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> Should Crumbling Regimes Worry Investors?
> MAR 1 2011, 9:30 AM ET
>
> Some had already considered democracies a safer bet than
> autocracies, and the recent events may drive others to assume the
> same.
>
> The unrest in the Middle East obviously will have a big impact on
> global politics, but could it also have ramifications on how
> investors view autocracies going forward? The market now understands
> that when oppressive regimes rule, instability is sometimes just a
> political movement away -- and the changes that result can affect
> the economies of these nations significantly. As a result, the
> recent events have made assessing the certainty of some global
> investments even more difficult for fund managers: investments
> linked to authoritarian regimes might contain more risk than
> previously thought.
>
> This assertion was made last week in one of the newsletters I
> receive from investment management firms. It said that, in the past,
> many investors did not discriminate between democracies and
> autocracies. In fact, some believed authoritarian regimes to be even
> more stable than democracies, which are more reliant on the whims of
> the people. But the unrest in the Middle East has begun to change
> that view. Suddenly, it has become clear that if the people demand
> democracy, then political instability can very quickly follow.
>
> The consequence is that investors may begin to associate a higher
> risk premium with investments tied to autocracies in comparison to
> democracies. While election cycles can introduce changes to the
> economic path a nation is on, giant swings in a government's
> structure through revolution that leads to unanticipated changes in
> leadership can more significantly alter a country's direction.
>
> Of course, some in the financial world should already have their eye
> on the more severe political risk that can result in autocracies.
> One major job for the credit rating agencies is to evaluate
> sovereign debt, and a government's stability is essential to their
> calculations. Have the events in the Middle East changed the way
> they view authoritarian regimes?
>
> If you look merely to downgrades, then it's clear that the unrest in
> the Middle East has had some effect. On January 31st, Moody's
> downgraded Egypt's government bond rating to Ba2 from Ba1. Its note
> read:
>
> Today's rating action was prompted by the recent significant rise in
> political event risk and concern that the policy response could
> undermine Egypt's already weak public finances. We had previously
> signaled that such developments may result in a ratings downgrade
> (see Moody's latest Credit Opinion on Egypt published 24th November
> 2010).
> S&P took similar action.
>
> But is there some broader change in philosophy? Are authoritarian
> nations in general -- beyond just those in the Middle East with
> citizens demanding democracy -- now viewed as more susceptible to
> political risk than they previously believed?
>
> "Succession risks or high concentration of power are factors that
> can pose risk to institutional stability."
> The rating agencies have complex models for evaluating nations'
> stability. For example, among other factors, Moody's criteria
> consider a country's institutional strength and susceptibility to
> event risk. Both of these risk factors would potentially be more
> significant in an autocracy than in a democracy. Similarly, S&P
> incorporates a "Political Score" as one of the five components in
> its newly proposedsovereign debt rating criteria. Although the firm
> does not explicitly name autocratic rule as a negative factor, it
> does say that "succession risks or high concentration of power are
> factors that can pose risk to institutional stability." Both of
> those may be bigger problems in an autocratic regime than in a
> democracy.
>
> Mauro Leos, a senior credit analyst in the sovereign risk group at
> Moody's, explains that some in the market perceived authoritarian
> governments to be generally stable. That's not quite right, however.
> "The problem with that type of government is that it is stable until
> it is not stable anymore," he says. According to Leos, this view of
> the potential problems autocracies face was captured by Moody's
> sovereign analytical approach even before the events in the Middle
> East. But once the events actually began unfolding in the region, a
> risk of contagion became apparent, which is one of the reasons why
> the agency began to consider downgrades.
>
> "The greater the political repression, the stronger the case for
> pricing in a high uncertainty premium."
> As mentioned, however, it's a central purpose of the credit agencies
> to monitor the stability of countries that issue rated debt. What
> about investors? In their case, attention to political risk probably
> depends on a number of factors, such as the firm's investing
> philosophy, methodology, and size.
>
> Investment management titan PIMCO considers political, social, and
> geo-political risks, along with economic and financial
> considerations, according to its CEO and co-CIO Mohamed El-Erian.
> PIMCO also viewed autocracies as having greater risk than
> democracies even before the recent events in the Middle East, he
> tells The Atlantic. According to El-Erian:
>
> Recent developments in the Middle East and North Africa will make
> investors much more sensitive to the possibility of complete
> paradigm shifts, and rightly so. These developments emphasize a
> point we have felt strongly about in our global investing--namely,
> the greater the political repression, the stronger the case for
> pricing in a high uncertainty premium.
> The recent events in the Middle East are not like to result in a
> sudden revelation for a large, sophisticated investment management
> firm like PIMCO. It has a deep research component that includes
> experts who understand geopolitical risk. The same goes for the
> rating agencies, which specialize in evaluating nations' economic
> stability.
>
> But for smaller investment management firms with less robust
> operations, such newly discovered risks reveal yet another challenge
> in the highly complex investing game. While global investment in
> emerging nations appears to be ripe for big potential returns, it
> also contains sometimes unexpected pitfalls. One of those has now
> come to the surface for investments tied to autocracies. The big
> question is how to separate out the more stable authoritarian
> regimes from those more likely to be affected by democratic reform-
> inspired protests and revolution. And that's where the analysis gets
> really tough.
>
> This revelation may cause some of those smaller investors to realize
> that the barrier of entry is simply too high to invest in markets
> for which they don't perform robust analysis of political risk. Or
> alternatively, if the potential profit on investments for such
> regions is big enough, this realization could encourage these firms
> to bring on additional experts who aren't focused on quantitative
> analysis, but who understand geopolitical risks and global politics
> instead. As the global market expands, perhaps those international
> studies degrees will become as attractive to Wall Street as they
> have previously been to Washington.
>
> Image Credit: AP/Kevin Frayer
>