Was political risk in Russia hiding in plain sight?


Western companies have begun the painful process of accounting for their losses in Russia. International banks owe more than $121 billion to Russian entities, with European banks having at least $84 billion in exposure, according to the Bank for International Settlements. Oil company BP plc could lose up to $25 billion. Shell said its writedown will be around $3 billion. IKEA closed all of its 17 stores in Russia, its fourth-largest market by sales after Germany, the United States and Sweden.

So what went wrong? Why did so many sophisticated global organizations lose in Russia? They are all voracious consumers of political risk models. Were the risk models wrong?

Not likely. The publicly available indices that are built into most political risk models were consistent. They have shown for at least the last decade moderate to high risk factors in almost all categories.

If the models were correct, however, why did so many organizations get it wrong? There are a few possible explanations. Business leaders either ignored risk models or did not believe them. Or they paid attention to patterns and believed them, but failed to act on them to mitigate risk. Or all of the above. Anyway, how can such behavior be explained?

When I have worked in high-risk countries in the Middle East and Asia, I have noticed this: when political risk remains at a constant level, regardless of its risk level, it gradually becomes less of a factor for the decisions-makers. Business leaders adapt to high but enduring political risk. In other words, they cease to recognize risk and the danger it creates. They also stop managing risk properly, usually failing to mitigate risk while they still can.

Here is an example. In Indonesia, from 1991 to the first half of 1997, the Indonesian rupiah traded at a moving average rate of 2,200 rupees per US dollar. Although economic and political risk models have shown the potential for enormous exchange rate volatility, years at a constant rate of Rp 2,200 have blunted business leaders at real risk. I heard many of them talking about the exchange rate of Rp 2,200 as if it was fixed and wouldn’t change, so they stopped hedging. To take advantage of favorable interest rates, they borrowed US dollars even though their income was in Indonesian rupiahs.

When the “Asian contagion” hit in July 1997, rapid devaluations plunged the rupee-dollar exchange rate from Rp 2,200 to Rp 14,000. Almost all major Indonesian companies became technically insolvent, with huge deficits in the amount of rupiah required to pay the debt denominated in US dollars. Most major Indonesian companies barely survived by collectively forcing international lenders to make massive write-downs on US dollar loans.

In Russia, there was a similar pattern. For many years, political risk levels have remained high but constant.

For example, perceived corruption is a factor in assessing political risk. The 2021 Corruption Perceptions Index ranked Russia 136th out of 180 countries. From 2016 to 2020, Russia’s CPI ranking was 131, 135, 138, 137, and 129, respectively. In other words, perceived corruption in Russia has been relatively high over the past six years, but within a range narrow.

TheGlobalEconomy.com’s 2020 Political Stability Index ranked Russia 151st out of 194 countries. The index uses around 300 indicators from the World Bank, International Monetary Fund, United Nations and World Economic Forum. From 2011 to 2020, Russia’s ranking on the Political Stability Index has deviated by less than 15% overall.

The Heritage Foundation’s 2022 Index of Economic Freedom ranks 184 countries on numerous factors related to political risk. Russia ranked 113 on the 2022 index. Over the past decade, Russia’s raw score behind its annual ranking has been in the moderate to high range, with no dramatic changes that could have triggered new political risk alarms. Here is the ten-year chart:

One of the reasons business leaders ignore the bad news of persistently high political risk is the absence of worse news. Companies crave predictability, so consistency – even consistently high risk – becomes kind of good news.

Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable, co-authored an article for hbr.org that talks about the intrinsic bias of business leaders toward good news and against bad news. “The business departments of bookstores are full of success stories; there are far fewer tomes about failure.

In Russia, has this bias caused Western business leaders to mistakenly focus on the “good” news of consistency instead of the “bad” news of high political risk? I think so.

The political risk models for Russia were not wrong. High levels of risk were there all the time, in plain sight but obscured by a risk factor that never changes: human nature.


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