By Ed Zwirn
Read in CFO Magazine November 2016
Political scenarios aplenty threaten global growth and the fortunes of multinationals.
The U.S. presidential election and all of its attendant ugliness and divisiveness may soon be an unhappy memory, but political developments around the world continue to cloud the risk profiles of global companies.
Whether they’re vulnerable to Brexit fallout, terrorism, or the latest rumblings from China or Latin America, multinationals are increasingly aware of the need to pay close attention not only to business plans and bottom lines, but also to cross-border threats in a politically volatile world.
Where’s the evidence multinationals feel threatened by global perils? Above and beyond protective hedging and diversification strategies, U.S.-based companies currently pay about $1.5 billion in annual premiums to specifically insure themselves against political risk, according to Stephen Kay, Marsh’s practice leader for structured credit and political risk insurance. That affords them some $150 billion to $200 billion of protection, he says.
“In the last two or three years we’ve seen a pickup in demand for this type of coverage from companies, banks, and commodity traders,” says Kay. “Everybody’s watching to see where the next train wreck will happen.”
Perils in the West
Of course, fear mongering is hardly constructive. But 2016 has presented companies with a number of challenges in marketplaces outside the United States.
According to Aon Risk Solutions’ 2016 Political Risk map, this year has been defined by “weak global growth, shifting trade patterns, and slow interest-rate normalization.” Aon’s analysis highlights a multitude of regional or country-specific disruptions, like greater use of capital controls in Africa, high levels of political violence and terrorism across the globe, and an increase in the flow of refugees to developed nations.
As pernicious as any regional or country-specific political threat is, there is also a broader trend evidenced by the UK’s vote to leave the European Union and the outcomes of other recent political contests, according to Cameron Brandt, an analyst at EPFR Global, which tracks institutional investor fund flows.
“We may be seeing the reversal of globalization,” he predicts. “Sometimes countries go into phases where they adopt more-restrictive policies on trade and immigration and set themselves up for slower growth.”
Much of the political risk that companies face is in emerging markets, but developed countries have been sources of risk as well and can’t be overlooked. During and shortly after the Great Recession, many companies focused first on surviving and then on recovering. Only after several years of steady recovery did demand for political risk insurance coverage begin to pick up in the United States.
A key trigger for that demand came courtesy of the Federal Reserve System, according to analysts. In mid-2013 the Fed started throttling back its quantitative easing program, which had helped to prompt the economic recovery. At the time, the program was pumping $85 billion monthly into the U.S. and world economies.
With the knowledge that quantitative easing was being gradually eliminated, investors in riskier venues became more skittish, and volatile emerging market investments began receiving more scrutiny in early 2014, analysts say.
This past year the major disruptive force, at least in the West, has been Brexit. Beyond the initial shock to securities markets, worries over Brexit have devastated the pound sterling, sending it to multiyear lows against other major currencies. In addition, “the fact that an EU member nation is invoking the right to secede raises fundamental questions about the viability of the EU federation going forward,” according to Christopher Whalen, senior managing director for Kroll Bond Rating Agency.
Says Brandt: “In the case of Europe, even though growth hasn’t been all that horrible and countries have benefited from the tailwind of cheap energy prices and European Central Bank policies, there’s political risk almost everywhere you look.”
Trouble Spots
But the threats in emerging markets, at least in recent years, are much more destabilizing, persistent, and hostile to the conduct of business. In some developing nations, political strife, economic volatility, corruption, and regulatory upheaval are a fact of life and continue to wreak havoc on entire economies and industries. Here are some examples of noteworthy political risks across the globe:
Turkey. Until fairly recently, the Republic of Turkey was on track to join the European Union and its economy was doing well, notes Marsh’s Kay. “Now, a near coup has spooked investors, the balance of payments is in the red, and growth numbers are in decline,” he says.
The failed military coup against President Tayyip Erdogan resulted in “mass arrests of military officers, academics, and politically active business leaders; and a further crackdown on all media outlets,” said A.M. Best in an August risk assessment. AMB says the relationship between Erdogan’s KP party and rival group the PKK “is unlikely to improve in the near term. Erdogan is trying to get the PKK characterized as a terror group and removed from parliament.”
On the economic front, “high external debt levels and low foreign exchange reserves make Turkey vulnerable to global economic shocks and exchange rate volatility,” says AMB.
Brazil. In Brazil, the senate ousted president Dilma Rousseff from office following an August impeachment vote that charged her with manipulating the country’s federal budget in an effort to hide mounting economic problems. “Whenever we, as brokers, bring a new Brazil [insurance] deal to the market, it gets scrutinized more now than it did before,” says Kay.
While Brazil has moderate levels of economic and financial system risk, according to AMB, it has high levels of political risk. “Corruption, continued political uncertainty, lower commodity prices, and on-going social unrest will all drag on economic growth near-term,” AMB’s report says. Gross domestic product is expected to shrink -3.8% in 2016 and again slightly in 2017.
Brazil’s ongoing corruption scandals, particularly the one involving state-run oil firm Petrobras, “have caused great political uncertainty and policy paralysis” at a time when “fiscal consolidation efforts are needed to stabilize government accounts,” says AMB.
John Chambers, global sector leader for sovereigns and supranationals at S&P Global Ratings, is taking a wait-and-see attitude toward Brazil. “The judiciary in Brazil has shown its independence, and in the long term that is a sign of institutional strength,” he says. “In terms of geopolitical risks there, I’m not necessarily sure they are higher now than in the past.”
China. China’s newfound military assertiveness in the South China Sea comes even as the country reports economic growth numbers that “we would die for,” observes Kay. “The question is whether we can believe the numbers and whether China is at risk of a financial bubble, a credit bubble, or a real estate bubble like [the U.S.] had in 2007.”
Politically, the problem in China is not instability. Actually, it’s the opposite. “How committed are the Chinese to reforms?” says EPFR Global’s Brandt. “When push comes to shove, the fear is that China is going to choose political stability.”
Says Aon in its 2016 political risk map, “Despite the fact that a number of corrupt officials have been removed from office, there remain relatively high legal and regulatory risks and obstacles to doing business, thanks to the interventionist tendencies of the ruling Communist Party.”
In addition, according to Aon, “there remains a large degree of uncertainty around the ability of the government to manage a slowdown in growth and the economic transition to more consumption-driven growth.”
Russia. Both Brazil and Russia are suffering from sustained low oil prices, and Russia added to global instability and oil price volatility in 2014 with the invasion of Crimea, which was viewed as a violation of international law.
“Military involvement in numerous conflicts including the civil war in Syria … and conflicts resulting in sanctions with Egypt and Turkey have contributed to potential instability,” says AMB.
Economically, Russia faces “numerous potential headwinds that include declining investment, volatility in currency markets, shrinking fiscal reserves, and interest rate movements,” says AMB, which forecasts a GDP contraction of -1.8% in 2016. Meanwhile, inflation continues to run above the Russian central bank’s target of 4%, “largely due to capital flight and a weaker ruble,” says AMB.
Finally, Russia’s business climate is, as it has been for years, unfriendly. “Continued intervention in the private sector has led to opaque regulations and an inefficient and corrupt legal system which suffers from political interference,” says AMB.
Payments Problems
Events and government actions that bring political unrest and uncertainty aren’t just headlines. They can cause any number of real problems for U.S.-based companies.
Global political risk constitutes “a continuous challenge for a business like ours,” says Richard Verasamy, CFO of Associated Foreign Exchange (AFEX). The California-based nonbank payments processor, which processes some $15 billion of international payments annually, does business in the United States, Australia, Europe, the Middle East, and Asia.
A survey of more than 500 companies (about 200 from North America), for which AFEX released results in October, showed 46% of respondents projected that their international payments will be up this year over last.
But political risks could dim the bright outlook for AFEX. How Brexit plays out, as well as the outcome of the U.S. election, “are prominent concerns [and could trigger] increased volatility and barriers to trade and payments,” Verasamy says. “International payments may be reduced in such circumstances, as companies locally source goods to avoid currency volatility impacts.”
The UK’s departure from the EU, a process scheduled to commence in 2017, “has many payment companies thinking about the way forward,” Verasamy says. “Also, many of our customers were surprised by the outcome of the vote and have been talking to us [about how] they can protect their business from a risk management perspective.”
While “global business is here to stay and international payments are an integral part of it,” the CFO says, many AFEX clients may face cost and organizational challenges. “Brexit means a lot of companies will have to restructure where they are domiciled, as being based in the UK will no longer give access to a single market.”
Terrorism also is posing a big risk to the global payments business—not simply because of the fear it generates, which hampers business, but also because of the controls governments are placing on payments transactions as they try to cut off funding to terrorist groups.
“There is more stringent oversight of certain types of payments given this current climate,” Verasamy says. “Regulations are becoming stricter to stop any terrorist funding. Given these changes, our compliance program is continuously reviewed and strengthened, which pushes up the costs of being in the payments business.”
Few Safe Havens
The impact of world politics on commodities markets is of primary concern for Pat Obara, who serves simultaneously as CFO of Canada-based Brazil Resources and of Texas-based Uranium Energy, both mining companies engaged in acquisitions in Latin America.
Brazil Resources, as its name suggests, has assets in Brazil but recently completed a transaction in Colombia.
Obara points to recent unexpected events like Colombia’s rejection of a peace deal with the Revolutionary Armed Forces of Colombia, which was a bid to end a decades-long civil war. While the vote “may be a bit of a setback for Colombian miners,” Obara says, he’s keeping hope that the situation will remain manageable.
“We recently sent a team of experts and prospectors there, and they didn’t need guns or anything like that,” he says. Referring to Brazil’s turbulent presidential politics he adds, “You get that all over the world, and we have our own issues in the United States. There’s risk here too.”
For LightPath Technologies, a manufacturer and distributor of optical components and assemblies, China is where political risk is particularly acute, says CFO Dorothy Cipolla.
Much of LightPath’s production facilities are in China, she explains, and the $17 million company was forced to take a $380,000 write-down on the value of its assets after currency moves by the Chinese government. “China’s central control over its economy is a political risk for us,” Cipolla says.
How China’s political situation sorts itself out may become clearer as soon as next year, which is expected to bring “a renewal in the leadership in the politburo and within that the standing committee of the politburo,” notes Chambers. But that’s no reason to expect a change in China’s interventionist policies. Or is it?
Unfortunately, assessing existing political volatility in China or any other country—including the United States—is worlds easier than predicting what may come next. “We don’t really have a forecast for the unforecastable,” Kay says.
Ed Zwirn is a freelance writer based in Bethel, New York.