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Shruti J. Shah
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Eric Carlson
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Was political risk in Russia hiding in plain sight?

Western businesses have begun the painful process of tallying their losses in Russia. International banks are owed more than $121 billion by 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 impairment will be around $3 billion. IKEA has shut down all of its 17 stores in Russia, its fourth biggest market by revenue after Germany, the United States, and Sweden.

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

Not likely. Publicly available indexes that are built into most political risk models were consistent. They showed for at least the past decade moderate to high risk factors in nearly every category.

If the models were right, however, why did so many organizations get it wrong? There are a few possible explanations. Business leaders ignored the risk models or didn’t believe them. Or they paid attention to the models and believed them but didn’t act accordingly to mitigate risk. Or all of the above. Whatever the case, how do we explain such behavior?

When I worked in high-risk countries in the Middle East and Asia, I noticed this: When political risk stays at a consistent level, no matter how high the risk is, it gradually becomes less of a factor for decision-makers. Business leaders adjust to high but long-lasting political risk. Said another way, they stop recognizing the risk and the danger it creates. They also stop managing the risk properly, usually by failing to mitigate risk while they still can.

Here’s an example. In Indonesia from 1991 through the first half of 1997, the Indonesia rupiah traded at a moving average rate of Rp2,200 to one U.S. dollar. Although economic and political risk models showed the potential for enormous exchange rate volatility, years at a consistent rate of Rp2,200 dulled business leaders to the actual risk. I heard many of them talk about the Rp2,200 exchange rate as though it was fixed and wouldn’t change, so they stopped hedging. To take advantage of favorable interest rates, they borrowed U.S. dollars even though their revenue was in Indonesian rupiah.

When the “Asian contagion” hit in July 1997, rapid devaluations plunged the rupiah-dollar exchange rate from Rp2,200 to Rp14,000. Nearly every big business in Indonesia became technically insolvent, with huge shortfalls in the amount of rupiah needed to pay U.S. dollar-denominated debt. Most of the big Indonesian businesses survived, just barely, by collectively forcing international lenders to take massive write-downs on U.S. dollar loans.

In Russia, there’s been a similar pattern. Over many years, levels of political risk stayed high but consistent.

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

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

The Heritage Foundation’s 2022 Index of Economic Freedom ranks 184 countries on many factors relevant to political risk. Russia ranked 113 on the 2022 index. Over the past decade, Russia’s raw score behind its annual ranking settled in the moderate-to-high range, with no dramatic shifts that might have triggered fresh alarms about political risks. Here’s the ten-year chart:

One reason business leaders ignore the bad news of consistently high political risk is the absence of worse news. Business craves predictability, so consistency — even consistently high risk — becomes a kind of good news.

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

In Russia, did that bias cause Western business leaders to focus wrongly on the “good” news of consistency instead of the “bad” news of high political risk? I think it did.

Political risk models for Russia weren’t wrong. High risk levels were there all the time, in plain view but obscured by a risk factor that never changes — human nature.

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