This article first appeared in Forum, The Edge Malaysia Weekly, on July 25 - 31, 2016.
Recent months have seen one political event after another convulsing financial markets or increasing uncertainty for businesses in some fundamental way. We have had the shock British decision to leave the European Union (“Brexit”), which could lead to years of uncertainty over how the fifth largest economy in the world will trade with the rest of Europe. In addition, we have endured a spate of unnerving terrorist attacks across the world; a military coup that left hundreds dead in Turkey, a once-stable cornerstone of the Middle East; a series of nuclear and missile tests by North Korea; and a migration crisis in Europe which has unleashed some racist and nationalist forces there.
The reactions in financial markets have varied greatly. In the case of Brexit, equity, bond and currency markets reacted violently, but after about two weeks, equities have more or less regained their ground, though the British pound remains a sizeable 15% below its recent peak. The Turkish coup mostly unfolded over a weekend, so its impact has been restricted to a weakening of the Turkish lira, though this could change if the ongoing crackdown on the opposition provokes a backlash. The other events did not generate direct market consequences, but have markedly affected business and consumer confidence.
To distinguish between political developments that really matter to the economy or financial markets and others that are just noise, we need to understand which dimensions of politics actually impact businesses, and then assess whether the political flashpoints that we know are coming contain enough of these dimensions to cause permanent or far-reaching dislocations.
Which dimensions of political risk actually matter to the economy?
There are always interesting political developments, but only some actually matter to businesses or markets. Typically, the political events that matter have the following characteristics:
• Does a change in political leaders or parties lead to a big ideological shift? A political change will matter if it represents a fundamentally different way of treating markets or private businesses or private property. In this respect, the third plenum of the 11th Central Committee of the Communist Party of China in December 1978 was a big deal because it led to the opening up of China and the reforms that have transformed not only China but the world. Ditto for the election of Margaret Thatcher as British prime minister in 1979, because it led to radical changes in economic policy, first in the UK and then eventually inspiring similar changes elsewhere. The return of Shinzo Abe as prime minister of Japan in December 2012 also produced an outsized impact on the economy, yen and equity markets. On a more positive note, there are indications that the emergence of Joko Widodo as Indonesian president could produce a decisive turnaround in the country’s fortunes.
• Wars, invasions and violent disruptions of business activity: Outright military conflict affecting regions that provide key resources such as oil or through which critical transport routes go or that house vitally important manufacturing or other business activities do matter. A war in the Middle East will disrupt the production and transport of oil, critical to the rest of the world. On a smaller scale, riots, protests and violent strikes can cause problems, but if they are localised and of limited duration, they matter less. Where they are prolonged and target centres of economic activity, as the protests in Thailand were and did in 2008 and 2010, they can hurt. Another example is if terrorist attacks damage the tourism industry in a country that depends disproportionately on tourism revenues. For example, tourist spending helps finance close to half of Turkey’s trade deficit, so the recent terrorist incidents and military coup could cause material economic damage.
• Where foundational frameworks underpinning political order and economic cooperation are impaired: An example is the US invasion of Iraq, which set in train forces that upset the political order in the Middle East. Anything that results in the division and weakening of Asean, the lynchpin of regional stability, would also be a substantial negative. Another set of forces relates to the frameworks that have facilitated the immensely beneficial expansion of trade and investment around the world. If new political elites who plump for protectionism while walking away from economic integration initiatives such as the Trans-Pacific Partnership arise, that would be damaging.
• Diversion of resources away from productive activity to military spending: For example, it looks like the recent uptick in tensions in the South China Sea is leading to more military spending. Something similar is happening in Europe following Russia’s intervention in Ukraine. The reverse happened with the end of the Cold War in 1989, which produced a huge peace dividend as defence spending was cut back and spent on productive causes such as industrial policy and human capital development.
• General rise in uncertainty hurting confidence: Finally, the series of coincident but unrelated political stresses in recent months is leading to a general sense of unease. This tends to raise the risk premium, causing businesses to hesitate about investing or hiring workers or undertaking risky research and development initiatives. Another example could be what is happening in Hong Kong these days. Here, a growing animosity towards China, greater willingness on the part of a minority to confront China, and recent actions that raise concerns about how politically separate Hong Kong can be from China are causing businesses and ordinary residents to worry about the long-term sustainability of the “One Country, Two Systems” model that has allowed capitalist Hong Kong to thrive despite returning in 1997 to Chinese rule.
Which of the looming political flashpoints fit this framework?
Let’s start with the easily identifiable political turning points that are ahead of us:
• The US presidential election in November could have immediate and negative consequences for Asia: Victory for the Republican candidate, Donald Trump, would result in a radical change, bringing to power a president who does not subscribe to the basic tenets of US foreign policy since 1945, such as engagement with allies in Europe and Asia involving costly military deployments and an openness to trade, investment and immigration. His questioning of alliances with Japan and South Korea, and his apparent affection for Russian President Vladimir Putin could upend traditional American alignments, while his intention to slap huge tariffs on Chinese exports to the US could result in trade wars. As our earlier column in March argued, we believe the most likely outcome will be a victory for the Democratic Party nominee, Hillary Clinton. However, recent incidents such as the killings of young men from minority groups by police and the resulting revenge attacks on police are inflaming racial tensions, which could be used against Clinton.
• Major elections in Europe: Next year sees important presidential and parliamentary elections in Germany, France and the Netherlands. These elections will tell us whether xenophobic parties, which have been gaining ground, will win enough political power to force fundamental changes in policy towards the EU. If they win power or greater influence, the integration process that provided the foundation for 60 years of cooperation and goodwill in Europe could be undermined, with dismal effects on global stability as well as economic openness. This will not produce immediate effects on Asia, but the longer-term implications could be damaging if the European integration project is reversed or breaks apart.
• Chinese leadership renewal: With the 19th Congress of the Chinese Communist Party approaching in late 2017, there is already an intense struggle among various factions to ensure their protégés are promoted and their rivals ousted from key posts. The structure of succession to President Xi Jinping is also not clear. There are some signs that economic policymaking is being politicised as part of this power tussle: That is a concern because China needs well-calibrated and timely economic interventions to ensure the imbalances in its economy do not lead to a crisis.
• Elections in Asia: The upcoming referendum on the new constitution in Thailand could open the way for the normalisation of politics two years after the military coup that removed an elected government. There is speculation of an early general election in Malaysia as well; this could generate uncertainty but could also see Prime Minister Najib Razak returned to power in a stronger position. South Korea has a presidential election as well, with much uncertainty about who will succeed President Park Gyun-hae.
Another set of political developments to watch out for are those where pressures are gradually building up and raising the chances of a momentous change, but where the timing and nature of that change are inherently unpredictable. Examples include:
• Territorial disputes in the South and East China seas: The recent ruling by an international tribunal that undermined the legal position of China’s claims in the South
China Sea has heightened concerns about the region. This could lead to greater disunity within Asean between those who favour accommodating China and those who are loath to give up their sovereignty claims. A weaker Asean is bad for stability, as we have argued above. Or there could be an increasing militarisation within the region, with claimant countries forming alliances with other big powers to contain China — that would run the long-term risk of potential big-power conflicts in the region.
• Thailand: Many observers of the country are worried about the succession to ailing King Bhumibol Adulyadej’s throne. The frequency of medical bulletins about the King’s health has increased of late. Given the immense affection with which the King is held among Thais, growing concerns about his health are bound to affect the business and consumer moods as well.
• North Korea: Frequent purges within the leadership; continued economic dislocations; the country’s worsening relationship with China, its only friend; signs of diminishing central government authority over localities; and the regime’s provocative acts such as nuclear and missile tests — all these have fuelled speculation that the North Korean regime may not be stable in the future, with some even forecasting its collapse. This is the kind of apparently low-probability but high-impact event that could throw markets off balance.
• Middle East instability: So far, the spillover from the failed states in the region — Libya, Syria, Iraq, Somalia and Yemen — into other countries has been contained. The fear that some analysts have is that domestic pressures are building in other so-far stable states such as Egypt and Saudi Arabia. Again, while the probability of a large-scale convulsion in those countries does not seem high, the impact of such instability should it materialise would be huge.
Conclusion: Watch political risks carefully, but do not overreact to events
There is no shortage of potential political shocks for investors to worry about. But the ones to focus on are those that impinge on how business is conducted; those that might spill over into other countries; and those that threaten to fundamentally damage existing structures or frameworks that ensure peace and cooperation.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy