Knowledge@Wharton

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Another related way that researchers have tried to assess risk is by determining whether governments are stable or not, regardless of whether they are democracies. Intuitively, one would think that a country where the government changes hands frequently would be a poor place to invest. But there are shortcomings to this way of thinking as well. By this measure, Italy would appear unstable. But Italy is certainly a safer place to invest than, say, the Democratic Republic of Congo (formerly Zaire), which went through a decades-long period where its autocratic regime remained intact.

A third method traditionally used to assess risk is to survey managers and ask them where they perceive risk to be. A firm may simply ask about the likelihood that a government will renege on a contract. Or, it could inquire whether a government is prone to raising taxes at a moment’s notice.

“On one level” Henisz says, “this approach is great. You’re asking the exact questions you want answers to. But if you’re trying to explain what part of the government is causing problems, you don’t really know.” In addition, the information is subjective and fraught with inconsistency.

Each of these traditional methods has shortcomings. First, they are primarily retrospective in nature. Macroeconomic accounting measures or investors’ perceptions of risk may provide nothing more than superficial information about trends. For instance, an accelerating growth rate may prompt foreign investors to flock to a country to take advantage of its economic “miracle.” But if there has been no substantive political reform, the underlying political risk probably has not abated. Second, the macroeconomic statistics may be subject to manipulation by politicians and others in key posts.

Third, the political science measures are objective and do focus on political institutions, but not ones of interest to investors. The final shortcoming relates to perceptual assessments. While it is true that less investment occurs in countries perceived by managers to be risky, this tells managers nothing about the fundamental sources of risk.

In an attempt to fill these knowledge gaps, Henisz has developed a model that takes into account two key components of political systems.

The first is whether the system contains “veto points” – whether one part of the government can effectively act as a brake on the arbitrary actions of another by nixing a proposal. In the United States, of course, this is the system of checks and balances.

Second, Henisz factors in whether these veto points are actually put into practice. Often they are not. Some African countries have constitutions, modeled on those of Western nations, that appear to have a robust system of political constraints. But the checks and balances exist only on paper. “You may look at the Supreme Court and find that everyone was appointed by the sitting president,” Henisz says. “Or you look at the legislature and find that everyone is a member of the same party as the president.”

Henisz has assembled data for countries around the world and computed a measure of how easy it is for governments to change policies based on their policy-making structures. “I’m interested how credible governments are and this is a measure of credibility,” says Henisz.

Henisz calls the model a “political constraint index.” It takes into account the number of veto points in a country’s political system — its executive branch, upper and lower legislative chambers, judiciary and sub-federal institutions. First, Henisz computes a measure of how policies are likely to change simply on the basis of the number of veto points. He then takes this initial measure and goes a step further. He adds such factors as which political parties control the different branches of a country’s government and the history of the political affiliations of jurists who have been appointed to its high court.

The index has been calculated for virtually every nation in world from 1960 to 1998. A high number, such as 0.85 for both Switzerland and the United States, means a nation’s political system has many constraints. Thus, politicians are less apt to behave capriciously, which is good for investors. A low number, 0.18 for Togo or 0.00 for Afghanistan, means the governing regime has few political constraints, and thus may pose serious risks for investors. Says Henisz: “Whoever is in power could wake up tomorrow and say ‘I’m going to double taxes and there are no courts or legislature to say ‘You can’t do that.’ ”

The table also reveals how certain countries have developed systems with many more political constraints than they once had. In Henisz’ native Poland and other nations in Eastern Europe, such as Hungary and Bulgaria, much progress has been made since the fall of the Soviet Union a decade ago.

In conducting their research, Henisz and Zelner spent considerable time with political risk analysts at several companies that have invested large sums of money in infrastructure investments overseas, including Enron Corp. and Duke Energy International, in an attempt to understand the full array of risks they face. These companies and others go to great lengths to assess political risk and have considerable experience in investing wisely. But Henisz says companies can also be arbitrary in the way they combine their information, and thus can miss some important trends.

How One Company Got Blindsided by Political Risk

Witold J. Henisz tells the story of Houston-based Enron Corp., which has had much experience building power-generating facilities around the world and dealing with the attendant risks. In 1995, Enron built its Dabhol Power Project in a relatively undeveloped region of India's Maharashtra state, an area in dire need of electricity.

"Concerned about risk, the company designed a contract that was very advantageous to them," Henisz says. "They were going to get paid a lot when the plant started producing electricity, and they were relatively well insured against the types of risks that they foresaw - exchange-rate risk and changes in demand. They had a lot of foresight and thought they had things pretty well covered."

But there was an election in the state and the Hindu nationalist Bharatiya Janata Party, which was somewhat hostile to foreign investment in general, came into power. The party, angered by what it thought were the high prices per kilowatt hour charged by Enron, threatened to take over the project and send the company packing.