Brace yourself: Political-market risks in 2009
— Preston Keat is director of research at Eurasia Group, a global political risk consultancy, and author of the forthcoming book “The Fat Tail: The Power of Political Knowledge for Strategic Investors” (with Ian Bremmer). Any views expressed are his own. For the related story, click here.
There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s ongoing quest to develop advanced nuclear technologies.
These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).
Political risks have historically mattered much more in emerging markets, but political risk in the developed, industrial democracies is rising more quickly than anyone would have predicted a year ago.
Political-market risk in emerging Europe is significantly higher now than any time in the past decade. Russia and Ukraine, and even recent star “emerging Europe” performers such as Turkey, Hungary, and Romania face serious vulnerabilities in the coming year. In addition, western financial institutions based in countries like Germany, Italy and Austria are particularly vulnerable to a credit crisis in Eastern Europe, where they have large loan exposures. Russia’s growing anti-westernism, its state intervention in strategic economic sectors, and its assertive posture regarding Georgia have been widely discussed, and will remain concerns in 2009.
This also plays into one of the most problematic country risk stories right now: Ukraine. Its steel-centric economy is in free fall due to dramatically reduced global demand, many of its companies have large foreign debt financing needs that they will struggle to meet, and its domestic politics are gridlocked and bordering on dysfunctional.
Add serious ongoing tensions with Russia to the list, and the situation looks bad from almost every angle. The year has already started badly, with Gazprom cutting gas supplies to Ukraine, and the standoff highlights the growing animosity between Moscow and Kiev.
The global financial and credit crises, combined with recession in Western Europe, have exposed several other countries in emerging Europe to serious financial market risks. In Hungary, the IMF and the EU needed to step in with a dramatic aid package in order to head off a potential currency and bond market collapse. And in Romania, there are growing concerns about a real estate bubble, rapidly declining economic growth, and the evaporation of repatriation cash flows from Romanians living in Italy and Spain.
Both the Hungary and Romania stories highlight the increasing interconnectedness of political and market risk in the EU. The newer member states can no longer be considered in relative isolation from the core, Western European countries.
The most notable example is the exposure of Western banks to credit risk in Eastern Europe. In recent years western banks have made substantial home mortgage, consumer, and business loans to eastern Europeans that were denominated in western currencies. The borrowers were exposed to local currency risks that the often did not fully understand .
Italy, Austria, and Germany had the largest exposures. Now these western governments may need to step in to assist with the solution. In fact, if the EU and European Central Bank had not intervened in dramatic fashion in Hungary, a number of western-European banks and pension funds would have been in very serious trouble. The problem is that this may only be the beginning of a crisis that could involve dozens of countries in both the East and the West.
The U.S. and Multilateralism
In the past several years the dynamics of “multilateralism” have evolved fairly dramatically. Two central developments this year:
1. A number of additional players such as India, China, and Brazil are actively seeking to play a larger role in multilateral negotiations and institutions.
2. The U.S. is in the process of a presidential leadership transition, with an expectation that the new administration will address these issues differently than its predecessor.
This new environment presents both challenges and opportunities. A larger number of “key” players at the table means that policy coordination could be much more difficult – a classic collective action problem. At the same time, engaging newer, emerging-market countries may make sustainable “breakthrough” outcomes more plausible, as these countries will be central to tackling complex issues such as climate change and global trade.
Prior to September of 2008, the central challenges of multilateral cooperation were in areas such as energy/climate change, trade, and security. Then the global financial and credit crisis offered an almost perfect experiment. How would the world’s leading countries, along with those who aspired to positions of greater leadership (e.g. China, India, Brazil) manage this systemic crisis?
When it comes to a new financial regulatory architecture, the U.S. is likely to find support for its agenda in the UK and China, who will share the its general aversion to giving meaningful regulatory authority to multilateral institutions such as the IMF. As long as these three key players can agree on general principles for market regulation, power will remain in the hands of national governments rather than any multilateral organization.
But this is where a key, lurking political risk comes into play – can the U.S. actually take the lead in developing a coherent approach to new regulation of capital markets?
Congress will probably feel that it needs to act in a dramatic fashion and enact new legislation. The Treasury and the Federal Reserve will also have serious, and potentially conflicting agendas. So even if the multilateral dimension looks manageable, the domestic and bureaucratic politics of new regulation present a substantial new risk.