Political Risk Analysis - Theory and Case Study South Africa

Political Risk Analysis - Case Study 1
Theoretical Component 2
Political Risk and Political Instability - A differentiation 2
Linking political risk and country risk 3
Understanding Macro and Micro risks 4
Conceptualizing political risk 5
Forecasting and Predicting 5
Assessing Quantitative and Qualitative Research 6
Practical Component – Risk profile of South Africa 9
Executive Summary 9
South Africa in the near future 9
Political Stability in South Africa – an assessment 10
Prospects for Economic Growth 11
Investor’s checklist of key political risk indicators in South Africa 13
References 17

Theoretical Component
Political Risk and Political Instability - A differentiation

Political risk differs from political instability in that political instability can be one of many characteristics of an environment whose levels of political risk are being analysed. Hence, political instability refers to the characteristics of an environment while political risk is a property of business. Political instability is usually associated with the political climate of a country, namely the workings of its body politik. For example, analysing the recurrence of conflict in a given place and its subsequent levels of violence constitutes an example of an assessment of political instability. An analysis of the political risk of a place is more comprehensive, encompassing not just political instability but also other factors such as economic and financial prospects, the impact of the places’ rule of law on business, the government’s attitudes as well as actions towards investment, particularuly foreign investment. In sum, it is a “catch-all term for risk dimensions of political events which have an impact on business decisions” (Sethi & Luther 1986:58). I comply with the tradition of catch-all conceptions of political risk and define it as the likelihood of you getting what you want, where you want it, how you want it.
A way to distinguish the two is by realizing that it is possible to have a place characterized by low levels of political instability that, nonetheless, holds a high level of political risk. A dictatorship can provide a very stable investment environment but if the state collapses impact on business will be very strong. This is also the case because political risk encompasses all those micro-risks that are peculiar to one particular business or to one particular investment area. Imagine that you are a diamond industry investor and a given country shows a flawless record of political stability and good governance, the country however simultaneously retains highly protective and traditionally hostile policies towards foreign investment on national mines. This represents a case where you have satisfactory levels of political stability (at the macro-level) that are however not enough to ensure a full-on safe, low-risk investment climate (at the micro-level of your sector). A case in hand is the one of Portugal, with impressive levels of political stability but at the same time showing low levels of economic and relatively rigid labour markets, offering an environment that is not always ripe for attracting foreign direct investment. Brink (2004:2-6) argues that, “risks should not only be avoided at all times, but actually be exploited and profited from (…) a low-risk environment might actually pose a risk in itself”. In my perception however risk in itself is not attractive, what is attractive is the possible profitability that is associated with it. What attracts in a Casino is not the probability to lose but the probability of winning a lot that is associated with the probability of losing.
Having said this, the element of political stability alone offers a very incomplete picture of the concrete investment environment of a place whereby political risk has the potential to provide with a much more comprehensive image.

Linking political risk and country risk

Country risk consists on a financial evaluation of a country’s financial strength or liability. It has been traditionally associated with credit risk, i.e. the likelihood that loans given to a country will be returned in due time. It is therefore restricted to the macro-economic affairs of a sovereign state. Political risk on the other hand is much more encompassing. Again, country risk can be one of the components of a political risk analysis. Country risk is contained inside political risk in that it represents a more basic evaluation of the risk of a place. Country risk collects a number of factors which put together are a subgroup of political risk. Political risk analysis goes beyond country ratings. Country risk analyses are traditionally characterized by being more of an instant “snapshot” of a country’s financial status vis-à-vis its lenders. Having low levels of country risk analysis can increase the likelihood of having low political risk but not necessarily. The dimension we are provided with is the state of the country’s “purse”. As so, we are not shown how the situation of a country’s finances is actually reflected on the day-to-day investment environment of the country. Moreover, because it reflects the country’s inability or unwillingness (Brink 2004: 20) to pay loans, it is from the start a negatively biased concept. It focuses on what a country will not be capable to provide financially and not on what it can potentially provide at other levels.
It is important therefore to understand what are the practical significance of the numbers and the levels of indebtedness on the daily practical affairs of the country. This will give us a much more substantiated awareness of what are the real possibilities for sustainability and stability of our investments.
Political risk is a critical and analytical assessment of the country’s situation that can comprise both quantitative and qualitative methods. It draws tools not just from the disciplines of economics and finances but also finds sociology, political science, international relations and other social sciences useful. These have therefore the potential to make the political risk report as complete a portrait of the political environment as possible by means of a holistic approach.
Also, it is possible to have high levels of country risk with high levels of indebtedness and an unstable financial system and yet retain fairly satisfying levels of political stability. This would be the case for example if a developing country has proceeded with a vast process of structural adjustments that has increased its levels of indebtedness but has meanwhile been able to politically stabilize itself and offer positive signals of economic growth. This has namely been the case with Mozambique in the last couple of years (MBIA 2007).

Understanding Macro and Micro risks

Macro-risk consists on generic risks that have the potential of affecting the great majority of businesses regardless of their sector specificities. Micro-risks in turn are all those risks that directly affect the particularities of your business (Fitzpatrick 1983:249). These are specific risks that threaten your individual sector, company or area. Micro and macro-risks interact with each other in providing the setting for aggregate risk levels. Macro-risks can be trigger causes and provide “clues” for the emergence of micro-risks. For example, broad social upheaval and rioting due to the macro-risk levels of social inequality can later lead to governmental policies of nationalization of specific areas of the economy (such as the mineral extraction industry) that only affect your sector and as such increase the levels of micro-risk. This also works the other way around: several crises arising at the micro level can lead to broader problems and bring about new macro-level risks or further exacerbate previously existing macro-risks. Macro and micro risks interact and affect each other in a dialectical way but overall micro-risks remain pivotal – micro-risk conditions are usually the ones that will have the deciding leverage in the final decision-making outcome because they are those more immediate to your particular venture.

Conceptualizing political risk

My conceptualisation of political risk is the following: how likely you are of getting what you want, when you want, where you want it. The fact that it is a rather fluid and adaptable abstract provides it with the ability of being able to adapt to changing environments, situations and “clients”. Its parsimony means that it is effective and practical in delineating the problem-solving challenge of risk assessment. These challenges are different for governments, multinational corporations, NGO’s or regional organisations but they still share the same will to understand what are the factors affecting the likelihood of success of your investment and how is it that these factors can work. This conceptualization retains therefore a good degree of flexibility while maintaining the ability to express the central reason behind the ethos of risk assessment: coming closer to the likely possibilities of success or failure of investments in a set environment and timeframe. All risk assessments are born out of a “wish to invest”, to “bet” on a strategy and therefore “wish” for a positive outcome. This broad desire of investment is reflected in the verb “to want”. The subcategories “where”, “how” and “where” are broad subheadings under which the different factors of risk-analysis can fall under. These categories can remain unaltered across time and space while the conceptualization of the factors needs to be regularly updated and revised in order to keep up with the rhythms of change.

Forecasting and Predicting

While predicting entails categorical claims or guesses about the future, forecasting alludes to possible outcomes and it is not its objective to accurately guess an exact outcome. Forecasting consists on an exercise of prospective somewhere into the future that will allow you as a decision-maker to carry out better informed actions, it is exercises the “eventuality of discontinuity” (Fitzpatrick 1983:250). It allows for anticipation of alternative outcomes in the sets of relations between different actors and forces composing the place and time-frame of the political risk analysis. Forecasting/prospective analysis contain in themselves both a logical, conceptual and methodological preoccupations but also an “artistic” side to it. “Art” in the sense that the risk analyst equipped with foresight tools will weave them together in a subjective and non-absolute way, this ability is innate to human beings. This however is not a justification for methodological sloppiness or disregard for systematic and well-grounded analysis. Exploring the future been becoming more and more fundamental in dealing with an increasingly competitive world. There is not one formula to exercise the future but the process of doing so can, according to Alvarenga & Carvalho (2007: 3) should assume a set of characteristics, namely:

• Organised and Flexible (for example, conceiving and implementing modular processes through multiple tools according to defined objectives and available resources).
• Systemic (searching to categorise and to interlink the different relevant elements for the analysis) and Systematic.
• Consistent and structured (searching and justifying the coherence of combination between different elements: trends, uncertainties, wildcards, weak-signals, etc.).
• Intuitive and Logical (combining intuition and creativity with rigor and logic).
• Useful (lighting up the present and identifying challenges for the future, stimulating decision-making and framing the implementation and monitoring of strategies).

Assessing Quantitative and Qualitative Research

As an information-seeker a quantitative method in analyzing risk in a place is more time-effective and ideal for quick on-the-go decisions. Numerically comparing risk values/factors and scaling the measurements can undoubtedly be a very powerful tool. However, only with the help of qualitative information can a more sustained and comprehensive picture of the investment environment be drawn. Qualitative analysis will enlace and explain the causal mechanisms linking quantitative data. Not only can it do that but it also can provide with a critical analytical risk assessment of its own. Including aspects of anthropology, sociology, environmental studies, development studies and cultural studies can complete a richer picture of your investment environment by alluding to the place’s cultural traditions and social ambience and also allowing for an historical approach to the study of trends. This ability is very important as a comprehensive understanding of the history of your investment target will “make trends more obvious” (Brink 2004:28). Accounting for this strictly through quantitative data is problematic if not impossible.
Quantitative research usually starts with a pre-set hypothesis, this means that objectives are often stipulated from the start and several components of the process are standardized and numerical. It aims at being objective and have the ability to generalize and replicate its findings as widely as possible. It has the goal of being systematic but it also means that quantitative research sometimes struggles with some levels of rigidity and inadequacy in adapting to a changing environment. It suits macro-analysis a lot better since it can sometimes be “over-econometric” when dealing with the peculiarities of the micro-level (Simon 1984). Qualitative research on the other hand tries first and foremost to capture and discover meaning. It attempts to do so by collecting elements of analysis in an ad hoc manner. The research procedure is particular and circumstantial, constantly adapting to its surroundings and going beyond rigid numerical snapshots. Its strength relies in its potential to provide a thorough and comprehensive ambience of the study object, often in an inductive way (Neuman 2000).
Overall, assuming one of the two as the better method can be highly problematic. More and more the two techniques are becoming interdependent. Comprehensive and serious political risk reports will necessarily incorporate aspects from both. Different combinations of the two methods adapt better to each situation, as so, retaining an open mindedness in respect to the two and being aware of their strengths and weaknesses is important.
The incorporation of non-business risks is double-edged. If on the one hand it gives the analysis a more ample edge it can also potentially lead to more analytical subjectivism and imprecision since it is not just these non-business risks that need to be operationalised but also their connection and impacts on the environment of the business. Qualitative analysis is flexible and more inclusive than quantitative analysis, it goes into more depth and detail of its study object however its finding are usually much harder to systematize. (Babbie 2001: 77)
One runs the risk of being overwhelmed by information. Both in quantitative and in qualitative approaches it is essential to meticulously collect and select your information. Quantitative analysis is particularly prone to reliability and validity problems whereby reports can fall into rushed conclusions over the causal mechanisms of the risk levels. The risk values can consequently incorrectly reflect the risk levels of the investment environment.
There is not one solution to the methodological problems of political risk analysis. At the end of the day, it is the responsibility of the risk analyst to be aware of the methodological weaknesses of its approach and instead of hiding them, make them explicit. Providing clients with content holding valuable and determinant information that is simultaneously methodologically honest is the first step towards sound political risk analysis.

Practical Component – Risk profile of South Africa
Executive Summary

South Africa’s growth rates have been fairly positive recently but this does not allow for a lax focus on economic transformation. The greatest challenges it now faces are improving on its competitiveness in relation to other global actors and in its domestic economic strength. These material improvements are dependent on how South Africa will tackle other issues such as: the pressing HIV AIDS and insecurity crisis; land reform; education and training of its workforce; workings of its rule of law; de facto assurance in the separation of powers between the executive and the juridical branches; the development of its infrastructure; and its central role in influencing regional stability in its continent.
If the urgent challenge of HIV aids and the agitating levels of raging inequality are progressively dealt with, and a stable, united and constructive social and political arena arrived at, South Africa’s prospective for economic growth are excellent and its investment environment second-to-none in the African continent.

South Africa in the near future

In the beginning of 2007 South African hearts and minds are already well focused on a set of events set to take place in the medium term. First of all, the country is preparing to set the stage for the 2009 presidential elections scheduled for April. These elections are still covered in uncertainty due to substantial internal splits within the ANC between Thabo Mbeki’s and Jacob Zuma’s factions which has left South African’s dominant party with a problematic credibility and succession crisis in its hands. The outcome of these elections will go a long way in determining if South Africa’s stride towards consolidating its democracy is successful. The hype behind the controversial personality of Jacob Zuma in particular and the outcome of the legal suit involving him in corruption charges will also be a major decider of the future of the ANC as a party.
Adding to the usual debates over aids, crime and the economic affairs of the country a great testing events looms in 2010 for South Africa in the form of the Football World Cup. Discussions over South Africa’s readiness to stage such a grandiose event are daily in particular when it comes to the infrastructure and security demands that need to be met under strict timelines. South Africa’s success or failure in hosting the 2010 World Cup will undoubtedly go a long way in shaping the psyche of South Africans when it comes to their country and in testing the practical vigour of South African Economic Growth in the first decade of the first Millennium.
The evolution of the Broad-based Black Economic Empowerment Act of 2003 and how it evolves in its economic, political and social dimensions will be important to observe. The act forms the backbone of South Africa’s struggle to overcome the legacy of apartheid and the structural inequalities along ethnic lines that still cut across the country’s economy and politics. The impact of the act in the mining and finance sectors in particular has already been felt, other sectors will soon follow suit (Armstrong et al 2005).

Political Stability in South Africa – an assessment

South Africa is currently politically stable but its stability is however not consolidated. South Africa’s legendary democratic transition has not yet come full circle. South Africa holds a bicameral parliament with a 400-member National Assembly and a 90-member National Council of Provinces. It is a democratic system but also a system characterized by single-party dominance. This one-party dominance is the distinguishing trait of South African party politics and is the fixture under which the strengths and weaknesses of the political architecture of the country lie. Looking back at the last 13 years these have been positive. Positive both in its economic performance and in improving political participation, however South Africa’s political stability longs for improvements in several aspects. After the democratic transition in 1994, the ANC emerged as the catch-all party incorporating a rather diverse spectre of political strands and ideological sub-groups. Since then, it has pretty much governed uncontested. This looks like a sustained trend in the political dynamics of South Africa as the second biggest party, the Democratic Alliance party did not go beyond mere 14.8% of the vote on the last 2006 general elections. This lack of party competition and absence of rotation in office dually offers a substantial degree of political stability but also sometimes brings about the problem of accommodation of the main party to power and a lack of de facto healthy party competition and rotation in office.
South African media is mostly government-controlled yet its fairness and impartiality is satisfactory. Freedom of press and expression is a reality in South Africa, a country that holds one of the most comprehensive constitutions in the world when it comes to protecting individual human rights.

Prospects for Economic Growth

South Africa is the powerhouse of its continent. Its GDP is second to none in its region with figures of $576.4 (2006) and its investment environment has recently been reported as the most attractive in Africa by the UNCTAD World Investment Report (2006).
The broad picture of the South African economy has been one comprised of two parallel images: the first, comprising a developed and competitive economy underpinned by a knowledge-based sector and relying on top-notch financial institutions and liberal policies to support economic growth; the second, comprising the large numbers of low-qualified labour earning low wages in the parallel economy and in labour intensive sectors such as the mineral and agricultural ones. Broad policies of economic liberalisation have connected South Africa to the global economy and have in the long run progressively reduced the budget deficit. In effect, “the budget deficit decreased from 9, 5% of Gross Domestic Product (GDP) in 1993, to 1,5% in 2005” (DTI 2006). International bilateral agreements with, for example, the EU and the US for example have also been important. The evolution of the African Growth and Opportunity Act (AGOA) and the related most-favoured nation tariff that South Africa has enjoyed with the United States is one example. This framework has enabled South Africa to fare rather well in terms of economic growth and development for the last few years. Since 2003 inflation has been under control and so have real interest rates, allowing for a cut in the interest rates. This in turn has created a great consumer boom as can be witnessed in the growth of the construction and automotive sectors. The South Africa Reserve Bank has been effective in making sure that the banking service industry has been running smoothly.
Indeed, the positive investment environment in the country is much indebted to the good performance in terms of the financial sector levels of transparency and in the reliability of monetary and fiscal policies. Growth in South Africa has been corporate ridden (Armstrong et al 2005) and a continuation of sound financial policy can keep stimulating growth at the level of the first image economy. This development remains nonetheless conditioned to development in the second image economy and to how policy will be increasingly able to actively reorganise its still uncoordinated workforce, tackling its abysmal figures when it comes to levels of unemployment (25.5% in 2006). An attempt to tackle this reality brought about JIPSA (Joint Initiative for Priority Skills Acquisition) – or in other words the advancement of Higher Education and Information Technology. JIPSA is a fundamental pillar for the success of the Accelerated and Shared Growth Initiative (ASGISA) as it focuses on short supplied yet critical skills that are required for a “skills revolution” in South Africa. The overall objective is to halve poverty and unemployment by 2014. By doing so, South Africa will be able to keep up with the current positive trend of rising levels of foreign direct investment. (ASGISA 2007; Vardy 2007; Mlambo-Ngcuka 2006)
Synergy between the financial, industry, labour and the educational sectors is on top of the agenda for South Africa. This synergy will be highly enhanced if partnerships with experienced foreign higher education institutions, in training and qualifying the labour force and in Research and Development are developed. All of this, while taking into account the problem of brain drain
In this context, how issue brought about by COSATU (Congress of South African Trade Unions) of subsidies for first job entries in the labour market unfolds will be important in determining the development of the labour market in South Africa.
Economic prospects remain positive if political stability is favourable. Its thriving natural richness in wildlife makes it one of the most exciting settings for anyone interested in investing in the different modalities of the tourism industry. Moreover, South Africa’s lands have materially gifted her with a remarkable wealth when it comes to natural resources. In effect, South Africa still holds: 80% of the world’s reserves of manganese ore; 88% of the world’s reserves of platinum group minerals; 45% of the world’s reserves of gold; and 73% of the world’s reserves of chromium (DTI 2006). All of this combined with good infrastructure (some of the lowest electricity prices in the world), attractive policies in terms of corporate tax and, due to the peculiarities of the two-images mixed economy labour costs that are cheaper than those from other emerging markets.

Investor’s checklist of key political risk indicators in South Africa

As an investor in South Africa a few peculiar risk indicators assume prevalence, namely:

• Competitiveness - The expansion and growth of JIPSA together with initiatives in terms of small and medium-enterprise development will be at the forefront of economic growth. Policies of export-promotion and the empowerment of the unprivileged population still living below the poverty line will also need to take precedence if political stability is to be consolidated. Small business incentives such as the Medium Enterprise Development Programme (SMEDP) in Gauteng province (GEDA 2007) should be further stimulated and adapted to other regions of South Africa. The case of Gauteng includes benefits at the level of micro and macro-risk management:
o Investments grant payable for the first two years on qualifying assets.
o Additional investments grant payable in the third year, based on the ratio of human resource remuneration to manufacturing costs.
o A foreign investment grant limited to US$150 000 per project for investments in new machinery brought into South Africa.
o All agricultural production, manufacturing, agro-processing, aquaculture, biotechnology, tourism, information and communication technology, culture development and business support can qualify
And at the level of micro-risk management in industry specific incentive schemes, including:
o The Motor Industry Development Programme, which encourages the production and export of vehicles and components.
o Rebates and Concessions for the steel industry.
o Science, Engineering and Technology Innovation Fund, which subsidies R&D into new systems and processes.
o Tourism promotion schemes
• Development through international partnerships – Together with pursuing competitiveness as an attracting domain for foreign investment, South Africa should still invest diplomatic and political efforts in establishing favourable economic relations. Considering that South Africa still is a developing country, its relations with the developed world should also explore avenues to strengthen more quickly and effectively key aspects of its domestic economy. A good example of this has been the privileged relations that South Africa has retained with the United States. Take the role of USAID: its achievements in post-apartheid South Africa have been undeniable with programs generating, for example, over 3000 jobs and more than $279 million in sales in the small and medium business and agribusiness sectors. One should also emphasize the important role USAID financing has had in combating HIV/AIDS, promoting sound democracy and governance and increasing access to housing, drinkable water and sanitation to the disadvantaged in South Africa. The investment fund protocol signed between the US and South Africa of $120 million Overseas Private Investment Corporation fund to make equity investments in South and Southern Africa is now bearing fruits, affordable housing is now on the cards for many thousands of people in South Africa. It has helped 350.000 South Africans to obtain mortgages and formed a provision of $300 million of funds. The American Trade and Development Agency has for its part played a crucial role particularly in the technical assistance to big energy projects (namely the Khanya electricity projects in the Eastern Cape and KwaZulu Natal and the Thekwini Electricity Distribution Systems Integration Project). (OPIC 2007; Tobias 2005; USTDA 2007; USAID 2006)

• The economic impact of the HIV-AIDS pandemic - Together with unemployment and income inequality this economic risk constitutes the backbone of South African gravest concerns and problems. South Africa has in its hands a pandemic not just at the national level but also at the regional one. The whole of southern Africa and places such as Swaziland should be included in a regional strategy to tackle the problem. The virus is threatening to take 1.5 million lives in 2010 alone and cost the South African government as much as 17% of its GDP. (USDS 2007)

• The issue of land reform - The South African state has run into trouble in the land reform mainly because it lacks sufficient funds to purchase the necessary property. The possibility of negotiated compulsory purchases is potentially on the cards for the future. This would mean that farmers not wishing to sell their farms to the state would not be able to do it to anyone else. The leakage of a secret land department document also suggests that foreign ownership of land is to be restricted.
• Levels of education - Provincial spending as a share of provinces’ budget has been falling – from 45.7% in 2002/03 to 44.7% the following year. 2008/9 is likely to see a further fall to 42.8%. Problems of large-dropout rates and the time students take to complete programmes are still prevalent but initiatives are being put in place. JIPSA is at the forefront of the government’s grand strategy on education and its outcome will affect all areas of South Africa’s economic life. (Mail and Guardian 2007:10)
• Effectiveness of the Rule of Law – There have been some cases of corporate failure including: Macmed (a healthcare company which collapsed in 1999) because one of its company secretaries was an unrehabilitated insolvent; Leisurenet, a lifestyle and health fitness company that collapsed for fraud committed by the two key executives. Company law should promote simplicity and time-effectiveness in its proceedings. Fraud and corruption situations need to be regulated with adequate legislation and law enforcement. Regulation also requires further improvements on the time-effectiveness of the judicial machine in processing these cases. (Armstrong et al 2005)
• Separation of powers - Further expansion on the division of power between the judicial and the executive powers is desirable and avoid situations such as the constant meddling of government into judicial affairs such as was the case in 2005 when it tabled draft laws to amend the constitution.
• Infrastructure – Transportation infrastructure is excellent but is still recovering from an apartheid bias against townships and non-white rural areas. In these terms, empowering local government with the right tools will be important. In 2005 government announced a boost in infrastructure spending of R372bn so things seem to be going on the right path. (EIU 2006)
• Violent Crime – Security and safety spending is on the rise and the hype over the issue cannot be underestimated. Crime reporting has been contentious. Fact remains that the situation in the whole of sub-Saharan Africa is problematic in particular due to the huge presence of small arms (30 million or one weapon for every 20 people). The particular situation of great inequality in the country is usually seen as the main reason for the levels of crime. Murder rates, one of the highest in the world are presently declining while money is pouring in into safety and security set to rise from R41m for fiscal year 2005/06 to R46.6bn (EIU 2006).
• South Africa’s role in providing Regional Stability – South Africa is the main power broker in its region and one of the main powers in Africa. Its leadership in the African Union and its participation in development initiatives such as the creation of NEPAD (New Partnership for Economic Development) show how the economic and political development of the country is very closely tied down with the faith of the continent as a whole. The unfolding of the Zimbabwe situation will go a long way in determining the faith of the southern Africa region in general and the economic and political development of South Africa within its geopolitical context. Because of its privileged relation and past with Zimbabwe, South Africa’s actions in the Zimbabwe debacle will vastly influence its political legitimacy not just at home but internationally. This is particularly important at a time when the country seeks to emerge as a global power within a new multilateral architecture of international relations.

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