The

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Hidden
Risks in
Emerging
Markets

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Witold J. Henisz (henisz@ Bennet A. Zelner

wharton.upenn.edu) is a ([email protected])
professor at the Wharton is a professor at Duke
School at the University University’s Fuqua School
of Pennsylvania in of Business in Durham,
Philadelphia. North Carolina.

W WHEN A FIRM with a value-generating technological

tions and other political events, economic crises, and

changing societal attitudes can disrupt the best-laid

The interplay of these forces—and the implications

for the political choices that multinational firms
make—will become especially prominent as national

lization following the global financial meltdown.

ommunications
and game theory
overnments from
y Witold J. Henisz

come more pronounced as discussions about the

or managerial capability invests abroad, its share- appropriate near-term policy response to the crisis
holders and the host country’s citizens both stand to give way to debates about who should pay and how
benefit. But no matter how good the apparent fit be- much. Politicians will struggle to balance popular
tween what foreign companies offer and what host demands to punish those perceived as responsible
countries need, success is far from assured. Elec- against fears of stymied innovation and the flight
of human and financial capital. Broader domestic
economic concerns—for example, protectionist sen-
plans in both emerging and advanced economies. timent in response to the realignment of economic
power in favor of emerging nations such as China
and India—will inevitably affect the debate as well.
The multinational firms best able to anticipate and
governments chart an uncertain course toward stabi- manage the related risks and opportunities will have
the strongest competitive edge.
ILLUSTRATION: GUY BILLOUT

Issues such as taxation of executive compensa- Historically, the biggest risks faced by foreign in-
tion, the proper scope of financial regulation, and vestors were in developing countries with immature
international M&A have come to the foreground in or volatile political systems. The chief concern was
the wake of the crisis, and stark international dif- “expropriation risk,” the possibility that host govern-
ferences in opinions and policies on these matters ments would seize foreign-owned assets. Today, this
are already evident. The differences will only be- risk has largely disappeared. Stronger international

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 THE HIDDEN RISKS IN EMERGING MARKETS

law and the symbiotic nature of growth in emerging Other recent data are consistent with the finding
and developed economies reduced asset seizures that policy risk has increased greatly. A 2001 Price-
to nearly zero during the 1980s. However, as inter- WaterhouseCoopers study concluded that an opaque
est in emerging markets has soared, host countries policy-making environment is equivalent to at least
have learned, according to George Chifor at the Uni- a 33% increase in taxation. A World Bank study in
versity of Windsor in Canada, “that more value can 2004 revealed that 15% to 30% of the contracts cover-
be extracted from foreign enterprises through the ing $371 billion of private infrastructure investment
more subtle instrument of regulatory control rather in the 1990s were subject to government-initiated
than outright seizures.” The risk that a government renegotiations or disputes. And a 2009 survey by
will discriminatorily change the laws, regulations, the Multilateral Investment Guarantee Agency and
or contracts governing an investment—or will fail to the Economist Intelligence Unit found that multina-
enforce them—in a way that reduces an investor’s fi- tional enterprises considered breach of contract, re-
nancial returns is what we call “policy risk.” strictions on the transfer and convertibility of profits,
Although the data on policy risk are less clear- civil disturbance, government failure to honor guar-
cut than the hard numbers on direct seizures, press antees, and regulatory restrictions all to be more sig-
mentions of policy risk (using terms such as “politi- nificant risks than the potential seizure of assets.
cal risk,” “political uncertainty,” “policy risk,” “policy Unfortunately, the traditional financial and con-
uncertainty,” “regulatory risk,” and “regulatory un- tractual mechanisms that firms use to assess and
certainty”) indicate that it has risen dramatically as mitigate business risks have limited value. There-
seizure risk has fallen. (See the exhibit “The Changing fore, investors must develop proactive political-
Face of Risk in Emerging Markets.”) Press mentions management strategies that lessen government of-
of actual seizures have also increased somewhat ficials’ incentives to divert investors’ returns. In this
since 2001, but that does not reflect a broad-based article, we explore the experiences of multinational
resurgence in seizures. investors as they confront these issues in a variety of
industries and countries, and we offer best-practice
guidelines for assessing the political landscape and
for modeling political decision making. As with the
The Changing Face of Risk management of any risk or uncertainty, political
in Emerging Markets mastery can become a source of competitive advan-
Overt seizures of foreign assets by host countries in emerging tage in addition to a means of avoiding losses.
markets essentially evaporated by 1980. However, other
political risks to those assets (for example, from potential It’s Hard to Hedge Policy Risk
regulatory action) have risen dramatically since then. Firms engaged in international business often use
PRESS
MENTIONS some combination of legal contracts, insurance, and
SEIZURE OF OTHER
ACTIONS POLITICAL trade in financial instruments to protect the income
RISKS
80 streams from their investments against currency or
70
20,000 price swings. These approaches, however, offer little
protection against policy risk.
60
For starters, legal contracts are useful only if they
15,000
50 are enforced, and shifting laws and regulations can
render them void. In the 1990s many Southeast
40
10,000 Asian governments wooing private power inves-
30 tors offered contracts that insulated the investors
from risks related to lower-than-expected demand,
20 5,000 fuel supplies, exchange rates, currency conversions,
10 regulations, and political force majeure. The Asian fi-
nancial crisis in 1997 brought those investors’ favor-
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

able treatment into sharp relief as currency values,

share prices, and electricity demand all plummeted.
SOURCE SEIZURE DATA (LEFT SIDE) FROM M.S. MINOR, “THE DEMISE Political officials had to choose between honoring
OF EXPROPRIATION AS AN INSTRUMENT OF LDC POLICY, 1980–1992,”
JOURNAL OF INTERNATIONAL BUSINESS STUDIES 25 (1994): 177–88. the contracts, at the risk of compromising their own

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Idea in Brief
Governments in developing Most of the traditional As companies such as the
countries no longer seize ways to limit risk to Italian oil giant Eni have
foreign investments. Instead your company’s foreign demonstrated, managing po-
they find ways to divert the investments are not very litical risk involves balancing
profits through regulation or effective anymore. You now operational efficiency with
selective lack of regulation. have to learn how to play political capital, mastering
The costs are estimated to politics directly. the art of political spin, and
be equivalent to at least a hitting the pressure points of
33% increase in tax. local decision makers. That
means mastering new ana-
lytic skills and tools.

popular support, and renegotiating them in order

to maintain that support. In the end, many career-
Political mastery can become a
minded public officials in Southeast Asia chose to
renegotiate or cancel scores of contracts.
source of competitive advantage
Even when contracts can be legally enforced, and a means of avoiding losses.
experience shows that inventive politicians can
circumvent them, through a wide variety of means
other than changing laws. For example, in 1998, place. As a result, underwriters price their products
when U.S.-based AES Corporation—then the world’s extremely high, offer very short-term coverage, or
largest independent power company—acquired the don’t offer any coverage at all.
Georgian electricity distribution company Telasi, Financial hedges have limited value for similar
high-priced lawyers constructed an ironclad set of reasons. Instruments for hedging against risks in spe-
guarantees that allowed AES-Telasi to pass the costs cific emerging markets—such as exchange-rate, mar-
of policy and other risks on to Georgian consumers. ket, and credit risks—are ubiquitous because multi-
One analyst remarked to us, “If you believed the ple parties are willing to participate. The project- and
contract, AES was guaranteed a 20% return on its in- firm-specific nature of policy risk, however, renders
vestment.” The Georgian government actually never conventional hedging strategies infeasible.
interfered formally with AES-Telasi’s ability to pass Some of the more-inventive instruments are
costs on to consumers. However, the venture was based on the average risk premium associated with
doomed by public officials’ inaction—for instance, existing companies in a given country—but they
their failure to terminate supply to nonpaying indus- give false comfort. Because the baseline risk premi-
trial consumers, to supply fuel to AES-Telasi, and to ums are those of firms that are actively participating
keep the government’s own account current—and by in a given market (and that often have their risk-
the government’s demand for tax payments on elec- mitigation strategies in place), new entrants are likely
tricity for which the company had never been paid. to face far greater exposure. In fact, foreign inves-
The result was that AES’s “guaranteed” 20% return tors who focus on constructing financial hedges at
became a shareholder loss of $300 million. the expense of developing their own risk-mitigation
Insurance offers limited protection against policy strategies may increase their exposure. It is therefore
risk because a firm’s exposure is largely determined not surprising that, despite the ability to calculate re-
by its own ability to manage the policy-making pro- sidual risk premiums, no financial institutions have
cess. In the words of one insurer: “I prefer to focus on used such premiums to price an instrument that
what my assured [customer] can bring to a risk. My pays out money when a policy risk is realized.
reasoning is that if you back the right assured, you
can usually keep problems from occurring in the The New Risk-Management Playbook
first place—and if they do happen, you have an ex- Given the difficulty of constructing hedges against
cellent chance of mitigating your loss.” Yet it is very policy risk through contracts, insurance, or finan-
difficult for insurers to know who the “right assured” cial risk-management tools, foreign investors must
is, and the firms with the greatest risk exposure are accept the responsibility for directly managing the
often those most likely to seek insurance in the first risk themselves. For many companies, that means

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 THE HIDDEN RISKS IN EMERGING MARKETS

Why Country Risk Ratings Don’t Work

When it comes to assessing levels of policy risk, To begin with, such ratings the proposed investment to
managers are far too quick to rely on the subjective usually fail to account for the the two parties (how easy is
ratings of country “experts.” One popular index fact that the levels of policy it for the firm to walk away,
focuses on asset-seizure and contract-repudiation risk vary among different and how badly does the
investors in a country, some local government want the
risks. Ratings are incorporated, in the form of
of whom may adapt their deal?). Finally, country risk
country risk premiums, into the discount rates used
business practices to local ratings are usually retrospec-
to evaluate investment opportunities. This approach norms and lobby key policy tive, reflecting past policy
appears to have the formal rigor of financial risk makers better than others outcomes. To assess the cor-
management, but it is actually inadequate. do. Also, policy-risk exposure relation with current policy
is to some extent contingent risk, an analyst needs to deter-
on the relative importance of mine how similar the past and

rewriting the playbook. Instead of looking for imme- “Now is the time to show that Petrobras [the state-
diate ways to improve operations, managers have to owned oil company] has long-term friends.” Eni and
move beyond the quick cost-benefit analyses that Petrobras have collaborated closely ever since.
they usually undertake and think more about how Framing the debate. When companies enter
they can frame and shape public debate. And they new countries, they often engage in extensive PR
must learn how to apply political pressure, either in- campaigns that amount to little more than adver-
dividually or as part of a coalition. tisements for the brand and specific commercial
Investing in goodwill. In the developed world, ventures. Instead, firms need to master the art of
managers spend a great deal of time and energy on political spin. Presenting a venture as “fair,” “equi-
improving efficiency. When companies move into table,” or “growth enhancing” is often a simpler and
less developed markets, they often expect huge, in- more powerful means of securing political support
stant efficiency gains from exploiting the technolo- than providing a cost-benefit analysis. The precise
gies, business models, and practices that they have meaning attributed to such labels varies depend-
managed to hone in their home markets. Unfortu- ing on a firm’s market position. New entrants garner
nately, the political costs of such practices may out- support for policies that favor them over incumbents
weigh those gains. by citing the abuse of monopoly power. Conversely,
Consider the 1997 Christmas blackout in large dominant firms appeal to “fairness” by arguing that
parts of Brazil, including Rio de Janeiro. The then smaller entrants cannot survive without the govern-
recently privatized electric utility Light (in which ment’s helping hand.
AES held a 13.75% stake) faced record-high outdoor This type of debate played out in the South Ko-
temperatures that week, and it was already strug- rean wireless market. LG Telecom—the third entrant,
In 2003 Greenpeace
gling with poorly maintained equipment that had activists in Hungary behind the much larger SK Telecom and Korea Tele-
deteriorated before privatization. However, the press protested against com—made repeated calls for “asymmetric” gov-
and the public focused on the 40% reduction in per- the use of cyanide ernment regulation of the market leaders in order to
technology at the
sonnel, combined with the utility company’s record Rosia Montana gold “level the playing field.” As the Korea Times reported,
profits, to paint a picture of an exploitative foreign mine in Romania. “The defining question is whether the government
investor. The negative sentiment toward foreign will back new entrants in the name of encouraging
firms in general and AES in particular contributed fair competition, or limit the pool to experienced
PHOTOGRAPHY: ATTILA KISBENEDEK/AFP/GETTY IMAGES

to the awarding of a 900-megawatt energy-supply players.” LG ultimately prevailed: In May 2001 the
contract the following spring to a joint venture led by South Korean government announced that it would
Brazilian firms (Votorantim Group, Bradesco Group, “guarantee a market share of at least 20% for a third
and Camargo Corrêa) rather than consortia led by major telecom operator through asymmetric regula-
AES and British Gas. tion on Korea Telecom and SK Telecom.”
A smarter approach was used by Italian state- Finding political pressure points. The net-
owned oil company Eni. After the 1998 devaluation work of relationships in a society greatly influences
of the real, when many companies put their invest- policy outcomes, especially in countries with weak
ment plans on hold or even exited Brazil, Eni’s then- legal systems. To turn these networks to their ad-
CEO, Franco Bernabe, visited Rio de Janeiro to an- vantage, international investors must identify and
nounce a $500 million investment. He proclaimed: engage local politicians’ power bases. Once again,

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present policy-shaping factors differences between them. previously favored companies culminated in the 2000
actually are. Faced with violent citizen experienced a backlash as election of socialist Ricardo
Even as purely country-level demands to redistribute the successor government Lagos as president. He shifted
measures, most political risk investor returns in the wake of renegotiated their contracts. some discretionary spending
scorecards are woefully short the 1997 Asian financial crisis, Chile, in contrast, had toward social programs but
on analysis, as an example Indonesia’s longtime military a democratic multiparty also respected the rule of
from Chile and Indonesia dictator, General Suharto, system and possessed a law and existing commercial
clearly shows. In 1997, one risk renegotiated contracts with well-respected independent contracts. Underlying risks
index ascribed an identical foreign investors that were judiciary—a further check in Chile and Indonesia were
score to those two countries. unaffiliated with his family against arbitrary policy change. therefore very different, but
The measure took no account or close friends. After he Pressures in Chile to enhance the country-level ratings didn’t
of the significant institutional was ousted in a coup, the equity and social cohesion reflect those distinct realities.

Eni has shown the way, this time in Kazakhstan. Taking these pages out of the political playbook
Through its subsidiary Agip KCO, Eni has adopted a requires building the sorts of capabilities in intelli-
business model that responds to the former Soviet gence gathering and analysis that are familiar to poli-
republic’s economic and social needs. The company ticians, spies, and journalists. Managers must begin
favors Kazakh over non-Kazakh suppliers, and it by understanding the attitudes, opinions, and posi-
conducts knowledge-transfer, training, and devel- tions of relevant actors toward their firm, the indus-
opment seminars for them. At least 60% of local em- try in which the firm operates, and any specific ac-
ployees are Kazakh citizens. The company also funds tions that the firm might take to influence outcomes
the construction of various public works, including on the playing field.
the national library, the prime minister’s residence,
schools, computer labs, and multifamily housing Tapping the Right Flow of Data
units for the poor. As a result, many Kazakh officials Traditionally, managers who have undertaken
now have a stake in Eni’s success. political analyses in a host country have directly
For the vast majority of organizations—which consulted employees, local business partners, and
do not possess enough leverage to influence the full supply chain partners. The information-gathering
range of relevant actors on their own—a crucial com- process varies in intensity and structure, ranging
ponent of an effective strategy is to assemble a coali- from surveying radio and newspaper stories to
tion of interests. In the South Korean wireless battle, conversing with locals to using computerized con-
LG Telecom benefited from the influence of up- tact-management systems. Some firms rely almost
stream suppliers. The major Korean carriers wanted exclusively on informal chats, whereas others favor
to shift to the globally favored WCDMA standard for more-formal Delphi (iterative expert survey) meth-
the newest generation of cellular service, but do- ods. (Also see the sidebar “Why Country Risk Rat-
mestic champion Samsung had developed a global ings Don’t Work.”)
leadership position in the competing CDMA2000 Although these sources provide valuable conven-
technology. Under pressure from Samsung, the gov- tional input, they can require more time and money
ernment insisted that one of the new 3G licenses be than such small, subjective, potentially biased snap-
awarded to LG Telecom in return for its promise to shots might merit. Moreover, given the availability
adopt CDMA2000. of multiple real-time indicators and metrics in func-
An international investor’s home government tional areas such as finance, marketing, and human
can also be a powerful channel of influence. Ob- resources, CEOs and boards of directors increasingly
servers in central Europe have noted the lobbying demand similar real-time data on the preferences of
success of the German and French governments on key players. This human intelligence can be effec-
behalf of national champions in countries seeking tively and continuously incorporated into enterprise
EU membership. However, the use of “foreign in- risk-management models and frameworks.
fluence” may create a perception of meddling, can To broaden their perspectives, more and more
stoke nationalism, and is generally less likely to have companies are reaching out to nonbusiness organi-
a lasting impact. There’s also the risk that your home zations that can help them anticipate and preempt
government will sacrifice your needs in order to gain consumer concerns about environmental, health,
traction on another issue. and safety issues. For example, after a bruising expe-

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 THE HIDDEN RISKS IN EMERGING MARKETS

Instead of engaging in PR campaigns that amount to little

more than advertisements for the brand, companies need
to master the art of political spin.
rience over the disposal of its Brent Spar oil-drilling bloggers and other observers—that routinely moni-
platform in 1995, Royal Dutch Shell now routinely tor the policy-making process in various countries.
includes Greenpeace in substantive environmental The large volume and relatively unfocused nature
discussions. Some companies also consult profes- of the material make it hard to synthesize, digest,
sional experts, ranging from well-positioned ex- and act upon effectively, even if a company has sub-
government officials operating on retainer; to the stantial resources for this activity. However, with
stringers who write for the Economist Intelligence information-extraction software, it’s now possible
Unit, Stratfor, and Oxford Analytica; to global politi- to identify the relevant political and social actors on
cal consultancies, such as Political Risk Services or a given issue and their intensity of interest in it.
Eurasia Group. Although employees, suppliers, and One approach, known as data mining, relies on
activists may have access to better information, they the coincident location of words to derive informa-
lack the specialized training that these advisers bring tion about key players’ preferences. For example,
to the table. the occurrence of “Russia,” “AES-Telasi,” and “pro-
Of increasing importance is the vast amount of test” in the same sentence implies a negative sen-
information emanating from third-party sources— timent in the relationship between Russia and the
primarily the mainstream news media, but also electricity investor AES-Telasi. Another tool, called
natural language parsing (NLP) software, facilitates
more-refined sentence-level inferences by syntacti-
cally distinguishing among subjects, verbs, and ob-
jects, thereby identifying the orientation of actions
Are the Locals Hostile to You? or preferences. Consider this possible sentence:
Information-extraction software can capture changes in attitudes toward “The Union of Consumers of Georgia is outraged by
a business venture by syntactically analyzing the content of media the AES-Telasi American company proposal to in-
reports about it. This example compares the total number of sentences crease the tariff on electric energy.” NLP software
in articles about Gabriel Resources’ plan to develop the Rosia Montana would recognize the precise grammatical relation-
gold mine in Romania with the percentage of sentences indicating NGO ship among “Union of Consumers of Georgia,” “is
opposition to the plan. outraged by,” and “AES-Telasi…proposal”—pointing
to a strong negative sentiment toward the U.S. com-
pany. NLP software can also gauge the intensity of
TOTAL NUMBER
10% OF SENTENCES 800 sentiment. If the verb phrase in the sentence had
PUBLISHED
9% ABOUT THE MINE been “objects to” instead of “is outraged by,” the
% OF TOTAL 700
SENTENCES THAT software would have recognized that the sentiment
8% INDICATE NGO
OPPOSITION 600 of the Union of Consumers of Georgia toward AES
7% was negative, but less so.
500
6% Similarly, information-extraction tools can
400
readily and objectively highlight shifts in an actor’s
5%
preferences over time. For example, a coalition of
4%
300 local and international activists sharply contested
3% the plan by Canadian mining company Gabriel Re-
200
2% sources to develop the Rosia Montana gold mine in
100 Romania. The exhibit “Are the Locals Hostile to You?”
1%
plots the frequency in the worldwide media of sen-
tences mentioning statements or actions against the
1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

mine by nongovernmental organizations through

2007, relative to the total number of sentences in

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articles about the mine during the same period. The each period. The selection depends on the direction
data show that NGOs were relatively indifferent to and intensity of the actor’s preferences, the salience
the issue until mid-2002, when negative reports in- of the issue, the cost of proposing or opposing a pol-
creased sharply. icy, and similar information about other actors. The
combined actions of all the actors result in a likely
The “Tummy Test” and Other Models policy outcome. The sensitivity of the outcome to
With data about political actors and their level of various assumptions and parameters can then be
interest in hand, managers must then synthesize calculated, helping to identify which actors are so
that information into a model of the policy-making pivotal that a change in their preferences, power, or
process. At the informal end of the synthesis spec- salience would have a large impact on policy.
trum is the “tummy test,” in which a decision maker Models like this are widely used by the intel-
who has spoken with or been briefed about relevant ligence community and by specialist consulting
sources draws upon his or her own knowledge of groups such as Mesquita & Roundell, Sentia Group,
similar cases to make an educated guess about the the Probity Group, and Commetrix. A growing num-
likely policy outcome. The accuracy of this tech- ber of multinational corporations are also adopting
nique clearly varies enormously according to the these tools. A large British company, for example,
skill set of the decision maker and the relevance of used such a model to decide how to influence the
his or her past experience to the current situation. To climate change debate in the European Union. Ana-
improve the accuracy of such judgments, managers lysts first identified which actors were most com-
can also involve specialized consultancies that draw monly cited in the press and whom these actors ref-
upon a more diverse set of experiences from mul- erenced in their speeches and writings. The analysts
tiple firms and industries in the target country or a then constructed a network of key “influencers” and
comparable one. modeled various points of entry into this system to
A sophisticated extension of the tummy test is identify the target areas and the messages that would
the “war room,” in which managers come together maximize their effect on the climate change debate.
for a one-off meeting or a series of brainstorming Although the integration of automated data col-
sessions. Sessions may be scheduled regularly or lection, dynamic expected utility modeling, and
triggered by a shock or event that requires a strate- influence-map visualizations remains in its infancy,
gic response. “Influence maps” are used to depict the potential applications are broader than the man-
each politically relevant actor as a bubble arrayed in agement of policy risk alone. Marketing research, fi-
space according to the player’s position on a given nancial analysis, operations, and human resources
issue, with the size of the bubble proportional to the all could benefit from a richer analysis of the best
player’s power. Linkages across actors or clusters ways to affect stakeholders’ opinions.
of actors can be indicated by either location or con-
necting lines. Although no formal analytic tools are OF COURSE, the risks of investment may simply be
used, the maps can help guide discussion of action too great to justify entry into certain political zones.
scenarios: What happens if we target actor X? What But in many cases investors who explicitly recognize
if we break the link between X and Y? What if we try the dynamism of the environment and implement
to reduce Z’s power? The insights produced by this appropriate strategies to address it will find the risks
approach are, of course, only as good as the infor- quite manageable. By combining data-mining and
mation brought into the room and the quality of the modeling technologies with traditional approaches,
team assembled. as we’ve described, they can start the journey for-
The most formal tool for modeling the policy- ward, moving from “tummy tests” toward an ana-
making process is the dynamic expected utility lytically oriented, defensible system for managing
model, which is based on game theory. It assumes policy risk that will greatly expand their investment
that, in each of several time periods, every actor (an options. At its heart, this system will always retain
individual or an organization) with a vested interest elements of tacit knowledge and experience, and
in an issue has a choice of three possible alternatives: not all managers and firms will be able to master its
proposing a policy, opposing a proposed policy, or intricacies. But those that do will find it a powerful
doing nothing. Each actor chooses the alternative source of competitive advantage.
that maximizes his, her, or its expected utility in HBR Reprint R1004H

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