Understanding and Managing Political Risk
An International Investor Guide to Political Risk
International investing is a powerful way to diversify and grow a portfolio, but often times, there's a higher level of risk than domestic investing. Many of these risks are unique to international investing and deal with things, like currencies or conflicts, that are specific to a particular country.
Political risk is among the most important risk factors facing international investors. In many emerging and frontier markets, the political situation is significantly less stable than the United States with the potential for widespread fraud and corruption.
What is Political Risk?
Political risks are those associated with changes that occur to a country's policies governing businesses, as well as external factors that could affect businesses. A common example of political risk might be a country that unexpectedly raises corporate taxes for a specific industry. A more extreme example may be an act of war or military coup that cuts companies off from global revenue sources.
There are many examples of political risk occurring in emerging and frontier markets. In early 2007, former Venezuelan President Hugo Chavez abruptly announced plans to nationalize CANTV - the local phone company. CANTV’s shares plunged almost 50% before the details of Chavez’s plans emerged amid rumors of a nationalization. Investors responded by selling first and asked questions later.
Another great example of political risk was the scandal surrounding the Brazilian oil company Petrobras in 2015 and 2016. Shares of the giant oil company plunged in early 2015 after the banking executive Aldemir Bendine was appointed as new CEO following the scandal. Many investors thought that Mr. Bendine was placed in charge by then-President Dilma Rousseff's political party.
It's important to note that political risks aren't always well-defined risks - in many cases they may just be rumors with little or no substance behind them. International investors must therefore keep an eye on the news rather than just looking at purely the facts in order to manage these risks. In some cases, it might be a good idea to sell the news, but in other cases, it makes sense to hold on for the long-term.
The Impact of Political Risk
A rise in political risks has a variety of impacts on a country and companies operating within its borders. While the most noticeable impact is a decline in equity prices, many countries facing higher political risk factors experience reduced foreign direct investment, which can prove destabilizing. A reduction in FDI can lead to slower economic growth across the board, as well as potential social issues.
These issues may also affect other asset classes. For example, slower economic growth could impact a country or company's ability to repay its debts, which could impact the bond markets. Slower economic growth or a crisis could also prompt currency-related issues. A decline in a country's currency value could in turn lead to slower exports and economic growth.
Managing Political Risk
The first step in managing political risk is understanding that these risks are often worth taking in order to maintain a diversified portfolio. Even if you keep all of your investments in the U.S., you are still exposed to decisions made in Washington D.C. Investors should maintain a diversified portfolio in order to avoid any specific political risk significantly impacting the overall portfolio.
The second step is monitoring investments for potential political risks. The Economist’s Country Briefings are a great place to start with a wealth of background information a country’s government, politics, and economy. Some questions to keep in mind: Are there any important elections coming up soon? If so, who are the candidates/parties and what are their economic policies?
It may also be helpful to setup Google Alerts or other automated reminders to keep track of potential political risks in key markets. This way, you can be alerted early on when problems arise and take the necessary actions in order to reduce exposure to riskier areas. The key is to not overreact to the news and learn to determine what's truly impactful and what's simply tabloid reporting.
International investors can manage riskier areas by hedging their portfolio against these problems. For instance, an investor that senses problems arising in Brazil might decide to buy put options on the iShares MSCI Brazil Index ETF (NYSE ARCA: EWZ). This position would gain in value if Brazilian stocks fell in value and could offset any losses realized from elsewhere in the portfolio.