Whatever promises emerging and frontier markets may offer, there are still investors who simply find these foreign territories discomfortingly unfamiliar. A key concern is that the governance of such territories can be unstable and unpredictable. To worry about the risk posed to an investment environment by changes to a country’s political rule, legal system or regulatory regime is to acknowledge what is known as country risk.
The term country risk is a broad and entails security risk, such as the chance of terrorist attack, government risk, such as the potential for a coup d’état or civil war, policy risk, such as the likelihood of nationalisation of key industries, and regulatory risk, such as the probability of prohibitive levels of taxation or restrictions on movement of goods and capital across national borders.
The terminology employed when analysing the impact of politics on markets can vary. ‘Country risk’ for example, is often used interchangeably with ‘political risk’. Yet some experts would argue that political risk refers to a subset of the country risk universe. But linguistics is not the biggest debate in the field of political risk. Rather, asset allocators and risk analysts disagree on whether or not you can quantify political risk and how much, if at all, politics influence markets.
Should You Care About Political Risk?
It is possible that a fund manager relies solely on quantitative models and their models do not quantify political risk. Such a model would normally take the view that politics follow fundamentals and not the other way round. The logic behind this argument being that in times of economic prosperity neither the government nor the population would have an incentive to alter the status quo and thus policy changes and social tensions are rare.
“But surely this is not the whole truth,” says Peter Eerdmans, Head of Investec Asset Management’s Emerging Markets Debt Team, referencing numerous examples in emerging economies where the influence of those in power can be substantial in any part of the economic cycle. Financial markets will react to political change, or rather markets will worry whenever political change is on the horizon. In the lead up to the 2007 elections in Brazil, for instance, markets were concerned that if elected, former unionist Luiz Inacio Lula de Silva would steer away from market-friendly policies. We now know that this was not the case and confidence in Lula’s pro-markets stance has been reflected in market sentiment throughout his two presidential terms. Eerdmans points out that in this example fundamentals were allowed to lead politics.
Given the potential impact of political events on economic success, “diligent analysis in asset selection by demanding sufficient risk premium is crucial,” says Eerdmans. However, Eerdmans is quick to clarify that investors cannot always demand a premium that covers the risk of the worst political outcome, but investing in a wide range of markets with reasonable risk premium “should offer protection against most events.”
Can Political Risk Be Quantified?
The notion of diversifying political risk mandates an understanding of the political environment in a variety of markets. Seeking risk premium for political risk exposure is built on the premise that political risk can be quantified to some degree. Thus, the market offers a variety of mechanisms which assign a value, score or price tag to country risk through products such as risk scales, risk maps, indices or political risk insurance, although the latter is usually unavailable to retail investors.
Control Risks is a global risk consultancy that is in the business of converting the somewhat amorphous concept of political risk into a more tangible product. Each year, they create a Risk Map and Risk Index that divides the globe into countries with insignificant, low, medium, high or extreme political risk. “Most of the risk allocation is where you would expect it to be,” says Michael Denison, Research Director of Control Risks’ Global Risk Analysis Team. He points out that risk is high in places such as Venezuela, where nationalisation has become the norm, medium-to-high in most emerging markets, and low-to-insignificant in the developed markets.
But simply because many emerging and frontier markets fall into broadly the same risk category does not mean that they face the same political pressures. Jonathan Wood, Global Issues Analysts with Control Risks, is adamant in pointing out that the BRIC countries have been incorrectly lumped together for the past decade or so. However, Brazil, Russia, India and China have undertaken four very different experiments with rapid economic growth, he explains. They are similar in that they all want to have a greater say in global political and economic affairs, but beyond that their agenda is not common, Wood says. While Brazil is a fairly consolidated democracy, Denison adds, Russia is experiencing political stagnation and rising discontent among even the country’s relatively docile electorate. China, on the other hand, still faces the problem of a single political party that needs to continually self-renovate, whereas one of the main challenges for India is the fragmentation of political power.
The Inherent Limitations of Risk Calculations
In addition to providing a tool for comparing political risk across countries, risk scales or indices can paint a picture of historic changes to political pressures in a single country. This can be a helpful backwards-looking indicator, but it can’t be relied on to time future events. Egypt, for example, was, according to Control Risks, a country with medium political risk for every one of the past three years. This hardly predicted that the country’s population would rise in mass civil unrest and boot its long-standing president out in February of this year.
Measuring the level of political risk and the timing of when such risk could materialise are two separate issues, explains Wood. Many factors, including structural demographic challenges in the MENA region, were largely forecast, he points out. This made the region heavy with imminent but unpredictable risks. In addition to MENA, Denison and Wood list sub-Saharan Africa as a region where long standing authoritarian leaders dominate the political landscape and one which, just like MENA, will be “stable until it is not.” In other areas, Denison notes that the issue of succession could also shake Thailand, whose symbolic and society-binding leader has been in power since 1948. However, Denison highlights that, as all these examples show, the “tipping point” in political agencies remains an “inherent unpredictability” in models forecasting political risk.
Because of these constraints of political risk models, it is “illusionary” to think that assigning a value to political risk can be accurate, says Plamen Monovski, Chief Investment Officer at Renaissance Asset Managers. As a manager of a dedicated emerging markets fund, Monovski says he accepts political risk at any given time. There is a general awareness that emerging markets are a risky play and therefore risk is already priced in, Monovski explains. Furthermore, he says his strategy is to compensate investors for the risk they agree to take by ‘promising’ a higher rate of return.
A Word to Risk Seekers
The pursuit of higher returns through taking more risk is the simple answer to why investors would buy into medium-to-high country risk markets to begin with. Beyond this basic trade off, explains Stoyan Angelov, Investment Analyst with Morningstar Associates, investors might accept exposure to political risk because it is one of the forms of risk that are more easily diversifiable. Political risk in one country or region tends to have a low correlation to similar risk elsewhere, Angelov explains. Hence, a portfolio of countries that are individually risky tends to provide good diversification against political risk. This is, of course, a different case from market risk, whereby, as is currently the case, global markets can be highly correlated.
That said, diversification should not become what Monovski calls “an excuse for ignorance.” It is important to keep track of the fundamental drivers of value in the markets and industries where your holdings are allocated or operate. As we have discussed before, the geographic location of your holdings’ operations and main markets is a question that extends beyond country of domicile.
See Our Political Risk Case Study: Is Russia Over-penalised for Risk?
