The past several years have led to a revamp in the way political risk is perceived by the financial community. It was not a single event that led to this rediscovery but rather a combination of events in multiple locations.
The global economic crisis undoubtedly caused shock waves across the globe, both politically and economically. This was followed by even more destabilising aftershocks. The blame game that ensued between governments and the banks, largely fuelled by public discontent, did little to allay fears. Some were blamed for causing the crisis, some for creating the conditions that led to it and others for not foreseeing it. Across the board, individual economies were subjected en masse to political risks that were either not foretold or ignored. Investors can no longer ignore political risk.
Prior to 2008, political risk rarely featured as a consideration in investment decisions in developed countries and only to a limited extent in developing nations. The extent to which the near absence of political risk contributed to exacerbating the crisis is difficult to assess, as the relationships between politics and economics are increasingly complex. However, what is certain is that the crisis and its accompanying events have highlighted the importance of incorporating political risk in investment decisions and more widely into economic outlooks.
Political risk is a very imprecise science. It requires analysts to have a deep understanding of what constitutes a risk, the likelihood of a risk occurring and the impact on an investment if a certain event were to happen. The ways such assessments are made are country specific. Here is an example. The possibility of a change of government in a developed country like France, for instance, is generally more likely to happen than in a non-democratic one, like Egypt. However, the impact of change in a non-democratic country is accompanied by increased political risk (such as civil unrest) that can potentially have far greater consequences than in a democracy.
**Country to country**
Political risk therefore is not something that can be extrapolated from one country to another. It requires analysts to have first and foremost a deep and current understanding of the political scene in the country being examined. This has led to a flourishing new industry of mainly region-specific consulting boutiques that understand and have the knowledge and local networks needed to undertake political risk assessments.
The post-2008 world has amplified the importance of political risk in the developed world, including Europe and North America. There are many examples of this: the effect of austerity and increased unemployment in countries like Greece, Italy, Portugal and Spain on the sovereign credit rating of those nations and fixed income investments.
Political considerations can also impact equity investments through interfering with the regulatory environment and fiscal regimes. Abrupt political changes that affect equity, fixed income and other types of investments are significantly more likely post-2008 than they were before. Investors need to carefully consider how an investment in what may seem to be a ‘safe’ environment can be impacted by political considerations. It may even be argued that investing in many, if not most, developed countries without a thorough assessment of the political risk is a high-risk strategy.
Besides the global economic crisis, the Arab Spring has also demonstrated why accurate political forecasting is not only desirable but essential. Questions that arose after the fall of the Mubarak and Ben Ali regimes in Egypt and Tunisia respectively have shown how interconnected politics and economies are. Both countries suffered a drop in tourism and other sources of foreign income. Both were eager to get foreign financial aid.
The aid that was coming would either come from sponsors of the new regimes or from international multilateral organisations like the IMF. In both cases, the loans or grants come with strings attached, often with substantial political implications. Some of those conditions included lifting food and other subsidies. This inevitably leads to a drop in the standard of living of large parts of the population and, in return, an increased risk of further civil unrest. While such conditions can present investment opportunities that may seem attractive, they also carry with them the risk of a cataclysmic political event that may have substantial impact on investments.
Whether investing in a politically stable or unstable environment, there is little doubt political considerations should become an integral part of the decision. It is an exercise that comes at relatively minor cost but has become essential. Ignoring political risk is a reckless strategy that carries economic consequences too big to contemplate.
