Geopolitical Risk... becoming a more common phenomenon!

Political Risk and World Economy

In the growing global economy, geopolitical risk is one of the key determinants of investment decisions and a major factor for market returns and volatility. A further fragmented world order leads to disruptions in the ecosystem of the markets and creation of gaps.

B. Lloyd, in his book, Political Risk Management, notes that political risks are primary reflection of the activity of governments. Franklin R Root further defines political risk in terms of, “…. Possible occurrence of a political event of any kind (such as war, revolution, coup d’état, expropriation, taxation, devaluation, exchange controls and import restrictions) at home or abroad that can cause a loss of profit potential and/or assets in an international business operation. Root categorizes the way political uncertainties affect a firm into three-

1)????Transfer i.e., uncertainty about flows of capital, payments, technology, people etc.

2)????Operational i.e., uncertainties about policies which directly constrains local operations.

3)????Ownership/control i.e., uncertainties about policies relating to ownership/ managerial control.

Geopolitical Risk and Power Process?????

Geopolitical risk is the risk associated with wars, terrorist acts, tension between states that affect the normal and peaceful course of international relations. It captures both the risk that these events materialize, or the new risks associated with an escalation of such existing events.

Laswell and Kaplan in their book, Power and Society (1950) notes that “The power process (i.e., politics) is not a distinct and separable part of the social process, but only political aspect of an interactive whole”. The society as per Laswell and Kaplan exists in its entirety and the power process becomes a key determinant of the changes happening in the society as a result.

In Power and Interdependence (2012), Robert O Keohane and Joseph S.Nye Jr., states that interdependence is the order of the day i.e., it refers to the idea that change in one part of the world is felt in all others. The key characteristic of this relationship is that the autonomy of each actor is constrained by the necessary estimation of the costs of any action, for e.g., states would rather trade than invade. It is the expectation of future trade what staves off war, but states can be pushed to war when facing potential for losing the benefits of future trade.

Measuring Geopolitical Risk

There are a variety of measures available that can aid in measuring the geopolitical risk. The two most widely used measures are discussed hereafter:

1.?????GPR Index by Caldara and Iacoviello

It is a newspaper-based index of Geopolitical Risk which uses aggregate macroeconomic data which can be daily, monthly, global or country specific to show that higher Geopolitical risk increases the probability of an economic disaster and predicts lower investment and employment. Elevated readings of the index reflect the realization or escalation of current adverse events as well as the expectations and threats about future adverse geopolitical events. To construct this, further Geopolitical Acts Index (GPA) and Geopolitical Threats Index (GPT) have been constructed.

2.?????Eurasia Group’s Global Political Risk Index

The index is a composite measure of the state of a country’s government, society, security and economy.?

Geopolitical Threats and Acts

The realisation of adverse geopolitical events has been a major cause for increased fear of adverse future events. The realization of adverse political event is a Geopolitical Act and the threat about future adverse event is a Geopolitical Threat. For example, in the event of ongoing Russia–Ukraine war, the Geopolitical act is the war and the recent developments of Sweden and Finland joining NATO is a step towards addressing the geopolitical threat of a possible war or invasion by Russia on the European countries.

Risks of 2022

The top geopolitical risks of 2022 are discussed hereafter:?

1.?????Russia- NATO Conflict

The war in Ukraine and Russia NATO conflict have impacted the world through a variety of channels including the financial flows, commodity markets, commerce, population displacement and market confidence. ?The prices of goods exported by Russia and Ukraine, such as energy, wheat, fertilizers and metals, have increased dramatically.

As per the EFI Policy Notes on “Implications of the War in Ukraine for the Global Economy” issued by the World Bank, 2022 the war has impacted the global economy in the following ways:

i.?Several economies in Europe and Central Asia have been hard hit because of strong linkages with Russia and Ukraine caused by disruptions to trade, financial and remittance flows, severance of supply chains and transport links, impacts on digital connectivity and heightened risk perception by investors.

ii.?Reduced real value of Remittances from Russia due to reduced economic activity and a weaker Ruble.

iii.?Impact on other parts of the world through commodity and financial markets as well as refugee flows. The spill overs from the war will cause a negative on net growth for Emerging markets and developing economies, Caribbean and Latin American countries as well. In contrast, the Middle East and North Africa region will see upgrades to near term growth as net benefits of higher oil prices to oil exporters outweigh the losses.

iv.?Impact on Global Commodity and Financial Markets

Russia is the largest exporter of wheat, accounting for 18% of global exports; Ukraine accounts for a further 7%. Russia is also the largest exporter of natural gas (25%), palladium (23%), nickel (22%), and fertilizers (14%). It also accounts for 18% of global exports of coal, 14 % of platinum, 11 percent of crude oil, and 10 percent of refined aluminum.

The prices of commodities supplied by Russia and Ukraine have risen sharply since the onset of the war. Oil prices have been exceptionally volatile, with futures curves displaying a wide range of future price outcomes in response to news. Spared from sanctions, Russian crude oil continues to find international buyers, albeit at a steep discount. Crude oil prices have been supported by lower-than-expected production among OPEC+. The inflationary pressures caused by surging commodity and food prices may accelerate monetary policy tightening, heightened risk of stagflation, increased food insecurity and increased poverty and inequality.

The equity market volatility has risen in the developed economies, namely Europe and US. More broadly, the financial instability could spread across countries through a rise in investor risk aversion, increased capital outflows from EMDEs, currency depreciations, falling equity market valuations and rising risk premia in bond markets.

2.?????Technology decoupling

The competition between the US and China is driving global fragmentation as both focus on boosting self-reliance , reducing vulnerabilities and decoupling their tech sectors. The US has tightened export controls on sensitive technologies and increased investments in domestic research and development. To fortify China’s economic resilience against potential high-tech supply chain disruptions, Xi Jinping introduced the Dual Circulation theory in May 2020, which broadly envisions a new balance away from global integration(first circulation) and toward increased domestic reliance(second circulation). The technology decoupling is driven by the trade conflict between US and China and Competition over technologies of the future such as AI, Quantum computing, 5G, Supercomputing and Semi-conductors.

The multinational technology corporations are at the received end of the increased risks due to the decoupling measures between the two superpowers. This will have wide ranging consequences on the restructuring of global value chains, R&D decoupling , falling investments levels and increasing risk of a lack of data governance system on global level.

3.?????Cyber attacks

Cybersecurity underpins the digital process undertaken by the world economies and necessitates the need for strengthening the network against malicious actors. This can no longer be considered a technical issue but is also a part of the geopolitical realm. Critical technologies act as a conduit to impact a country's national security, economic progress and societal values. Recent developments in the Russia Ukraine war also marks an increased threat of cyberattack from Russia. A series of cyber-attacks continued against Ukraine as form of cyber warfare throughout the early months of 2022, with malware being launched against government and financial websites, as well as non-government, charity and aid organisations, in this case hindering the distribution of medicines, food and relief supplies. Other cases involve phishing attacks against citizens and government services, and attacks against telecommunication service providers, disrupting Ukrainian networks were also found.

4.?????Middle east tensions

Geopolitical events are endogenous to the cycle of oil prices and financial liquidity. There are two primary factors that have contributed to massive arms build-up in Middle East oil-rentier states. First being the arms purchase from the US, western-European countries, China and other sources causing massive petrodollar flows to major middle east oil exporting countries during periods of high oil prices. Second being harmonization of regional security arrangements with US and NATO partners which provides further non-pecuniary incentives for Western powers to encourage the military channel of petrodollar recycling. During periods of increased geopolitical risks, the large arsenals accumulated during the years of plentiful petrodollar magnify the risk of widespread violence and destruction (El Gamal 2016).

In early 2022, the Iran backed Houthi militia in Yemen fired five ballistic missiles and several explosive laden drones in multiple attacks on airports and a oil refinery in the UAE. Correspondingly the oil prices jumped to a seven-year high, adding to the continued tightness in the oil market and thereby the oil futures reflecting a growing risk premium after the attack. Saudi Arabia, the largest oil producer has been under pressure to ramp up the oil production, after EU partially banning the oil from Russia and further plans to cut the Russian imports by the end of this year. Under the current global situation, it can be observed that the growth rate in current account surplus as per the data published by Saudi Central Bank translates to an almost 81% increase compared to the fourth quarter of 2021.

The inflation rates as well in the Arab countries is expected to rise in 2022 reflecting the impact of international supply chain challenges and the rise in price of agricultural and industrial commodities as well as energy products due to current global developments.

5.?????Emerging Markets Political Crisis

Emerging markets which were already struggling with inflation and a slow economic rebound from the pandemic are now facing increased pressure from high food and energy prices, higher U.S. interest rates and slowing Chinese growth. Social unrest, already noticeable in various fragile countries, is a risk well into 2022. The current political scenario of Sri Lanka is an example. The country was smothered with depleting foreign currency reserves, poor policy making, mismanagement of funds and crippling economy.

?6.?????China and its strategic policies

China, a global economic power, has been at the centre stage of recent geopolitical tensions with widespread economic implications. The rising tensions with US and the ongoing decoupling in terms of technology and the economic activities, China has been a critical player in the geopolitical realm. Post Covid 19 and after US trade restrictions, the Chinese economy being one of the largest hubs of production in the world is facing a risk of losing its economic share to other competing economies. There is a looming threat of China and Russia joining forces in the current global scenario.

Here we are discussing in detail the impact of rising US- China tensions by taking the case study of HSBC Holdings Plc:-

One of the Europe’s top firms to face the consequences of rising US- China tensions and geopoliticisation first hand is HSBC. It is the largest foreign bank in China with 39% of its revenue and more than 60% of its profits earned in Hongkong and Mainland China. There were two major contributing factors here – a) It was revealed in 2019 that the bank had provided information to the US department of Justice in Huawei ordeal and b) HSBC broke its political neutrality over the anti-government protests in Hongkong. This led them to face reputational damage both inside and outside China. The bank in its Q1 of 2021 Earning Release also made a note of the rising geopolitical risk in China. For the Q1 of 2022, HSBC’s stock has outperformed with London listed shares gaining 5.4% whereas its Hang Seng Index has fallen by 14.5%.

As per the latest reports, Ping AN Insurance (Group) Co. of China Ltd., the second biggest shareholder of HSBC is calling for a spinoff of its Asia business thereby making the new Asia based HSBC bank a Hong Kong or China regulated entity to reduce geopolitical risk from China.

7.????Terror attacks

As per the Global Peace Index, 2022 issued by the Institute for Economics and Peace, the average level of global peacefulness deteriorated by 0.3% where Afghanistan is the least peaceful country in the world for the 5th Consecutive year. The economic impact of violence on the global economy in 2021 was $16.5 trillion in purchasing power parity terms. It was also noted that the GPI indicators of political terror scale, intensity of internal conflicts faced largest deterioration. Countries such as Afghanistan and Somalia suffer from higher costs from conflict deaths, terrorism, losses from refugees and GDP losses.

8.????Climate policy

The change in climate trends and extreme weather events can cause famine, migration, pandemic , asset destruction and conflict over scarce resources. The political agendas will be largely based on how climate change is managed and how global leaders address the issues in relation to the same. The world will need more alternatives to fossil fuels, and we think the crisis will make the word’s transition to net-zero carbon emissions more regionally divergent. In Europe, this will likely boost decarbonization plans and make clean energy more competitive as the oil-importing region seeks greater energy security. Since ?the benefits for producers are higher, and the burden of higher energy costs on U.S. consumers will be lower than in the EU. The economic overhang of the COVID-19 crisis and weakened social cohesion—in advanced and developing economies alike—may further limit the financial and political capital available for stronger climate action. Also, as carbon-intense industries employ millions of workers, their rapid termination could trigger economic volatility and increase societal and geopolitical tensions as many developed economies may be ill-equipped to do the same.

GLOBAL ECONOMIC PROSPECTS, 2022 – REPORT BY WORLD BANK

The major points with relation to the global incidents addressed in the Global Economic Prospects issued by the World Bank are as follows:

i.?The forecast for EMDE growth in 2022 has been downgraded by 1.2 percentage points, largely on account of the adverse effects of the war.

ii.?Global consumer price inflation has climbed higher around the world and is above central bank targets in almost all countries which have them.

iii.?Additional adverse shocks would increase the possibility that the global economy will experience a period of stagflation reminiscent of the 1970s, with low growth and high inflation.

iv.?The energy prices are forecast to rise 52 percent in 2022, 47 percentage points higher than previously projected. Brent crude oil prices are forecast to average $100/bbl—an upward revision of $24/bbl.

v.?Since the beginning of the year, U.S. and euro area stocks have fallen about 13 percent and 12 percent, respectively. The invasion of Ukraine triggered an initial appreciation of the U.S. dollar against EMDE currencies.

Financial Stability Report 2022 - by RBI

India, like most of the nations, was not safe from the fallout of the recent global developments and geopolitical tensions. The insurgence of Covid 19 along with prolonged supply chain disruptions have affected the economy severely and stagflation is a rising risk scenario. Recurring spikes in volatility and tightened financial conditions is a common factor noticed across the emerging and developing economies.

1.?????Crude oil prices :The Reserve Bank’s estimates show that a 10 per cent rise in crude oil price above USD 100 per barrel could increase domestic inflation by 30 bps and reduce GDP growth by 20 bps respectively15. Since February 2022 policy, the Reserve Bank had revised GDP growth downward by 60 bps and inflation upward by 220 bps primarily because of the rise in Indian basket of crude oil price – as on June 16, 2022, it rose to USD 117.2 per barrel from USD 73.3 per barrel in December 2021.

2.?????At the same time, portfolio flows have become increasingly risk averse with flights to safety impacting EMEs as an asset class

3.?????Forex reserves: During 2021-22, foreign exchange reserves increased by USD 30.3 billion on account of net inflows of ECB and improved banking capital, and sizable net FDI. As on June 17, 2022, foreign exchange reserves declined to USD 590.6 billion from a peak of USD 642.5 billion on September 3, 2021, which is equivalent to nearly 10 months of imports projected for the current financial year, thereby providing sufficient buffer against external shocks

4.?????Currency depreciation: Heighted global uncertainty from the geopolitical conflict, surge in crude oil prices and monetary policy tightening by systemically important central banks have weighed heavily on the INR in 2022 relative to the preceding year. The USD-INR exchange rate touched an all-time low of 78.98 on June 29, 2022, as recession fears and risk-off sentiment spread worldwide.

5.?????Equity markets in India: In line with corrections underway in stock markets in major economies, sentiments in Indian equity markets have turned bearish and have registered negative returns, with the BSE Sensex decreasing by 11.6 per cent and Nifty 50 declining by 11.5 per cent between end-December and June 16, 2022.

6.?????FII in India: Indian equities witnessed selling pressures from foreign institutional investors (FIIs) for the eighth consecutive month up to May 2022 with the total net outflow of `1.3 lakh crore in 2021-22 and cumulative net outflow of `66,809 crore in April and May 2022

7.?????Systemic Risk Survey, May 2022: global spill overs and financial market volatility moved to the ‘high’ risk category. Global growth uncertainty, commodity price movements, geopolitical conditions and monetary tightening in advanced economies were perceived to be the major drivers of escalation in global risks.

Three-fourths of the respondents perceived that the war in Ukraine to have a medium impact on the Indian economy. The majority felt that the impact of the war is likely to be more on edible oils, crude oil and gas, automobile sector, base metals, agricultural commodities and fertilisers.

8.????The global economy faces downside risks to growth prospects even as inflationary pressures persist. Central banks the world over face the challenges of managing soft landings while maintaining macroeconomic and financial stability.

Conclusion

The increasing impact of the political decisions of one nation can be felt in the tremors faced by?the economies of other global nations. Geopolitical risk has grown to be one of the key risks to be considered by the world nations and multinational companies while making strategic decisions. In a world with growing dependencies and evolving power structures, the cohesiveness of the economies and understanding the geopolitics is becoming far important than ever.?