Political and Legal Systems in

National Environments

International Business
Strategy, Management & the New Realities

by
Cavusgil, Knight and Riesenberger

International Business: Strategy, Management, and the New Realities 1

 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 referred to as ‘political risk’.
Each country has a unique political and legal
system that may pose challenges for company
strategy and performance

International Business: Strategy, Management, and the New Realities 2

 What Gives Rise to Country Risk?

• Immediate cause is a political or legal factor, but

economic, social, or technological developments
may be the root cause.
• Laws may be unexpectedly strict & political/
legislative actions may harm business (even
though not the intent).
• Example - In China, the government censors
material that criticizes the government. Yahoo
must monitor the information that appears on its
Web site to prevent the Chinese government
from shutting down its China operations.
• Weak law enforcement is also often a factor.

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 What are Political and Legal Systems?

• Political system - a set of formal institutions

that constitute a government and how these
groups interact with each other. Includes
legislative bodies, political parties, lobbying
groups, and trade unions.

• Legal system - a system for interpreting and

enforcing laws and regulations. Includes
institutions and procedures for ensuring order
and resolving disputes.

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Three Major Types of Political Systems

• Totalitarianism
• Socialism
• Democracy

These categories are not mutually exclusive. E.g.,

most democracies include some elements of
socialism.

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 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 sustained via secret police, propaganda, regulation of
free discussion and criticism.
• Examples: China (1949–1980s), Germany (1933–1945),
Soviet Union (1918–1991), and Spain (1939–1975).
• Today, some states in the Middle East and Africa employ
totalitarianism.
• Many ex-totalitarian states have much government
intervention, red tape, and bureaucracy
International Business: Strategy, Management, and the New Realities 9
 Socialism

• Capital and wealth 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).
▪ Frequent government intervention in the private
sector.
▪ Corporate income tax rates are higher.
International Business: Strategy, Management, and the New Realities 10
 Two Key Features of Democracy

• 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.
• 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

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 Democracy’s Link to Economic Freedom

• Empirical evidence suggests that

democracy -- greater economic freedom –
leads to higher economic living standards.

• Economic freedom flourishes in systems

characterized by:
▪ Free market economics
▪ Strong ‘rule of law’
▪ Minimal government intervention in business
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 Command (Centrally Planned) Economies

● The state is responsible for making all decisions: what

goods and services the country produces; quantity of
production; prices at which they are sold; and distribution.
● The state owns all wealth, land, and capital, and allocates
resources based on which industries they want to develop.
● Common in the 20th century, command economies proved
so inefficient that most have gradually died out.
● Central planning is less efficient than market forces in
synchronizing supply and demand.
● Today many countries exhibit some characteristics of
command economies; e.g., China, India, Russia, and
certain countries in Central Asia, Eastern Europe, and
Middle East.
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Market Economies and Mixed Economies

In market economies,
• Decisions are largely left to market forces, the
interaction of supply and demand.
• Individuals and firms are main decision-makers.
• Government intervention is limited.
• Associated mainly with Capitalism

Mixed economies have features of both market and

command economies, combining state intervention
and market mechanisms (e.g., Sweden, Singapore)

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 Five Types of Legal Systems

The five legal systems are the foundation for

laws and regulations:
• Common law
• Civil law
• Religious law
• Socialist law
• Mixed systems

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 Common (Case) 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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 Civil (Code) 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 between civil law and common law is that
common law is mainly judicial in origin and based on court
decisions, whereas civil law is mainly legislative in origin and
based on laws passed by legislatures
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 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.

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 Socialist Law

• Found mainly in China, former Soviet

Union, and a few states in Africa
• Based on Civil Law, with elements of
socialist principles that emphasize state
ownership of property -- state rights take
precedence over individuals’
• Tends toward loose treatment of property
and intellectual property rights

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 Actors in Political and Legal Systems

• The government, or the ‘public sector’, is the most

important actor, operating at federal and local levels.
• Supranational agencies such as the World Trade
Organization, United Nations, and the World Bank
• Regional trade organizations, such as the
European Union (EU), the North American Free
Trade Agreement (NAFTA), etc.
• Special interest groups such as labor unions and
environmental groups
• Local competing firms oppose foreign firms, and
lobby their governments accordingly.
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 Country Risk Produced by the Political System:
Government Takeover of Corporate Assets

• Confiscation: seizure of foreign assets without

compensation. E.g., Venezuelan President Hugo
Chavez confiscated a major oil field owned by
French firm Total.
• Expropriation: seizure of corporate assets with
compensation.
• Nationalization: government takeover of an entire
industry, with or without compensation. In 2006, the
government of Bolivia nationalized much of the
country’s oil and gas industry.
• Privatization: selling state-owned enterprises to
private interests.
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 Country Risk Produced by the Legal System

• Foreign investment laws affect the type of entry

strategy firms choose, as well as their operations
and performance. Nations impose restrictions on
inward FDI, such as Japan’s large retail store law or
the U.S. and Dubai Ports World

• Controls on operating forms and practices affect

firms’ production, marketing, and distribution
activities. E.g., China requires market entry via joint
venture in its huge telecommunications sector.

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 Country Risk Produced by the Legal System

• Marketing and distribution laws determine which

practices are allowed in advertising, promotion, and
distribution. E.g., laws may restrict TV advertising
aimed at children.
• Laws regarding income repatriation limit the
amount of net income or dividends that firms can
bring back to the home country.
• Environmental laws are intended to preserve
natural resources, combat pollution, and ensure
health and safety. E.g., in Germany, firms must
follow strict recycling regulations.
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 Country Risk Arising from the
Home-Country Legal Environment

• Extraterritoriality: application of home-

country laws to other countries. E.g., the
European Union has pursued Microsoft for
perceived monopolistic practices.

• Foreign Corrupt Practices Act (1977) made

it illegal to offer bribes to foreign parties. But,
definition of a “bribe” is unclear; Harms U.S.
interests because foreign competitors are not
so constrained.
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 Accounting and Reporting Laws

Differ widely around the world. Examples:

• Physical asset valuations: Canada and the U.S.
use historical costs. Some Latin American
countries use inflation-adjusted market value.
• Uncollectible accounts allowance: in the U.S. –
yes; France, Spain, and South Africa – no
• Research and development costs are: expensed
as incurred in most of the world; Capitalized in
South Korea and Spain; Belgium, Malaysia,
and Italy use both conventions.
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 Transparency in Financial Reporting

Transparency -- degree to which firms regularly

reveal substantial financial & accounting
information
• Timing and transparency of financial reporting
vary widely around the world.
• Sarbanes-Oxley Act (2002) promotes greater
transparency in accounting practices. But, cost
of compliance is high; Discourages foreign firms
from listing or transacting extensively in the U.S.

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 Ethical Values and Practices

Ethics refers to the moral behavior of people,

firms, or governments- issues often arise, or
may be exacerbated, by deficiencies in legal
systems.

Corruption typically involves the use of bribery

and fraud to achieve business goals. Most
common in developing economies.

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 Contract Law

Local contract law is a factor in five types of

contracts:
1.Sale of goods or services;
2.Distribution via foreign intermediaries;
3.Licensing and franchising;
4.Foreign direct investment; and
5.Joint ventures.

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 Protection through Legal Contracts

• A legal contract spells out the rights and obligations of

each party; especially important when relationships go
awry.
• Three approaches for resolving contractual disputes:
1. Conciliation is the least adversarial method; a formal
process of negotiation that aims to resolve
differences in a friendly manner. Common in China.
2. Arbitration is a process in which 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.
3. Litigation is the most adversarial approach, and
occurs when one party files a lawsuit against another;
Most common in the United States.

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