Chapter 6 Political and Legal Systems in National Environments

6.1 Describe political and legal environments in international business.

6.2 Identify types of country risk produced by political systems.
6.3 Identify types of country risk produced by legal systems.

6.1 Describe political and legal environments in international business

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.
• Similar to “political risk,” but also can include economic challenges
• Each country has unique political and legal systems that often pose challenges for company performance.
• Political or legislative actions can harm business interests, such as laws that are unexpectedly strict or result
in unintended consequences. Many laws favor host-country interests—that is, interests in foreign countries
where the firm has direct operations.
• One of the four major risks in IB

Example
• Coca-Cola’s business fell off in Germany when the government enacted a recycling plan. New laws required
consumers to return non-reusable soft drink containers to stores for a refund of 0.25 euros. Rather than cope
with the unwanted returns, big supermarket chains pulled Coke from their shelves.
• In China, the government censors TV programs such as Downton Abbey, House of Cards, and The Walking
Dead, whose content is considered inappropriate for Chinese citizens. Chinese authorities forbid the broadcast
of Western shows that feature sex, violence, extramarital affairs, and content critical of the Chinese
government.
What is the Political System?

• Political system: A set of formal institutions that constitute a government. It includes legislative bodies,
political parties, lobbying groups, and trade unions. The system also defines how these groups interact with
each other.

• Three major types of political systems:

– Authoritarianism
– Socialism
– Democracy
• These categories are not mutually exclusive

What is the Legal System?

• 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
• Mixed Systems

Political Systems: Authoritarianism

• 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, regulation of free discussion and criticism.
• Today: Some countries in the Middle East and Africa; Cuba, North Korea.
• Ex-authoritarian states tend to have much government intervention and bureaucracy.
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.

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 & 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.
Examples of Countries Under Various Political Systems

Elements of Authoritarianism Found in Elements of Socialism Found in Largely Democratic

Afghanistan Bolivia Australia

Iran China Canada
North Korea Egypt Japan
Venezuela India New Zealand
Several countries in Africa (such as Eritrea, Romania United States
Sudan, Equatorial Guinea, Zimbabwe)
Blank Russia Most European countries
Blank Tanzania Most Latin American countries

Relationship Between Economic and Political Freedom

Compared to totalitarianism and socialism, democracy is associated with greater economic freedom and higher living
standards. Economic freedom flourishes when governments support the institutions necessary for that freedom, such
as freely operating markets and the rule of law. As countries develop economic ties with foreign trading partners and
integrate themselves with the global economy, they tend to liberalize their markets and reduce restrictions on foreign
business.

Example: With the introduction of economic reforms and open markets in India since the 1990s. Countries with the
highest living standards—for example, Australia, France, Germany, Japan, United States—also tend to have the most
political and economic freedoms. By contrast, countries with the lowest living standards—for example, Libya, North
Korea, Pakistan—tend to score lowest on political and economic freedoms.

Democracy and Openness

• Democracy is associated with “openness”, the lack of regulation and barriers to the entry of firms in foreign
markets.
• Openness is associated with:
– Successful market entry.
– Increased market demand.
– Competition on quality, which improves overall product quality.
– Increased competition, leading to efficiencies and lower prices.
 Example

• India has steadily lowered entry barriers to its car market. Foreign carmakers entered the market, greatly
increasing the number of models for sale. Greater competition increased the quality of available cars, and car
prices fell.

Political and Economic Systems

• Authoritarianism is associated with command economies, wherein the state makes all decisions on what to
produce, how much to produce, and what prices to charge. In command economies, sizable bureaucracy
thrives, and central planning tends to be less efficient than market forces in synchronizing supply and demand.
For example, goods shortages were so common in the Soviet Union that people often waited in lines for hours
to buy basic necessities such as sugar and bread.

• Democracy is associated with market economies and capitalism, in which decisions are largely left to market
forces, that is, supply and demand. Government intervention in the marketplace is limited. Market economies
are closely associated with capitalism, in which the means of production are privately owned and operated.
The task of the state is to establish a legal system that protects private property and contractual agreements

• 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). In France, for example, the
government partly owns dozens of companies, mainly in the transportation, communication, and energy
industries. Peugeot and Renault are partially state owned. In Germany, Japan, Norway, Singapore, and Sweden,
the government often works closely with business and labor groups to determine industrial policy, regulate
wage rates, and/or provide subsidies to support specific industries.

Legal System

Sampling of Differences between Common Law and Civil Law

Legal Issues Civil Law Common Law

Ownership of intellectual Determined by registration. Determined by prior use.

property

Enforcing agreements Commercial agreements become Proof of agreement is sufficient for

enforceable only if properly notarized enforcing contracts.
or registered.

Specificity of contracts Contracts tend to be brief because Contracts tend to be very detailed, with all
many potential problems are already possible contingencies spelled out. Usually
covered in the civil code. more costly to draft a contract.

Compliance with Noncompliance is extended to include Acts of God (floods, lightning, hurricanes,
contracts unforeseeable human acts such as etc.) are the only justifiable excuses for
labor strikes and riots. noncompliance with the provisions of
contracts

Legal Systems: Religious Law

• Strongly influenced by religious beliefs, ethical codes, and moral values, 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.
Legal Systems: Mixed Systems
• Two or more legal systems operating together.
• The contrast between civil and common law has become blurred as countries combine both systems.
• Authoritarianism 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.

Dominant Legal Systems in Selected Countries

Primarily Primarily Primarily Mixed Systems

Common Law Civil Law Religious Law

Australia Canada Ireland Much of western Europe Much of the Middle East Bangladesh
New Zealand United and Latin America Japan and North Africa India Indonesia
Kingdom United States Russia South Korea Afghanistan Mauritania Israel Kenya Malaysia
Pakistan Sudan Philippines

6.2 Identify types of country risk produced by political systems.

Government Takeover of Corporate Assets. Governments occasionally seize the assets of corporations. The industry
sectors most often targeted by government seizure are natural resources (for example, mining and petroleum), utilities,
and manufacturing. Fortunately, aggressive seizure is less common these days as governments in many developing
countries have adopted institutional reforms that aim to attract FDI from abroad and foster economic growth.

Embargoes and Sanctions. A sanction is a type of trade penalty imposed on one or more countries by one or more
other countries. Sanctions typically take the form of tariffs, trade barriers, import duties, and import or export quotas.
They generally arise in the context of an unresolved trade or policy dispute, such as a disagreement about the fairness
of some international trade practice. There is much evidence suggesting that sanctions often do not achieve desired
outcomes.

• Example: The United States has imposed trade sanctions on Iran and Syria. However, goods continue to flow
in and out of both countries from China, Germany, Japan, and numerous other trading partners.

An embargo is an official ban on exports to or imports from a particular country to isolate it and punish its government.
It is generally more serious than a sanction and is used as a political punishment for some disapproved policies or acts.

• Example: The United States has enforced embargoes against Iran and North Korea, at times labeled as state
sponsors of terrorism. The European Union has enacted embargoes against Belarus, Sudan, and China in
certain areas, such as foreign travel, to protest human rights and weapon-trading violations.

Boycotts Against Firms or Nations. Consumers and special interest groups occasionally target particular firms
perceived to have harmed local interests. Consumers may refuse to patronize firms that behave inappropriately. A
boycott is a voluntary refusal to engage in commercial dealings with a nation or a company. Boycotts and public
protests result in lost sales and increased costs (for public relations activities needed to restore the firm’s image).

• Example: Disneyland Paris and McDonald’s have been the targets of boycotts by French farmers, who believe
these firms represent U.S. agricultural policies and globalization, which many French citizens despise. Activists
in numerous countries organized a boycott of petroleum company BP following its oil spill in the Gulf of Mexico.
In 2013, activist groups advocated boycotting Russian products and the Sochi Winter Olympics over concerns
that Russia’s government discriminates against gays and lesbians.

Terrorism. Terrorism is the threat or actual use of force or violence to attain a political goal through fear, coercion, or
intimidation. It is sometimes sponsored by national governments.
 • Example: Terrorism has escalated in much of the world, as exemplified by attacks in France, India, the
Philippines, Spain, the United Kingdom, and the United States, as well as various countries in the Middle East.
In India, more than 30,000 people have died in terrorist attacks in the past two decades. Most recent terrorist
attacks have occurred in Afghanistan, Iraq, Nigeria, Pakistan, and Syria. In addition to causing loss of life,
terrorism can severely damage commercial infrastructure and disrupt business activities. It induces fear in
consumers, who reduce their purchasing, potentially leading to economic recession. The transportation and
retailing industries are particularly affected. Terrorism also affects financial markets. In the days following the
September 11, 2001, attacks in New York, the value of the U.S. stock market dropped some 14 percent.

War, Insurrection, and Violence. War, insurrection, and other forms of violence pose significant problems for business
operations. Although such events usually do not affect companies directly, their indirect effects can be disastrous.

• Example: Violent conflict among drug cartels and security services along the U.S.–Mexico border has led some
firms and financiers to withdraw investments from Mexico because of perceived heightened risks and political
instability. In India, Tata Motors (www. tatamotors.com) shifted the location of a major new factory due to
violent protests by local farmers who feared the loss of their livelihood. To minimize losses from violent acts,
firms can purchase risk insurance.

6.3 Identify 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 on income repatriation
• Environment laws
• Contract laws
• Internet and e-commerce regulations
• Inadequate or underdeveloped legal systems

Country Risk Arising from the Home-Country Legal Environment

Extraterritoriality refers to the application of home–country laws to persons or conduct outside national borders. In
most cases, such laws are intended to prosecute individuals or firms located abroad for some type of wrongdoing.

Example: A French court ordered Yahoo! to bar access to Nazi-related items on its website in France and to remove
related messages and images from its sites accessible in the United States. In 2015, the European Union charged
Google with monopolistic practices in the promotion of its web search services. Monopolies are considered harmful
because they can unfairly restrain trade. Businesses generally oppose extraterritoriality because it tends to increase
the costs and uncertainty of operating abroad.

• The Foreign Corrupt Practices Act (FCPA). Passed by the U.S. government in 1977, the Foreign Corrupt Practices
Act (FCPA) banned firms from offering bribes to foreign parties to secure or retain business.
• Accounting and Reporting Laws. Accounting practices and standards differ greatly around the world, posing
difficulties for firms. When valuing physical assets such as plant and equipment, Canada uses historical costs.
Some Latin American countries use inflation-adjusted market value.
• Transparency in financial reporting. The degree to which companies regularly reveal substantial information
about their financial condition and accounting practices.