In the aftermath of the 2008-09 global crisis, there has been an increasing emphasis in business, media and academic circles on 'democratic dysfunctionality' -- in particular, the apparent unwillingness or inability of US, EU and Japanese governments to tackle their long-term fiscal problems. Given the outperformance of some economies under authoritarian governments or deeply flawed democracies over the past decade, especially China, such critiques often also imply that non-democratic systems are better at fostering long term growth. However, such assumptions may be flawed; markets are in danger of mispricing the medium-term political risks associated with economic management by authoritarian governments, relative to pluralistic democracies.
Impact
- Even after the Arab uprisings this year, developing world political risk looks set to remain seriously discounted by most market players.
- Attention to political risk is mostly focused on developed economies -- an error attributable to 'last war'/last crisis thinking.
- Business leaders risk conflating current benign conditions in many authoritarian regimes with long-term stability.
What next
Pluralist democracies' possession of political 'circuit breakers' (eg elections, robust judicial review, divided government powers) gives them a critical long-term economic advantage in terms of resilience in the face of political risk. The very policies that have enabled rapid growth in some emerging economies with authoritarian governments -- heavy government-led infrastructure investment, a neo-mercantilist emphasis on exporting finished goods, and credit systems dominated by state-controlled banks -- may be sowing the seeds of serious systemic political and economic crisis, which they lack the institutions to confront.
Analysis
Much current thinking about the prospects for global growth exhibits a strong degree of 'presentism' -- the notion that current conditions will define future trends over the long term. While it is critical to focus on the present crises of fiscal policy and governance in the developed world -- indeed, the situation in the euro area appears to be approaching an acute phase -- markets risk losing sight of the fact that established, pluralistic democracies possess critical advantages that mitigate political risk over the long term.
Myopic markets
The loss of confidence in economically developed democracies as engines of stable growth has been significant:
Bond spreads
Following US flirtation with 'voluntary' sovereign default in early August due to political polarisation, emerging market bonds -- particularly those issued by the 'BRICs' (Brazil, Russia, India and China) climbed in value. This fall in BRIC bond yields was the opposite of the usual 'flight to safety' response, in which US Treasuries and other developed world securities gain as emerging market bonds fall. Indeed, since late August, BRIC yields have largely moved in tandem (albeit with a slight lag) with Treasuries as worries grew over a potential euro area crisis.
FDI perceptions
According to Ernst & Young's 2011 European Attractiveness Survey, China was rated as the world's most attractive investment region, with a 38% score -- ahead of the entire developed world. In real dollar terms China lagged the United States as the top FDI destination in 2010 (101.0 billion dollars and 186.1 billion, respectively), but it is advancing rapidly.
Investor surveys
Euromoney's biannual political risk survey continues to rate the United States, most EU members and Japan highly relative to authoritarian emerging economies. However, almost all G7 countries experienced spectacular falls in absolute ratings points over the past decade.
Investor wariness is apposite in the wake of the 2008-09 systemic crisis, particularly given continuing fiscal policy paralysis in the United States and apparent sovereign credit contagion in the euro area. Yet beyond the immediate crisis, many businesses now apparently assume that emerging markets will remain much less prone to political risk than they have been in the past.
Fukuyama's fallacy?
This represents a sea change from the broad worldview among global business, political and media opinion leaders during the early 1990s -- a period when post-Cold War triumphalism prevailed in Washington. 'The End of History and the Last Man' (1992), the work in which political theorist Francis Fukuyama predicted that liberal democracy represented the apex of human political economy, is now seen as something of a historical artefact. Published just three years after the collapse of communism in Europe and Tiananmen Square, it appears to discount the possibility that authoritarian regimes could successfully adopt market capitalism over the long term.
Nevertheless, it contains a useful barometer of the most severe forms of political risk. Fukuyama argued that the durability (or otherwise) of human socio-political organisations is based on whether they contain internal "contradictions". A 'contradiction' is not merely a problem (eg unemployment or budget deficits), but an issue so severe that it "corrodes the legitimacy of the system" to the point of collapse.
Searching for 'contradictions'
The United States and the rest of the developed face very severe political problems; arguably, certain EU structures confront something closer to a 'contradiction'. However, the institutions of liberal democracy in the United States and many European capitals remain exceptionally durable -- particularly in the former. The US political system has experienced much higher levels of unemployment than at present without generating social unrest sufficient to unsettle its institutions.
China and many other authoritarian states are very different. Public discontent can be repressed, bought off, contained, or reduced due to rising living standards. Yet that systemic durability may be situationally dependant -- that is, in the absence of certain conditions, such as robust economic growth, it cannot be taken as given.
'Dysfunctional democracy'?
In the current moment it is developed economy democracies, rather than authoritarian regimes, that are associated with political risk. This emphasis is misplaced, particularly over the longer term. For example, while the US political system is currently experiencing the highest level of ideological polarisation since the 19th century, its institutions have still managed to force compromises avoiding disaster ('voluntary default'), and take decisive action to stem systemic crisis (eg, passage of the Troubled Asset Relief Program).
Pricing political risk
Indeed, even the messiest aspects of the political process in democracies tend to be useful for markets as a means of 'pricing-in' risk. Political risks in pluralist liberal democracies such as the United States tend to be transparent and quantifiable, due to strong media scrutiny and divided powers, relative to authoritarian regimes. Emerging market democracies, such as India, enjoy similar (perhaps lesser) comparative advantages.
Yet companies seem to have trouble both recognising this distinction and incorporating it into their risk management policies. Political risk management at most firms tends to be anecdotal, and simply allow or prohibit investment; the idea of risk weighting capital according to political risk is foreign to most firms. Yet in the absence of such risk management tools, FDI in authoritarian regimes appears to resemble what UK economists Martin Wolf and John Kay term a 'Taleb Distribution' -- apparently low risk, but with the possibility of catastrophic losses.
