Political risk returns as scourge of investors

Political risk returns as scourge of investors

Politics is playing a dominant role in financial markets today _ and generally speaking, investors do not like it.

The impact of the ouster of Bo Xilai, former Minister of Commerce of China, on the trade in luxury goods shows how politics in one part of the world can affect global markets. (File Photo AFP)

Political risk is an additional layer of uncertainty that has to be factored in when 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 will do is even worse.

Consider how politics on 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 1.4 million, the second highest number in the world, which means 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 reported 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 goods 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 17 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 very significant (at least not for 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 (or the overwhelming majority of employees in financial markets) have never had occasion to include assessments of political risk in their investment decision-making. The minority who recollect the early 1990s have generally forgotten the art of factoring in this 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 non-natives to understand a country's politics. In a globalised financial system, this is 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 19th 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 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.

We are now in a situation where markets are increasingly influenced by politics, but investors lack experience in pricing political risk, find it hard to price political risk in globalised markets and suffer from political misinformation 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.


Paul Donovan is a managing director and deputy head for global economics at UBS Investment Bank.

Paul Donovan

Deputy Head for Global Economics at UBS Investment

Do you like the content of this article?
COMMENT (3)