Modeling A Country’s Political Environment: An Application Of Dynamic Factor Analysis Methodology

Abstract

Political uncertainty generates non-trivial costs for business, resulting in suboptimal decision-making and suppression of economic activity. Decreasing political uncertainty and attaining greater accuracy in risk analysis of a country’s political environment remain a challenge. Our research attempts to fill this gap by: (1) re-directing scholarly attention from the questions of what and why to how political uncertainty and risks can be identified and assessed by (1) offering a process-based theoretical framework of a country’s political environment; and (2) proposing a new methodological framework based on Dynamic Factor Analysis (DFA) to estimate the dynamic structure of a country’s political environment. To demonstrate the application of this methodology, we analyze Brazil’s political environment for the period 1984-2018 using monthly political risk time-series data. Specifically, we demonstrate how the results of the DFA methodology allow us in evaluating the characteristics of the country’s political environment, in terms of: (1) complexity of the political environment, (2) potency (or importance) of the drivers and dimensions of political environment; (3) stability of political environment, and (4) nomological validity of the model. The paper ends by mapping Brazil’s historical political environment with our empirical results and focusing on the methodological challenges and opportunities of using DFA.