It is necessary to be systematic about the classification of risk. The classification must fit the specific problem under analysis, which in this case is the determination of FDI. There are numerous ways of classifying risk, each reflecting the particular focus of interest. For example, an econ- omic historian interested in the influence of risk on the process of econ- omic development might define a risk-generating event as inherently capital-destructive or labour-destructive. Such an historian might argue that the environments of different parts of the world differ in the bias of their factor destructability (Jones 1987). Or a classification might be made which distinguishes natural, social, market or power (political) risk according to their different sources. The course of economic development is marked by phases during which the different risk types predominate (White 1987). Moss (2002) has produced a model which considers phases in the USA which differ according to the nature of government interven- Risk and Risk-generating Events 31
tion to control risk. On the other hand, concentration on financial markets has yielded a very different classification of risk (Saunders 2000).
The main emphasis is on the distinction between systematic and non- systematic risk but a much more ad hoc classification is made regarding the sources of risk. The classification lacks coherence, largely because the source of the risk is considered irrelevant to an analysis which concen- trates on the impact. All financial textbooks contain such a classification, usually differing in detail but covering the same ground. This classifica- tion focuses on the impact of risk on the value of the enterprise, its cash flows or returns, mostly on market or credit risk, taking into account risk elements such as price, notably interest, risk, differing maturities risk, even credit risk and off-balance sheet risk. It includes as separate ele- ments, liquidity and insolvency risks. Often there is some reference to operational risk or technical risk, that is, the difficulty of mastering a new technology, and to political and transfer risks.
From the perspective of this book it is necessary to develop a dif- ferent classification, one appropriate to FDI, a process begun by Miller (1992). The second section of the book completes this process, whereas this section explores the principles by which such a classification should be made. We can start with the question, what sort of events are relevant to direct investment in general and to FDI in particular?
Such events range from those occurring at the macro level, natural events such as storms or earthquakes, or human-initiated shocks such as economic recessions or terrorist attacks, to those occurring at the micro level, the bankruptcy of a creditor or the failure of a vital piece of machinery. The frequency of incidence and both breadth and depth of impact differ from shock to shock; in particular cases the impact is strongly mediated through strategic and structural responses by decision makers acting within the relevant organisations.
It is also necessary to refer to the risk which arises from the competi- tion between strategy makers, which might be called strategic risk, at the international level, a combination of competition risk and country risk. The term strategic risk is used since it describes the risk which arises from ignorance of the strategies of others and of the pattern of action, response, and reaction which ensues from the implementation of any particular decision (Smit and Trigeorgis 2004). The indetermi- nateness of unfolding scenarios is shown both by the different solu- tions to problems set up as games and by the path dependency of actual outcomes, which often reflect the potency of apparently small events to influence a historical path (David 1985; Arthur 1989). Any investment decision must be viewed in the context of the strategies of all other significant players.
Risk exists at different levels of the system – global, national, indus- trial, enterprise, project and individual. The relevant level can be defined by the source of the risk-generating event, by its area of impact or by the location of risk responses. At all levels the relevant risk- generating events have a powerful potential impact on business, but only after a filtering process makes specific the impact. From an eco- nomic perspective the significant impact might be defined by some performance indicator, anything from the GDP growth of affected countries to the profit of a particular enterprise experiencing the impact or the return on a particular project.
Risk is systematic to the level to which it refers, particularly above the level of the enterprise. It affects those on whom the risk has an impact in a similar, although not identical, way. The most relevant type of risk, country risk, affects to a varying degree all those investing in a particular country. On the other hand, industry risk affects all those investing in a particular industry. Global risk has the potential to affect everyone. The key levels are dealt with in separate chapters in part three of the book.
The risk facing an enterprise arises at all levels. It is possible to combine in a simple way the generic industry and country risks rel- evant to a project, with one type of risk on each axis of the matrix.
This investment risk diagram can be constructed with the help of quantitative measures of risk (see Moosa for the use of such a diagram for another purpose).
Risk and Risk-generating Events 33
Country risk
Industry risk Figure 3.1 The matrix of country and industry risk
The slope of the boundaries reflects a trade-off between the two kinds of risk. In some cases, the significance of industry risk may be much greater than of country risk, in other cases the ranking may be reversed.
One enterprise may be relatively intolerant of the risk in a particular country although it has expertise in the relevant industry. Another may be happy with the country location, but be operating in an industry which is a fast changing one.
The critical risk levels for the purpose of this book are not those at which generic risk arises, but the enterprise and project levels. Since an enterprise is unique in its various identifying features – resources, struc- ture, strategy, personnel and history, and has a set of capabilities or competencies which include the control of risk specific to the enter- prise, the higher level risk is filtered to the enterprise in a unique way through relevant control responses. There is therefore what might be called vertical overlapping between the risk levels. There is also hori- zontal overlapping in that different shocks may bunch because of some causative connection. Natural catastrophes are often linked with war.
Economic risk is a source of political risk. The nature of risk at these different levels is discussed in chapters 4, 5, 6 and 7.
The potential impact of particular events is described as the risk exposure. This is the extent to which external contingencies threaten the value of the enterprise (Miller 1998: 497, 499). Such an impact reflects the nature and value of the assets affected. In order to specify exactly what value is at risk, it is necessary to specify both the proba- bility distribution of relevant events, including any skewness or kurto- sis of the distribution, and the assets or income streams at risk. The confidence level selected to help determine the value at risk reflects an important third element, the risk appetite.