Political risk has reappeared as a driver of investment decisions. But where one country loses, another may gain. Charles Piggott reports.

Political stability has increasingly been taken for granted by investors in the past few years, but in the wake of September 11, political risk is back. According to AT Kearney’s recent survey of multinational executives, overseas investors now consider political risk as the third biggest factor influencing investment decisions behind macroeconomic growth and the development of countries’ domestic markets.

Paul Laudicina, head of AT Kearney’s Washington-based global policy unit, says: “Political stability had largely been taken for granted in the past few years, but risk has once again become an important issue for investors. Investors are clearly much more sensitive to political risk than they were one year ago.”

In recognition of investors’ rising concern with non-financial risk, US investment bank Lehman Brothers and political risk consulting firm Eurasia Group last month launched an index that rates emerging market countries’ political risk. In addition to economic, social and political stability, the index also takes into account security issues. Commenting on the launch of the new index, John Llewellyn, Lehman Brothers’ chief global economist, says clients “need a form of risk measurement that goes beyond economic factors”.

Risk models that analyse and compare countries’ social and political stability have long helped investors calculate the risk of investing in emerging market countries. However, in the light of the events of September 11, it may no longer be enough simply to factor in the likelihood that a president is toppled by the opposition or that a government falls victim to a corruption scandal.

Says Ben McTurnon, ratings editor at US risk consultancy Political Risk Services: “What changed after September 11 is that we now have to take into account the possibility that a well-organised and well-financed group can bring a country as large and powerful as the US to its knees. Suddenly the danger that a president is toppled does not look so bad compared with the risk of a fundamentalist group getting hold of a nuclear or biological weapon.”

John Wade, senior political risk consultant at international risk consultancy Control Risks Group (CRG) also thinks that country risk models need to be updated. He says: “The world changed on September 11. Although it is too early to predict the outcome for every individual country, it is clear that the geo-political risks need to be re-evaluated in the light of what happened in the US.”

In terms of knock-on effects, CRG’s Mr Wade is worried by the increased pressure on international friction points, for example relations between India and Pakistan, Israel, Gaza and the West Bank, and also the possibility of the overthrow or assasination of Pakistan’s president Pervez Musharraf. He also worries that instability in Pakistan caused by the perception that the US intends war against Islam could extend to Saudi Arabia, Indonesia and other strongly Muslim states.

Changing times

The threat of escalation in the US-led war on terrorism changes the risk profile of many countries. Says PRS’s Mr McTurnon: “In middle eastern and south-east Asian countries, there may be the perception of a looming war against Islamic people and this will affect stability. Countries such as Pakistan, Saudi Arabia and Indonesia are obvious examples of countries that may become destabilised.”

According to the Economist Intelligence Unit’s (EIU) country risk analysis, major emerging market countries such as Malaysia, Taiwan, Singapore, South Korea and China have all become more risky in the past 12 months. While Brazil’s country risk remains unchanged, India, Hong Kong, Mexico and Russia all face diminished risks (see table).

Bridge building

Although the net effect of September 11 was to increase country risk around the world, analysts admit that the coalition against terror may strengthen western relations with some developing countries. For example, although there have been anti-western demonstrations in Pakistan, the government’s pro-US stance in the wake of the terrorist attacks has already brought swift reciprocal financial aid. Although the situation in Pakistan is finely balanced, the removal of sanctions placed on Pakistan in 1998 following nuclear tests and the rescheduling of $379m in bilateral US debt may bring some economic relief.

Similarly, Uzbekistan is likely to receive increased international financial support in return for allowing US military personnel to operate on its soil. Iran could also benefit from more open contact and financial assistance from the west. Says Mr Wade: “There has been a lot of to-ing and fro-ing between Iran and the West recently, but there are also traditional forces that may prevent closer international relations.”

Other countries may be perceived as comparatively less risky. For example it is possible that Latin America benefits from capital outflows from middle eastern and south-east Asian countries that face an uncertain Muslim reaction to the US-led war against terrorism. It would not be surprising if US emerging market investors concentrate more on Latin American countries closer to home in preference to countries on the other side of the globe that have large Muslim populations that could potentially react adversely to US-led military action.

Mr McTurnon says: “Two months ago, Ecuador may have looked like one of the riskiest countries in which to invest. Now there is a greater concern with political risks in middle eastern countries and Ecuador, for example, could appear relatively less risky.” Others believe that all emerging markets will be hit by indiscriminate financial market contagion.

Says David Anthony, an economist responsible for the EIU’s country risk warns: “September 11 was an important trigger. It changed everything, tipping the scales between confidence and risk. Now the exuberance of two years ago – in which everything was glorious and the sky was the limit – has gone.”