Expert Zone

Straight from the Specialists

Decoding political risk no mean feat

By Paul Donovan
July 18, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Politics is playing a dominant role in financial markets today — and generally speaking, investors do not like it. Political risk is an additional layer of uncertainty that has to be factored in while making investment decisions. Because political risk is intimately linked with the uncertainties of human behaviour, the impact of political risk can at times seem to be almost random. After over two decades as a professional economist, I can assert that forecasting economies is tough. Trying to forecast what politicians are going to do is even worse.

Consider how politics in one part of the world can have repercussions on the other side of the globe. Chinese politics has impacted the most unusual areas this year. China as a country is relatively poor. China is also a society that is relatively unequal in terms of its income distribution. Estimates put the number of Chinese millionaires at around 1.4 million, the second highest number in the world — which means that the Chinese market for luxury brands is important. Or rather, it was.

The politics surrounding the Bo Xilai affair has led to a change of policy in China. The Xinhua news agency reports there are new rules restricting official spending on vehicles, overseas trips and other areas that might be termed “luxury spending”. Associated with that, the practice of gift giving has declined. The result is a poor outlook for luxury brand sales in China at the moment, arising from local political pressures. Investors who thought luxury good producers would benefit from the nouveau riche of China are now likely to be disappointed, and it is all due to politics.

The Euro area is another instance of political angst. Economic outcomes, banking regulation (and thus bank lending), investment flows and risks to other countries are all contingent on the political decisions of seventeen or twenty seven countries acting collectively. Attempting to understand Euro area politics is enough to cause an economist to give up in despair.

This upsurge in politics presents three challenges to investors in financial markets: comprehension; localisation; and concentration.

Markets do not price political risk terribly well. During the “great moderation” that lasted roughly from 1993 to 2007, political risk was not especially significant (at least, not for the OECD economies). Monetary policy mattered, and central bankers were elevated to almost divine status by investors, but politicians were seen as an annoyance at best. Investors who began their careers after 1993 (and that is the overwhelming majority of people employed in financial markets today) have never had occasion to include assessments of political risk in their investment decision making. The tiny minority who recollect the early 1990s have generally forgotten the art of factoring in political risk. The modern, more politicised investing landscape is alien to most investors.

Moreover, understanding political risk is a great deal more time consuming and ultimately more difficult than understanding economic risk. Economics is global. As an economist, I can go anywhere in the world and talk about consumer price inflation, or trade, or interest rates, and people will generally understand the broad outlines of what I am talking about. Politics is not like that. Politics is local — really local. Politics is about culture, traditions, social structures, regional variations, nationalism and so forth. It is hard for anyone not born to a country to understand that country’s politics. This makes political risk in a globalised financial system a dangerous force.

Finally, there is the condensation of power that occurs in a crisis. The Euro problems are an ideal example of this. In the run-up to the nineteenth summit to save the Euro in June, media were full of comments from “informed opinion”. Cabinet ministers, unnamed officials, and senior advisers were all opining on what the summit would decide. This deluge of comment had one common factor — it was all completely wrong. The outcome of the summit bore little if any relation to the anticipation, because ultimately the decisions taken were concentrated into the hands of a very small number of individuals. The history of past European crises shows us that normally heads of governments will take decisions, and compromise over those decisions, at a very personal level. The decision is then presented as “take it or leave it” to the governments and officials who have been offering opinions without any real knowledge or insight.

What this means is that we are now in a situation where markets are increasingly influenced by politics, but investors also lack experience in pricing political risk, find it hard to price political risk in globalised markets, and suffer from plenty of political misinformation but very little accurate political information in advance of key decisions. This adds up to a volatile environment for financial markets, and a world where no single asset class can truly be considered “safe” with absolute certainty.

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