Political risk is defined as the risk of a foreign government acting against international law in relation to an investment or receivable owned by a foreign government or company. It is safe to say that the recent events in Ukraine, Crimea and Russia caught everyone off-guard and have highlighted the political risks facing businesses operating in emerging markets.
Now the emerging Eastern European markets are engulfed in geopolitical strife, infrastructure investors find themselves in an uncomfortable position. Difficult questions must be asked: Can infrastructure assets be protected? What will be the extent of possible losses? Will the disruption stop with the Crimea, or will other parts of Europe also be at risk?
If the international community thought Russia's move into Georgia in 2009 was a one-off event, the annexation of Crimea has represented a worrying repeat. The borders of two European countries have changed yet again, not exactly an uncommon event in the continent’s history, but few commentators thought this would become a regular event. The Crimean situation has shown that businesses need to protect themselves against this sort of ‘political’ risk, even in countries where an environment of stability was commonly assumed.
Much of the recent financial and economic media focus on the Ukraine debate has revolved around gas supply and infrastructure. This is unsurprising given the wider ramifications of disruption to either. However, East-West gas flow has proved to be remarkably resilient to political upheaval. Even in the Cold War, the European need for gas and the Russian need for cash ensured steady flows.
What risks do infrastructure companies now face in Ukraine?
Although it is impossible to predict how the current situation in Ukraine will develop, there are a number of scenarios that could play out. These range from: the new and uncomfortable status quo remaining in place; Ukraine further breaking up (potentially driven by the Polish-dominated north-east of the country looking to separate); increasingly aggressive and disruptive sanctions being imposed on Russia; and the horrific prospect of an all-out infantry war between Ukraine and Russia. All of these possible scenarios contain different levels of risk for European infrastructure investors.
There is also the very real chance of an economic war being fought between the West and Russia. This is a very sobering prospect for those investors with assets in Russia or for those who have business connections and agreements with companies that are linked to senior Russian officials.
Regardless of how this situation develops, there is a checklist of typical ‘political risks’ investors should start considering:
Nationalisation and expropriation: Infrastructure, especially that which involves an aspect of ‘national’ interest is always at risk of nationalisation in times of economic or political disruption. For investors with assets in the Crimea, there is now uncertainty over agreements and even the current ownership of assets.
Western investors that have loaned money to Ukrainian companies may now find these companies have ceased to exist. An even more difficult scenario is that a foreign investor may not lose their assets or company, but may find they have a new ‘partner’. Only losing 30 percent of an asset (or operation) may make investors unable to easily get out of a difficult situation. Downstream risks here could include the ongoing loss of proprietary systems and intellectual property.
Legal risk: At best, foreign investors may now find that they are now working under a new legal regime. Agreements made under Ukrainian law are now under Russian jurisdiction. The legal issues of the Ukraine/Crimea situation are complicated (and no doubt expensive) and the practical realities of obtaining legal redress for any subsequent loss of investment as a result will not be straightforward.
In a situation like Ukraine/Crimea, risk managers and insurers need to undertake legal risk analysis. Are licensing agreements still valid? Is your insurance still valid? Russian and Ukrainian insurance are very different beasts. Are your hard assets and property still covered and protected?
Recriminations and social unrest: The Balkans, East Timor, Yugoslavia, Syria, and Libya ( to name but a handful) are all tragic examples of what can happen when countries are divided and local, regional, and religious tensions are forced to the surface. In a worst case scenario, the collapse of political, social and legal constraints can have a long-term effect on investment, cross-border finance and general business operations.
Sanctions: We have already seen Russian businesses being affected by initial US sanctions targeting the business interests of senior Russian officials. MasterCard and Visa have suspended operations with a number of Russian banks and – as sanctions on Russia become more entrenched, expanded and better understood – the impact on investors will expand beyond just Ukraine.
Investment and finance: Another effect infrastructure investors may face as a result of this crisis is the drying up of investment funds for projects in Ukraine and the emerging Eastern European markets – any place where Russian intervention is a risk. Refinancing of bonds will also be a major issue for infrastructure investors. As funding becomes harder to obtain, companies will face the very real prospect of running out of money. As many infrastructure assets are seen as being part of the national interest, even the suggestion of an infrastructure provider failing increases the chances of nationalisation – thus completing a vicious circle for infrastructure investors.
Mitigating and minimising political risk: Companies must consider political risk insurance as a form of investment protection and risk mitigant as they move into new markets. Some key considerations and risk indicators include:
– The strength or weakness of the central government: The weaker a country’s central government, the greater the risk. The political divisions and central government weaknesses evident in Ukraine during the European Union versus Russia economic debate highlighted wider areas of political risk.
– Social cohesion: Ethnic and religious divisions should always be factored into an investor’s political risk assessment. For Ukraine and Russia, the Crimea was always a potential flashpoint. The question now is whether there other possible areas of division in the Ukrainian state?
– Nationalism, extremism, and national identity: The levels of extremism in a county are a strong indicator of likely social unrest. Likewise, a strong and universally respected figurehead, such as a king or queen, can bind various political views and minimise the overall impact of political disruption.
– Economic resilience. Political risk is greatly reduced in countries where economic conditions are strong. This has been evident in Thailand where, despite ongoing political protests, the local economy has continued to function and develop.
Crimea: a political risk advertorial
Saving a few dollars on political risk insurance makes sense until a situation like Ukraine develops. Banks, traders and infrastructure investors should take this type of risk very seriously, even though it is hard to predict. Foreign investors are easy targets and they are the ones with the most at stake.
Unfortunately for investors affected by the Ukrainian/Crimean crisis, the time to look for political risk insurance has long passed.
The current situation in Ukraine has shown that, even in countries where the level of political risk was assumed to be relatively low, the situation can quickly change. For investors with significant amounts of money tied up in immovable assets, the implications of nationalisation and sudden border changes should be factored into all business plans.