The assaults on foreign investors by Russia’s Vladimir Putin and Venezuela’s Hugo Chavez highlight one inexorable fact: political risk is back, and it’s here to stay. International investors who seek to analyze risk by purely economic means ignore it at their peril.
Political risk never entirely disappeared. Even during the holiday-from-history nirvana of the 1990s there were countries like Serbia, North Korea and Congo where your money wasn’t safe. Nevertheless, it is not a coincidence that political risk has reared its head again recently; political and economic developments have combined to make it do so.
In the nineteenth century, political risk was a minor problem, concentrated largely in Latin America where early versions of Latin American populism reared their head from time to time. Contrary to popular memory, the West did not generally sort it out by means of a flotilla of gunboats, though the bombardment of Alexandria in 1882, rescuing as it did Prime Minister William Gladstone’s 53,000 pound investment in Egyptian bonds, was a notable exception to this. In any case, the great majority of 19th Century defaults were due to the country concerned running out of money, rather than to any overtly hostile activity on the part of its government.
World War I was bound to make a huge mess of international obligations, as was the inflation that followed in Germany and the economically catastrophic break-up of Austria-Hungary. However the Soviet default on Czarist bonds and nationalization of foreign-owned assets was a different matter. Here was a major economic power, active in international markets for the previous century which not only defaulted on debt (as did Austria-Hungary and, though inflation, Germany) but also seized foreign-owned assets without compensation, an action that had no immediate economic justification. From then on, political risk became a continuing problem in the 1920s and 1930s, as bond defaults that were often due to economic circumstance were accompanied by asset expropriation
After World War II, there was a short burst of defaults by the unfortunate countries of Eastern Europe that were sucked into the Soviet empire, and by China going Communist in 1949, after which political risk died down considerably. From time to time a country such as Cuba or Angola would go Communist, seizing foreign assets, and there were continual worries about the possible effect of a Communist win in Italian or French elections, but generally foreign assets were safe from anything but the occasional nationalization with full compensation, as with the British steel industry in 1949 and again in 1965. The Francois Mitterrand government in France, in retrospect not a particularly extreme bunch, caused much more frisson in 1981-83 than it would have done fifty years earlier when it nationalized the French banking system, some of which was foreign owned. As Guy de Rothschild memorably said as he moved to New York “To be a Jew under (French wartime collaborationist leader) Petain was bad enough; to be a banker under Mitterrand, c’est insupportable.”
After the Berlin Wall fell, it seemed that political risk had more or less disappeared. Communism and socialism appeared to have been discredited by history, with even those countries like China that remained nominally Communist giving more and more emphasis to private property and achieving rapid growth by doing so. Meanwhile Eastern Europe and most of the former Soviet Union opened their economies to private ownership. Although the security of private property in those countries remained shaky for many years, there appeared to be little evidence of backsliding in any country into which a rational person would have invested. Relapses such as Bulgaria’s return to Communism in 1995-97, for example, saw awful depredations to domestic property, but little damage to foreign ownership rights beyond the occasional well-timed assassination.
Nevertheless since 2000 the tide has clearly turned, with first Argentina and more recently Venezuela and Russia being the most obvious examples of expropriation. It’s worth looking at what changed, and whether the new instability is permanent.
The first and most important new factor has been cheap money, and with it an upsurge in investor enthusiasm for risk. Whereas even in the late 1990s investors remained cautious about political risks in emerging markets, and were suitably scarred by the Argentine debacle in 2001-02, the continued overexpansion of the world’s money supply since then has caused normal caution to be abandoned altogether in search of extra yield. The J.P. Morgan Emerging Market Bond Index (EMBI) has soared, reducing the average yield spread above US Treasuries on such bonds to well under 2%, remarkable for an index which is concentrated 50% in the un-emerging economies of Latin America and another 16% in the distinctly dubious Russia.
When investors are eager to lend and invest new money, there is little point in expropriating them, but also little damage from doing so. The action of Ecuador’s new finance minister Ricardo Patino, calling in Argentine consultants to advise him on debt default and then announcing proudly that the consultants had advised him it wasn’t worth it, instead he should go out and borrow some more money first, is typical of the unpleasant new era in its gross disregard of private property rights. There can be little question that even when destruction of property rights isn’t imminent, as in this case, it awaits only the next economic downturn.
The second factor that has changed since 2000 has been the resurgence in oil prices and commodity prices generally. While in some few cases such as Indonesia this has caused a distinct improvement in the economic prospects and living standards of many impoverished people, in most cases it has simply enriched a tiny and unattractive elite. More important, it has appeared to demonstrate to those seeking an alternative to capitalism that if your country has natural resources, it can avoid capitalism altogether and expropriate the value of those resources to government boondoggles, armaments and corruption.
For this is the true dirty secret of human development: capitalism, the economic system that develops economies and produces unimaginable riches, is deeply unattractive to the majority of people. In a democratic system, any demagogue offering a plausible alternative to capitalism will find his electoral path magically smoothed. Any transitional difficulties as in Russia or long term problems caused by state ownership of resources as in Venezuela will offer opportunities to blame capitalism for the problem and offer some form of statism as the solution. If the economy’s main revenues flow through the government, as in oil producing countries, it becomes impossible to wean either the government or the electorate off a state-directed model.
Even in successful capitalist economies, such as Britain and the United States, it is notable how quickly the political system ditched Ronald Reagan and Margaret Thatcher, the leaders who had won the battle against Communism, replacing them not with other capitalists but with soft-centered populists of the Third Way, Tony Blair and Bill Clinton. Such leaders purported to offer the soft ideological pabulum of socialism without sacrificing the real benefits of the free market, an attempt to have it both ways that was irresistibly attractive to ill-educated electorates.
Socialism is not dead, it will never die – while the majority of voters are ignorant of economics it can suffer only the most temporary of setbacks.
Vladimir Putin and Hugo Chavez both took office at low points in their countries’ fortunes, and benefited from a sharp appreciation in the price of their most important resource. Future believers in Great Man theories will agonize over the possibility that Vladimir Putin and Boris Yeltsin might have been switched in time, so that Putin could have presided over the 90s chaos with his admirable efficiency while Yeltsin took advantage of the economic upturn brought by high oil prices to establish a true democracy. Realists will be sure that Russia’s problems of the 1990s would have turned Vladimir Putin into a hopeless alcoholic, albeit a gloomy Dostoyevskian one, while the surge in the country’s wealth and status since 2000 would have turned Yeltsin into a bombastic tyrant, albeit a jolly Krushchevian one. You’re free to choose either alternative!
The interesting question is what happens when the period of cheap money and high oil prices (which are of course interconnected) comes to an end. In the short term, there will unquestionably be more expropriations of private property, some of them in very unlikely places where investors had never previously felt threatened. If the oncoming recession is a deep one the apparent “failure” of the capitalist system will bring electoral success for numerous crazed and dangerous demagogues, as it did in the 1930s – electorates almost never have the sense to turn towards capitalism rather than away from it in periods of economic difficulty.
Then the level of political risk will depend on the response of the major capitalist economies to their citizens’ foreign investments being seized. One possibility is that as in Russia in 1998 or Argentina in 2001-02, the response of the international financial institutions, statist themselves, will be to provide short term cash to the looters and ease their path back to the conduits of international money. In that case the property seizures will appear to have been justified, and the looting governments as in Argentina will enjoy several years of apparent recovery based on consuming other people’s resources.
If that happens, political risk will again have become endemic in the system, and the globalization of international debt and equity capital will go sharply into reverse, as in the 1930s. Trade barriers, exchange controls and a reluctance to invest abroad will become the norm. Needless to say, the world will by this course be pulled onto a much slower growth track, if indeed overall economic growth continues at all.
If on the other hand the West responds aggressively to looting, cuts off looting countries from sources of international capital and restricts their access to trade finance, then looting governments may quickly find their local popularity dissipate, after which something better may emerge. (The only difficulty here would be those looting countries like Russia that have massive nuclear armaments, for whose governments World War III may seem an attractive alternative to loss of office.) In this case, a sharp distinction will rightly be drawn between those countries that seize private property and those that don’t, for whom trade avenues and international credit will remain open. By rewarding good behavior, the West will thus reduce the prevalence of bad behavior.
Cynical as I am about the competence and motivations of the current political classes, I would bet on the first rather than the second of these two outcomes. But in human life, there is always hope.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)