What is Geopolitical Risk and How Does it Influence the Markets?

Geopolitical risk might be described as the ‘probability that  an investment’s  profitability will suffer due to circumstances related to unexpected changes involving political revolutions, coups, elections, ethnic conflicts, disputes in the arena national or international policy, property rights, and a number of similar factors. To best assess the impact of such events – geopolitical analysis – it’s essential to understand both domestic and international political factors and the dynamic that exists between them.

Based on the above definition, or attempt at such, at the equity level, geopolitical risk affects the interaction of a specific company (or its stock and related financial instruments) and specific events or developments in a host country or host region. In some cases, where governments are weak or weakened, large companies such as multinationals may themselves play a role in affecting the outcome of a domestic political process. International relations scholars have recognized the ability of multinationals in to exercise a certain degree of control over foreign governments (Source: Joseph Nye, 1974). Generally, however, the geopolitical risk that concerns investors relates to policies and societal dynamics that influence corporations.

The progressive loss ofcontrol over the effectsofdecisions and actionsin relation toeconomic and financialmarketsdueto the increasingcomplexityof international  variables, and the increasing weightofthe latter in 2019-makes it essentialfor investors to keep geopolitics (or geopolitical risk) in mind.Theanalysisofpolitical risk, or geopolitics,addresses thisandseeks to minimizethese effects. Normally, global institutional investors seeking to manage portfolio risk consider geopolitics as governments intervene in the economies of rich and poor countries. But, how often have times been ‘normal’? Certainly, not in 2019. The most notable ‘sign’ that geopolitics are weighing heavily on the financial markets is that the price of gold has made its most bullish move in seven years. The fact that the price of silver has also leaped only confirms the fact that the equity markets are jittery.

Examples of Current and Developing Geopolitical Risks to Watch:

China: China’s relentless effort to de-throne the United States as top economic and military power and quest for global leadership. China is winning over governments worldwide thanks to its non-political intervention (for example in Africa, used to adopting often unproductive Western economic and financial recipes in exchange for loans). China is exploiting this to expand its own influence. Beijing is also boosting investment in science and technology (AI for example), becoming a world leader. China also controls strategic mineral resources (rare earths) essential to many technological sectors.

Iran, Middle East and International conflicts: Syria continues to act as a source of tension, while Saudi Arabia and the UAE remain embroiled in heavily under-reported yet vicious conflict in Yemen. These add to the rising potential of a major international conflict war, which could involve millions of people in a large conflict, considering the ongoing tensions between the United States and Iran and the related cancellation of the Nuclear Deal. Among other consequences – including jittery behavior from Israel vis-à-vis some of Tehran’s regional allies: Iraq, Syria and Lebanon (Hezbollah). Apart from instability, this keeps oil prices on ‘high alert’ – along with the entire extractive sector. A jolt in the oil price would affect the whole economy. Moreover, Iran tensions have also o worsened relations between Washington and Beijing (the trade talks certainly have suffered) as China is one of the biggest buyers of Iran’s crude oil.

Tech Wars: As control over data becomes more important, States and corporations will be challenging each other for dominance. New technologies remain important attractors of capital and investors (into companies such as Alphabet Inc. (Google), Facebook, Twitter, etc.) but they also risk causing a financial crash. 

Brexit and More EU Tensions: The UK could exit the European Union in October 2019 without an agreement. The new Prime Minister Boris Johnson has suspended parliament, raising the political stakes, highlighting the potential for an apocalyptic scenario, which may leave the UK without adequate supplies of food or medicines. Furthermore, the ongoing Brexit and economic slowdown in Germany – along with the risk of a major banking crisis, triggered by Deutsche Bank – will fuel populist sentiment within the European Union. These populists, whether from the Right or the Left, are hampering efforts for greater integration in the European Parliament. If even one more EU member State should threaten to exit the Union – and there is a growing number of candidates, including founding member Italy – it would spell the collapse of the EU.

Awareness of Geopolitics is Preemptive Risk Management

Geopolitical risk is an exercise in preemptive risk management – that is following certain international dynamics before the markets begin to absorb them, can help investors identify trendsand market opportunities before the ‘pack’ – maximizing eventual returns, or avoiding calamity. Markets are always sensitive to political instability, the kind that threatens a country’s social and political order – and which can quickly affect an entire geographic region in the short and long term (for example, the protests of 2010/2011 in Tunisia, triggered the so-called Arab Spring). Conflicts or crises can have repercussions on the economic, commercial and financial situation, determining the success or failure of an investment. Thus, a political crisis can provoke the flight of capital from a country; vice versa, a foreign policy that creates positive prospects of stability can determine the influx of capital.

Naturally, such factors as the size of a company (and its stock) and the sector in which it operates affect investors’ perceptions or calculations of risk. Some manufacturing companies, for instance, have greater freedom to choose opportunities and key markets than others, such as those involved in extractive or resource activities. The latter companies often have little choice: they take on significant risks, as they need to be close to the raw material fields. Similarly, a company’s national base also affects its risk exposure as does its expansion or international sales plans – absorbing the associated regulatory regimes and/or sanctions (see European companies, operating in Iran or Russia for example). The impact of national institutions and traditions on the performance of multinational companies (financial facilities, research and development potential, traditional social structures, foreign investment strategies) cannot be ignored. (Source: Pauly & Reich, 1997.)

The evolution of economic and geo-political scenarios affects industrial and financial assets: That’s why every time that a company engages in foreign investment, it must also take these into account. The monitoring of “country risk” has become increasingly important in light of recent events. Just think of the events of the Arab Spring and Egypt to realize how even countries considered to be generally predictable are not exempt from political risks. The Arab Spring received worldwide attention and analysis; however, companies conduct business all over the world and each region and state presents their own specificities. Politicalrisk also often encompasses corruption, expropriation, and terrorism, as seen recently in Indonesia. This basket of uncertain risks is important to understand, not just from the perspective of the direct stakeholders, the company owners and shareholders, but also for fund managers assessing the countries entering developing markets.

Political risk is perhaps the most important consideration of the more general analysis of ‘country risk’, and often serves as a substitute. Even as most people can understand what country risk represents at an ‘instinctive’ level, it is more difficult to define its various nuances. It is certainly related to the risk of insolvency of public and private entities, linked to a specific geographic area of ​​origin and independent of their will. It is also the risk related to the origin of a particular investment or financial instrument, which are dependent on political, economic and social variables. Therefore, corporations interested in investing beyond their borders inevitably consider the essential elements of country risks in order to assess the viability of doing business in a given region. While some of the cited elements can be analyzed with quantifiable tools, especially in emerging markets, such data simply frame what is a far more complex and colorful picture comprising many dynamics. Former US Secretary of Defense Donald Rumsfeld described it best as “the known unknowns”, a definition that actually makes more sense than it should.

Categories of Political Risk

Country risk can be broken down into six general categories that have an impact on expected return of an investment or outcome of a project, as described in Duncan H. Meldrum’s paper “Country Risk and Foreign Direct Investment”, which is considered a standard in the methodology for Country Risk Assessment.

• Political Risk. This refers to a whole range of non-economic events related to political factors and it is the least quantifiable and most unpredictable. It can refers to events of great impact such as conflicts, as well as shifts in the direction of economic policy as in the case of expropriation and nationalization related to institutional changes and unilateral acts of governments. These risks are difficult to predict and are especially relevant in the mining and resources sector. Political Risk are subject to a number of influences stemming from the both the grass roots and the leadership. There are a number of examples from the past two years that have reminded investors of problems related to political risk in emerging economies, not the least of which has been the series of massive anti-establishment protests, described as the ‘Arab Spring’, which has forced a major re-assessment of risks in the Middle East and North Africa. It is not just the fear of political violence that concerns investors; indeed, environmental protests such as those orchestrated by the Save Malaysia Stop Lynas (SMSL) in 2010-2012 were exploited by political opposition, politicizing the granting of an operating license for the Lynas LAMP rare earth processing plantissue into an election issue.
• The term “sovereign risk” refers to the ability or the willingness of a sovereign debtor to meet payment obligations. It therefore concerns the actual availability of resources and the reputation and the presence of and/or previous debt restructuring.
• Credit risk refers in more detail to the economic decisions of the various countries that affect growth rates, the degree of openness of the economy and exchange rates. We can include the risks related to authorities’ decisions to adopt restrictions on capital movements, on the repatriation of dividends and profits in this category as well. Exchange rate risk is also included – that is the unexpected fluctuation of exchange rate or the sudden abandonment of a fixed rate for a variable one. These are very important in the mining sector as noted by Vale SA in its recent experience with the Rio Horizonte potash project in Argentina. In extreme cases, the risk can be related to a state running out of foreign exchange reserves, forcing it to unilaterally adopt restrictions on payments to foreign countries and investors.
• Position or regional risk. This is the risk stemming from the contagion of a given ideological or political trend due to its proximity to neighboring countries or similar economies (such as the PIGS or BRICS) in their typicality or vulnerability. The events of the ‘Arab Spring’ are a classic case as are the shared risks in the former Soviet Republics, known as the ‘Stans’ or even of South Korea, Japan and China due to the actions of North Korea.

Political risk factors are inversely proportionate to investors’ knowledge about a country, which depends heavily on transparency by the nation under consideration. Companies and institutional investors intending to invest for the long run should do their best to assess the subjective and non-quantitative elements that can be thought of as political risk. Corporations in some sectors, such as oil and gas or mining, pay considerable attention to these factors, given that they must enter into negotiations with government entities for rights to the resources that bring them to a developing country. They know that political risk in many developing countries can entail nationalism that puts them at a disadvantage.

Understanding political risk gives advantages in analyzing the behavior of particular stocks, as political climate affects factors as diverse as sanctions, national budget deficits or surpluses and aid flows.  Ultimately, developing formulas and tools to study political risk as precisely as possible helps investors find the best strategies for approaching profitable investments in emerging markets.

Original article: What is Geopolitical Risk and How Does it Influence the Markets?

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