Volatility in geopolitical relationships: their effect on investment

The rise of geopolitical tensions worldwide and the fragmentation of relationships between countries have introduced new dimensions to the risks of foreign direct investment. Mitigating the risks of geopolitics is a big concern for executives, shown by PwC’s survey of almost 4000 executives in 2023. But political and corporate leaders are ill-equipped to understand and react to geopolitical risk. The researchers suggest that companies might find it valuable for their business leaders to develop competencies for thinking beyond local stakeholders, and to be able to shuffle between multiple and often contradictory pressures created by unstable political relations between their home government and host countries, say the researchers.

“We wanted to show the effects of geopolitical volatility and risk because the recent past and the near future will be increasingly characterised by it,” said Dr Christopher Sabel, who is Assistant Professor in the Department of Strategic Management and Entrepreneurship at RSM.

The researchers analysed the effects of geopolitical volatility in relations between countries on subsidiary investments using a sample of 1054 US public firms and their subsidiary investments in 106 countries, between 2000 and 2015.

They found that US firms reduced their investments in countries that exhibited high volatility of political affinity in relations with the US. These firms also reduced the number of employees and had lower local sales in these countries.

This effect was less so for countries that have a good relationship with the US in general, and firms with political connections to US politicians are less affected by volatility. The researchers assumed that the quality and volatility of a country’s relationships with other countries mirrored the way that that country voted in the UN General Assembly, and gauged the relationships accordingly. [JW1] 

The reasons why volatility in political affinities is such a warning sign for investors is because it can be the cause of consumer boycotts, discrimination by foreign officials, government expropriation, or suppliers behaving in an expropriating manner by imposing price increases, quantity mandates, or terminations of contracts. 

The researchers point to several examples of companies withdrawing foreign investments when things looked volatile. “There are so many countries around the world that rely heavily on foreign investment, and its absence in the developing world can be particularly critical. Even developed countries are competing for foreign investment and the creation of local jobs.” 

This new knowledge from the researchers introduces a different viewpoint from the usual behaviour of investment managers. “Often, investment managers pay more attention to the overall quality of the relationship and whether it’s high or low, yet volatility in both good and bad relationships makes outcomes more unpredictable – and most likely unfavorably so. But developing high quality relationships with politicians in their home countries can lessen this effect. Companies that have better relationships like these are less likely to reduce their investments,” said Dr Sabel.

The researchers also say it’s important for government officials to understand their findings. Sudden shifts in officials’ behaviour are detrimental for their country because they diminish its attractiveness as an investment destination. When the representatives of countries are more consistent in their behaviour then companies can better predict and manage outcomes from investments made there. And in fact advanced economies in the EU and the US have recently sought to increase foreign investments with subsidiaries. The researchers have shown that maintaining stable political relationships – even conflictual ones – is important for creating a predictable environment for investments. 

The researchers are hoping the information in their study reaches governments, and the risk management and market entry divisions of investment companies.