)
• Anti-boycott regulations

• Accounting and reporting laws

• Transparency in financial reporting

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 Country Risk Arising from the Home Country

• Extraterritoriality: the application of home-country

laws to other countries. For example, the European
Union pursued Microsoft for monopolistic practices.
• The Foreign Corrupt
Practices Act (1977;
U.S.) made it illegal to
offer bribes to foreign
parties. But the act may
harm U.S. firms because
foreign competitors are
usually not so constrained.
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 Country Risk Arising from the Home Country (cont’d)

• Accounting and reporting laws differ widely

around the world. Two examples:
▪ Physical asset valuations: Canada and the U.S. use
historical costs. Some Latin American countries use
inflation-adjusted market value.
▪ R&D costs: expensed as incurred in most of the
world; capitalized in South Korea and Spain. Some
countries use both conventions.

• Transparency in financial reporting is the degree

to which firms regularly reveal substantial financial
and accounting information. Varies worldwide.
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 Ethical Connections
● Many countries lack antibribery laws for international
transactions.
● The Organisation for Economic Cooperation and
Development (OECD) recently called for a ban on
“grease payments,” small-scale bribes intended to
speed up telephone hookups, government paperwork,
and other everyday matters in global commerce.
● A culture of grease payments and other corruption is
corrosive, harming the rule of law and sustainable
economic development.
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 Managing Country Risk
● Proactive environmental scanning: Management
should develop a comprehensive understanding of
the political and legal environment in target
countries. Scanning – ongoing assessment of
potential risks and threats to the firm, via
intelligence sources such as:
▪ Employees working in the host country
▪ Embassy and trade association officials
▪ Consulting firms, such as Business Entrepreneurial
Risk Intelligence (http://www.beri.com)
● Minimize exposure to country risks
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 Managing Country Risk (cont’d)

• Strict adherence to ethical standards: Firms that

engage in questionable practices or operate outside
the law invite redress from the governments of the
host countries where they do business.
• Alliances with qualified local partners: For
example, firms often enter China and Russia by
partnering with local firms who assist in navigating
the complex legal and political landscape.

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 Managing Country Risk (cont’d)
• Protection through legal contracts: Contract law varies
widely. The firm must follow the law in each country. Three
approaches for resolving contract disputes:
o Conciliation is a formal process of negotiation whose
objective is to resolve differences in a friendly manner. It is
the least adversarial method and common in China.
o In arbitration, a neutral third party hears both sides of a
case and decides in favor of one party or the other, based
on an objective assessment of the facts.
o Litigation occurs when one party files a lawsuit against
another. The most adversarial approach, it is common in
the United States.

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