3 min
20-July-2024
Political risk refers to the potential for an investment's returns to be adversely affected by political changes or instability within a country. This instability, which can impact investment returns, may arise from shifts in government, legislative bodies, foreign policy decisions, or military control.
The financial markets in any country are intricately linked to the country’s government and its policies. Any change in the governing body or the prevailing governmental regulations could affect the economy, the financial markets and various investments in the country. If the impact of such changes is negative, that is a manifestation of political risk.
In this article, we delve into the meaning of political risk, explore how you can identify and manage it and see which factors affect this type of risk.
Also known as geopolitical risk, this type of risk is more common in long-term investments that are exposed to the prevailing political climate for extended periods. Investments in every country are affected by political risk. However, some countries may have higher risks than others.
Some changes may be favourable, while others, which pose a higher political risk, may adversely affect the economy in general and investments in particular. For example, if a new government changes the tax laws to increase the tax rates on a specific category of mutual fund schemes, the net returns from such funds would reduce. This is a prime example of political risk.
Micro risk: This type of political risk stems from internal factors within the government or the economy, like corruption or internal conflict.
Sovereign risk: This is the risk that a government may be unable to meet its debt obligations. Such risk directly affects investors who have purchased government bonds.
Regulatory risk: This type of political risk occurs when there is a change in the existing regulations, which, in turn, affects investment returns directly or indirectly.
Instability risk: This is the possibility of investments losing value due to political instability in the country.
Geopolitical risk: This subset of political risk arises when the government takes measures like military action, which affect the geopolitical climate.
Macroeconomic risk: This is the risk of government changes, policies or instability affecting the economy at large.
Currency risk: This kind of risk is the possibility of the national currency losing value due to certain policies or actions of the government.
Monitor the political climate: Keep track of the political scenario and follow news of elections, leadership changes and government policies.
Evaluate the regulatory environment: Analyse the regulatory landscape and be aware of any potential changes in laws, taxes or industry-specific regulations.
Understand the interplay of socioeconomic factors: Be aware of how socioeconomic issues like income inequality, poverty and social unrest can affect political stability.
Review historical data: Study past events to understand how previous instances of political instability or policy changes affected the returns from different investments.
Look into expert opinions: Gather insights from local analysts, consultants and industry experts to understand the nuances of political dynamics and their impact on investments.
Related articles to read
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What is market risk definition?
What is credit risk?
What is default risk?
What does risk tolerance mean?
What is inherent risk?
Political risk indices: You can keep track of political risk indices to better understand the level of this type of risk in the country.
Using risk reports: Risk reports from global and national organisations and analysts also give you insights into the level of political risk in a country.
Scenario planning: You can also develop and analyse different political scenarios and their potential impact on the economy, businesses and investments.
Studying stakeholder surveys: Look into various stakeholder surveys to understand the political climate within a country and gauge political stability.
Portfolio diversification: Investors can minimise this risk by spreading their investments across different asset classes as well as leveraging geographical diversification.
Risk monitoring: It also helps to continuously monitor the political situation in the country or in areas where an investor holds assets or a business operates.
Flexibility in operations: Businesses can manage this type of risk by ensuring that their operations are flexible and capable of adapting quickly to political changes.
Due diligence: Both businesses and investors must conduct due diligence before entering a new market or making a new investment to keep political risk to a minimum.
Exit strategy: If the political stability in a region is compromised, it helps to have a reliable exit strategy in place.
Scope of impact: Political risk has a broader range of impact and can affect investors, businesses, citizens and communities in different ways. One single event can have far-reaching consequences.
Causes or triggers: Although the impact of political risk is experienced by investors and businesses, it is often due to causes outside their control. This makes it harder to manage the risk.
Predictability: Predicting political risk can also be quite a challenge as the political scenario of a country is nuanced and influenced by various internal and external factors. Many events that trigger this risk are unexpected.
Control and management: It is harder to control political risk than it is to manage other types of risk. This is because the affected parties have little to no control over when and how this risk manifests.
Government stability: Frequent changes in leadership, political turmoil or weak governments can create an uncertain environment for businesses.
Policy changes: Sudden changes in laws, regulations or tax policies can also impact business operations and investment returns.
Corruption levels: High levels of corruption can lead to bribery, unfair practices and legal uncertainties and may affect business operations significantly.
Social unrest: Protests, strikes and social movements can also disrupt economic activities and lead to instability.
Geopolitical tensions: When a country is involved in international disputes or has conflicts with neighbouring countries, it can affect domestic stability.
International relations: Diplomatic relations and trade agreements with other countries can also influence political risk. Poor relations can lead to sanctions or trade barriers.
Public opinion: Strong public opposition to certain industries or foreign investments can pressure governments to implement adverse policies, potentially leading to disruptions.
The different types of political risk include sovereign risk, instability risk, regulatory risk and currency risk.
Measuring and managing political risk is a challenge because it is multifaceted and harder to trace.
This type of risk is affected by various factors like government stability, policy changes, international relations and public opinion.
On the Bajaj Finserv Mutual Fund Platform, you can find over 1,000 mutual funds for your portfolio. What’s more, you can compare mutual funds, check their composition and returns and choose the schemes that are the right fit for your goals. You can also use the mutual fund calculator to get a better idea of how much you need to invest to potentially earn the returns you require to fulfil your goals.
Essential tools for all mutual fund investors
The financial markets in any country are intricately linked to the country’s government and its policies. Any change in the governing body or the prevailing governmental regulations could affect the economy, the financial markets and various investments in the country. If the impact of such changes is negative, that is a manifestation of political risk.
In this article, we delve into the meaning of political risk, explore how you can identify and manage it and see which factors affect this type of risk.
What is political risk?
Political risk is the possibility that an investment may lose value because of changes in the country’s political structure, instability in its political climate or corrupt practices in the government. Any changes in the government’s regulations and policies could also affect the returns from an investment.Also known as geopolitical risk, this type of risk is more common in long-term investments that are exposed to the prevailing political climate for extended periods. Investments in every country are affected by political risk. However, some countries may have higher risks than others.
Understanding political risk with an example
Any changes in the existing political setup will have far-reaching changes in a country’s economy. From broad factors like tax rates and interest rates to more focused aspects like sectoral impact and purchasing power, various facets of a country’s financial systems are affected when any political change occurs.Some changes may be favourable, while others, which pose a higher political risk, may adversely affect the economy in general and investments in particular. For example, if a new government changes the tax laws to increase the tax rates on a specific category of mutual fund schemes, the net returns from such funds would reduce. This is a prime example of political risk.
Different types of political risk
Depending on the political aspect that causes the risk, political risk can be categorised as follows:Micro risk: This type of political risk stems from internal factors within the government or the economy, like corruption or internal conflict.
Sovereign risk: This is the risk that a government may be unable to meet its debt obligations. Such risk directly affects investors who have purchased government bonds.
Regulatory risk: This type of political risk occurs when there is a change in the existing regulations, which, in turn, affects investment returns directly or indirectly.
Instability risk: This is the possibility of investments losing value due to political instability in the country.
Geopolitical risk: This subset of political risk arises when the government takes measures like military action, which affect the geopolitical climate.
Macroeconomic risk: This is the risk of government changes, policies or instability affecting the economy at large.
Currency risk: This kind of risk is the possibility of the national currency losing value due to certain policies or actions of the government.
Identifying political risk
There is no single surefire strategy to identify political risk. This is because it is multifaceted and can stem from different factors. Also, political risk affects different investments differently. However, the following strategies can help you stay ahead of the curve.Monitor the political climate: Keep track of the political scenario and follow news of elections, leadership changes and government policies.
Evaluate the regulatory environment: Analyse the regulatory landscape and be aware of any potential changes in laws, taxes or industry-specific regulations.
Understand the interplay of socioeconomic factors: Be aware of how socioeconomic issues like income inequality, poverty and social unrest can affect political stability.
Review historical data: Study past events to understand how previous instances of political instability or policy changes affected the returns from different investments.
Look into expert opinions: Gather insights from local analysts, consultants and industry experts to understand the nuances of political dynamics and their impact on investments.
Related articles to read
What is risk return trade off?
What is market risk definition?
What is credit risk?
What is default risk?
What does risk tolerance mean?
What is inherent risk?
Measuring political risk
There are no specific indices to measure political risk directly. However, you can get a broad idea of the level of risk in a country using the following strategies and tools.Political risk indices: You can keep track of political risk indices to better understand the level of this type of risk in the country.
Using risk reports: Risk reports from global and national organisations and analysts also give you insights into the level of political risk in a country.
Scenario planning: You can also develop and analyse different political scenarios and their potential impact on the economy, businesses and investments.
Studying stakeholder surveys: Look into various stakeholder surveys to understand the political climate within a country and gauge political stability.
Managing political risk
Managing political risk can be easy if you are aware of the political scenario and have clarity about its impact on the investments you want to include in your portfolio. Here are some effective strategies for individuals and businesses to manage this type of risk:Portfolio diversification: Investors can minimise this risk by spreading their investments across different asset classes as well as leveraging geographical diversification.
Risk monitoring: It also helps to continuously monitor the political situation in the country or in areas where an investor holds assets or a business operates.
Flexibility in operations: Businesses can manage this type of risk by ensuring that their operations are flexible and capable of adapting quickly to political changes.
Due diligence: Both businesses and investors must conduct due diligence before entering a new market or making a new investment to keep political risk to a minimum.
Exit strategy: If the political stability in a region is compromised, it helps to have a reliable exit strategy in place.
Examples of political risk
You may have already witnessed a few instances of political risk in action without being aware of it. For more clarity, let us understand how political risk works with a couple of examples.Example 1:
Say you have substantial investments in the pharmaceutical industry. If the government enacts stringent new policies on drug approval and pricing processes, the launch of new drugs may be delayed and the profit margins of pharma companies may reduce temporarily. This, in turn, may lead to a dip in the stock price and affect your returns.Example 2:
Political risk can also affect you if you are investing in mutual funds. For instance, say you have invested in debt mutual funds and the government unexpectedly changes fiscal policies, leading to a sharp increase in interest rates. This political decision may cause bond prices to fall, resulting in reduced net asset value(NAV) of the debt funds you have invested in.How is political risk different from other types of risk?
Political risk is different from other types of risk in many ways. Here is a closer look at the key differences.Scope of impact: Political risk has a broader range of impact and can affect investors, businesses, citizens and communities in different ways. One single event can have far-reaching consequences.
Causes or triggers: Although the impact of political risk is experienced by investors and businesses, it is often due to causes outside their control. This makes it harder to manage the risk.
Predictability: Predicting political risk can also be quite a challenge as the political scenario of a country is nuanced and influenced by various internal and external factors. Many events that trigger this risk are unexpected.
Control and management: It is harder to control political risk than it is to manage other types of risk. This is because the affected parties have little to no control over when and how this risk manifests.
Factors that affect political risk
The following factors have an impact on the level of political risk in a country.Government stability: Frequent changes in leadership, political turmoil or weak governments can create an uncertain environment for businesses.
Policy changes: Sudden changes in laws, regulations or tax policies can also impact business operations and investment returns.
Corruption levels: High levels of corruption can lead to bribery, unfair practices and legal uncertainties and may affect business operations significantly.
Social unrest: Protests, strikes and social movements can also disrupt economic activities and lead to instability.
Geopolitical tensions: When a country is involved in international disputes or has conflicts with neighbouring countries, it can affect domestic stability.
International relations: Diplomatic relations and trade agreements with other countries can also influence political risk. Poor relations can lead to sanctions or trade barriers.
Public opinion: Strong public opposition to certain industries or foreign investments can pressure governments to implement adverse policies, potentially leading to disruptions.
Key takeaways
Political risk is the possibility of an investment losing value or a business facing losses due to changes in the government, political instability or changes in the government’s policies.The different types of political risk include sovereign risk, instability risk, regulatory risk and currency risk.
Measuring and managing political risk is a challenge because it is multifaceted and harder to trace.
This type of risk is affected by various factors like government stability, policy changes, international relations and public opinion.
Conclusion
This sums up all you need to know about political risk. It is one of the many types of systematic risks that can affect your investments. To minimise the impact of this risk, you need to focus on diversifying your portfolio. One of the easiest ways to achieve this is by choosing mutual funds, which inherently offer the benefit of diversification.On the Bajaj Finserv Mutual Fund Platform, you can find over 1,000 mutual funds for your portfolio. What’s more, you can compare mutual funds, check their composition and returns and choose the schemes that are the right fit for your goals. You can also use the mutual fund calculator to get a better idea of how much you need to invest to potentially earn the returns you require to fulfil your goals.
Essential tools for all mutual fund investors