Political risk has come home, and we must combat it

The past decade has upended my profession almost entirely. I work in political risk, and my job is to advise companies how to manage political and economic instability. A coup in Turkey, sanctions against Russia, unrest in Venezuela, debt default in Argentina – such risk events are the bread and butter of political risk analysts such as myself, and of political risk underwriters who offer insurance policies against such perils. Until recently, these risks occurred almost exclusively in emerging markets such as Turkey and Russia. No one ever asked us to analyze the politics of the Netherlands. No one ever tried to buy political risk insurance against civil war in Canada. To have done so would have been preposterous. Indeed, the absence of political risks from the “advanced economies” of North America, Western Europe and Japan was almost definitional. The certainty that politics would not impact business operations was what made these countries safe havens for investment; it was part of the formula that enabled these countries to become, and remain, rich. The Eurozone crisis changed all that. Greece’s sovereign default in 2012 was the first default by a rich, industrialized country since World War II. (And even during World War II, defaults were rare.) It was an event that most people had considered inconceivable. For Greece, the economic costs of political uncertainty turned out to be enormous. Perhaps hoping to stave off cognitive dissonance, in 2013 Morgan Stanley Capital International duly reclassified Greece as an “emerging market.” Such risks are not limited to Europe. In 2011, the US lost its AAA debt rating from Standard & Poor’s, in...

The global outlook: beware falling objects

The world economy has in the past few years undergone a dramatic shift. Chinese industrial growth – for decades 10 percent or higher – has declined nearly to nil. Global commodity prices have shifted from high to low. At the same time, the U.S. dollar has surged from low to high against most other currencies. Partly this latter surge has occurred in response to the expectation of rising U.S. interest rates; and partly in response to turmoil elsewhere (most recently, the Brexit vote). When the world shifts in a way that is unfavorable, the first reaction of those adversely affected is to hang on for dear life. That tends to work for a while. Budgets can be cut; credit lines called upon. But eventually, those hanging on by their fingertips tend to fall. Some jump, recognizing that the shift is irrevocable and hoping they might land somewhere soft. Others hang on until they lose their grip. And thus, a few years into this dramatic shift, the world outlook is: beware falling objects. What might fall as a result of this economic shift? To answer that question, go back in time. We don’t have to go too far back: more or less this same shift occurred in the early 1980s (see chart). Commodity prices were high in the 1970s; in the 1980s they were low. U.S. real interest rates were low in the 70s; in the 1980s they were high. The US dollar (not shown) was weak in the 70s, and strong in 80s. The first objects to fall were the emerging markets (see chart; I first wrote about this...

Two decades of geopolitical analysis

I’ve been employed to analyze geopolitics and the world economy for about twenty years now, which means, alarmingly, I’ve got a track record. (Most of my publicly-available articles are now posted on this blog.) What did I get wrong, and what did I get right? The worst calls Turkey My worst call has been Turkey. In a 2004 editorial, I contended that Turkey was on the path traveled by so many Eastern European states: convergence with Western Europe. I even invested in Turkey, I was so sure of this call. To be fair to myself, the problem arguably wasn’t with Turkey: to my surprise, the EU got cold feet. Just recently, I’ve doubled down on Turkey with a new article predicting a turnaround. This is an example of what Daniel Kahneman would call irrational decision-making based on “loss aversion.” C’mon Turkey! This is your year! China Starting with my 2003 book The Kimchi Matters, co-authored with Marvin Zonis and Dan Lefkovitz, I’ve continually been predicting trouble in China. But, China just keeps on booming. I did get some things right: in a 2004 editorial, I predicted that China would get into trouble by stimulating its economy too much if it faced a downturn. That is indeed what happened during the 2007-8 global slowdown, and China now faces a severe debt problem as a result. So I’ve recently doubled down on this prediction as well. But there’s no denying that, blithely disregarding my sniping from the sidelines, China is still booming today. Good for you, China. The best calls Venezuela In 2004, I wrote an article forecasting that Hugo Chavez...

A Turkish Turnaround?

Most reasonable people would agree that the administration of Turkish President Recep Tayyip Erdoğan has been heading, alarmingly, towards authoritarianism. Erdoğan has been accused of imprisoning journalists, censoring the media, attempting to exert political influence over the courts, and using the security services for his own purposes. He has pushed through revisions to the country’s constitution, arguably in his favor. He served as Turkey’s prime minister for more than a decade before becoming president. But there is one fact that is difficult to reconcile with this chain of events. Included as part of Turkey’s recent agreement with the EU on Syrian refugees was a little-noticed, and even less-discussed, provision: resumption of Turkey’s EU accession negotiations. On the face of it, it is a paradox. If Turkey is becoming increasingly authoritarian, why on earth is Erdoğan attempting to re-open accession negotiations? After all, part and parcel of EU accession negotiations is an intrusive and meticulously verified set of requirements for democratic reforms. Is Erdoğan schizophrenic? Was the measure adopted by the Turkish government despite Erdoğan’s opposition? Or, just possibly, is Erdoğan misunderstood? I would argue the latter – and that there is a distinct possibility of a Turkish turnaround. It is undeniable that Erdoğan has shown authoritarian tendencies. But he has also been misunderstood, for two reasons. First, his rhetoric is worse than the reality; and second, he has been pushed by circumstances into his authoritarian role. On the topic of Erdoğan’s rhetoric, he suffers the problem of any politician who relies on pious supporters: he’s scary when playing to his base. Of course, it is not only Erdoğan who...

Is China at risk of instability?

In a chapter contributed to my recent edited volume on country and political risk, Michel-Henry Bouchet of the Skema Business School makes the case for a new indicator of political risk: capital flight. He writes: “when attempting to understand the complexities of country and political risk, it is perhaps the most useful to turn to those who are embedded in the country’s matrix of social, political and economic forces, and hence understand these forces best – that is, a country’s residents.” To be sure, there are also more direct indicators of political behavior that one might wish to use to track political risk. Protests, for instance. Or even – as has lately become popular in the era of big data – natural language analysis of postings to blogs and social media. But, as Bouchet points out, capital flight has much to recommend it as an indicator, because capital flight involves putting one’s money on the line: “there are costs and risks associated with transferring one’s money abroad. When citizens do so consistently over time and en masse, it is meaningful.” (To this, I would add, somewhat cynically: in contrast to protests or social media posts, capital flight has the advantage of being, in the main, an indicator of the behavior of a nation’s wealthy elite, who are perhaps more likely to be in the know in regard to the true state of their country’s politics and economy.) Of course, where money is involved, one must also consider financial motivations. Bouchet and a co-author have constructed a model explaining capital flight in 43 countries. An overvalued currency and negative real interest...

The Greek crisis explained, in pictures

Between 2007 and 2012 several Eurozone countries — Portugal, Ireland, Greece, Spain — needed bailouts. In each case, the recipient countries threatened that they would leave the Eurozone if the bailout terms were too harsh. Germany and the other AAA-rated European countries countered with threats to withhold the bailouts if the recipients did not agree to austerity and economic reforms as part of the bailout terms. The threats were treated by financial markets as credible (the price of gold, for instance, soared, as each bailout deadline approached). Hence both sides gained leverage and the bailout packages, though harsh, conformed to the desires of the recipients. This was a classic game of chicken, illustrated here with tractors in honor of the American movie Footloose. In 2013, Cyprus attempted the same strategy. Eurozone financial markets did not react. Probably, Cyprus was seen as small enough that if it exited the Euro there would be little impact on other Eurozone economies. As a result, Cyprus had no leverage. The brinkmanship strategy was a failure. The terms of the bailout Cyprus received were exceptionally harsh – much harsher than those currently offered to the Greeks. Money was taken from Cypriot bank accounts to pay for the bailout, for instance. Cyprus accepted the bailout nonetheless. This was the last time a Eurozone member employed a brinkmanship strategy… …until 2015. Greece, under a Syriza-led government, made another attempt. Rather than threatening to leave the Euro, though, they threatened to default on debts from prior bailouts. The financial markets once again did not react, even as negotiations went to the brink and Greece defaulted on IMF debt. Greek negotiators tried everything, including good-cop-bad-cop and...

Is a wave of sovereign defaults on the way?

The sovereign debtor that would win hands down a nomination as “most likely to fail” is surely Greece, which has just threatened to default on its next payment to the IMF. But Greece could be a distraction – history suggests sovereign default risk is rising elsewhere, and that a wave of such defaults could be on the way. Contemplate for a moment the following graph produced by Oxford Analytica, as part of the publicity materials for their new online tool that prices political risk. The graph tracks three indicators over time: oil prices, expropriations of foreign direct investment, and sovereign defaults. The relationship between oil prices and these two types of country risk is strikingly apparent. When oil prices rise, governments move to expropriate. High oil prices mean that natural resource investments are suddenly spectacularly profitable, and seizing these investments therefore becomes increasingly attractive. In the 2000’s, regimes from Kazakhstan to Chad to Russia to Bolivia indulged this temptation, and not only in oil – some mining investments, also with soaring profitability, were similarly nationalized. High oil prices also give cover to governments wishing to pursue extremely unorthodox economic policies. Venezuela, which seized not only oil but much foreign investment in the country, stands out as a recent example. On the graph, the link between oil prices and expropriation is obvious in the mid-1970s: expropriations peaked just after oil prices surged. The link is apparent again in the 2000’s, as a second surge in oil prices triggered another wave of expropriations, albeit with a less dramatic peak. The relationship between oil prices and sovereign defaults is precisely the opposite....

Is Cuba coming in from the cold?

One of the most extraordinary geopolitical trends of recent years has been what might be called, with apologies to John le Carré, “coming in from the cold.” Many countries that had excluded themselves from the globalization system and maintained an adversarial relationship with the West have recently performed an about-face, opening themselves to foreign investment and normalization of relations. Myanmar (formerly Burma) was the first of the recent converts, making rapid progress since 2011. Iran has followed with on-again off-again negotiations on a nuclear deal. Is Cuba the latest example? To answer this question, one must first understand the trend itself. Generally speaking, there are two factors that appear to be driving these countries’ decisions to put aside decades of isolation. The first of these is the emerging markets boom. A heat map of global economic growth in 1992 (see below) was hardly a compelling advertisement for the globalization system. “Open your markets to the West,” it said, “and the West will get really rich while you struggle.” As the map shows, most emerging economies outside of Asia were floundering, while the U.S. powered head. This was the tail end of the so-called “great divergence,” in which the poorest countries of the world became relatively poorer, in complete contradiction of economic theory. By 2005, the global economic growth heat map looked very different. Nearly every economy in the world was booming. Led by China and India, the ‘BRICs’ were catching up with the West, and looked set to surpass the United States in economic size. The only emerging economies whose performance was wobbly were the refuseniks: Iran, Cuba, North...

Can Russia change direction?

Venezuelan President Hugo Chavez and I go way back. In the late 1990s, as a young political risk analyst, I traveled down to Houston to talk to one of the oil majors about a large investment they were planning to make in Venezuela. “Venezuela is risky,” I confidently informed them. “Hugo Chavez has a radical agenda.” Meanwhile, my colleague cooked up various disaster scenarios involving political violence or the loss of assets. The oil company’s project team, several of them Venezuelans, sat through our presentation in stony silence. Walking us to the elevator, though, they had something to get off their chests. “You don’t know anything about Venezuela,” they said. “Hugo Chavez is a pragmatist, not a radical.” “And,” they continued, “you don’t even know how to pronounce Chavez. It’s ‘TCHA-VEZ’!” In the long term, I was right (except about pronunciation). I wouldn’t, of course, be telling this story otherwise. The assets of most foreign oil companies operating in Venezuela were indeed expropriated, with limited compensation, on the orders of Chavez. But I admit it was the oil company’s project team that had the better grasp of the situation in Venezuela. Chavez was indeed a pragmatist. He did not jump right in and start nationalizing things, as I had predicted. At first, his economic policies were relatively moderate. But over time, he began to change direction. Not necessarily because he had planned to. But Chavez had made a lot of promises he could not keep. “So much riches,” he had said, “the largest petroleum reserves in the world, the fifth-largest reserves of gas…and 80 percent of our people live...

Will China crash?

A tongue-in-cheek economic indicator with an uncanny track record of accuracy is that any country building the world’s tallest building will shortly thereafter enter recession. Malaysia completed the Petronas Towers in 1998, just in time for the Asian financial crisis. In 2000, the US took the top spot by adding an antenna to the Willis Tower. The global financial crisis was not far away; but more importantly, the building was originally completed (as the Sears Tower) in 1973, and the US entered recession a year later, in 1974. The commencement of construction on the building that is currently the world’s tallest, the Burj Khalifa in the UAE, was followed in short order by the bursting of that country’s real estate bubble and a deep recession. There is a good reason the indicator works so well: the taller a building is, the more of its lower floors are lost to elevator space (because every elevator shaft needs to reach the ground). There are ways around this problem, most recently elevators that decide for themselves on which floors they will stop (in case you have not visited New York recently, you key in your desired floor on a keypad, and a display shows you which elevator car to take). Despite such advances, constructing tall buildings tends to be uneconomic, and so it only happens when a country is in the throes of an asset price bubble – usually, a bubble that is about to burst. Of course, there are countries that have defied the fates. Specifically, there are two: Taiwan, which, despite the construction of Taipei 101 in 2003, has so...

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Sam Wilkin is a business economist and public speaker on the global political and economic outlook.

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