Lessons Learned: How One Global Economist Evaluates Political and Economic Risk
For the latest installment of our Q&A series, we spoke with Simon Baptist of the Economist Intelligence Unit (EIU). More than 100 economists and experts at the EIU analyse political and economic risks for some of the world’s biggest companies. As Global Chief Economist and Managing Director of its Asia operations, Simon Baptist shared his advice on how companies can identify and mitigate risks effectively.
Q: How do you define economic risk?
A: At the EIU we are a forecasting organisation so we think about anything with more than a 50% chance of happening as more of a core forecast than a risk. Risk is anything that could happen but has a less than 50% chance of doing so. The way I think about economic risk is similar to how I think about other sorts of risk. The first step of any risk analysis is to understand your exposure. Companies are exposed in different countries where there might be particular financial risks or risks related to infrastructure. There is exposure at different points along a supply chain, so a company first needs to understand the web of potential impacts that economic risk has, and often when they look into this they find they have more exposure to a particular country than they first thought because three or four supply chains might go through that country. So understanding that map of exposure is the important first step. It is important for companies to take a very broad view on what economic risks they might face. At the EIU, we think about economic risk as a broad level of categories. Financial risk might include the banking sector, currencies or capital controls. It might include macroeconomic risk—risks to a country’s inflation outlook or the risk of a balance of payments crisis. There are risks around infrastructure, and government policy changes around a particular regulation or taxation. There is a risk in a country’s legal system and how fairly a contract between a local firm and a foreign firm is going to be enforced, or if it will be enforced at all. Then there are other kinds of corruption.
Comment [SL1]: Link to: http://www.eiu.com/
Q: How should companies monitor the risks they face?
A: Once a company has mapped out possible risks, it needs to stay on top of news and events across these themes. It can be quite hard to cut through the volume of potential chatter on these topics—there are tens of thousands of news sites, so if you want to read articles about particular countries you will be drowning in information. The challenge is not so much finding out about stuff, but being able to process it and getting a handle on what matters.
Another challenge is that in countries where there is exposure to risk, many things may not necessarily be covered in the mainstream media because risk is stuff that, by definition, has not happened or might not even be likely to happen. So you need to have some kind of concept of what the distribution of risk could be, how likely different events are, what degree of severity each risk has, and how they might impact your company.
Companies also need to think about what the dollar value of their exposure is, to understand how much they might be exposed to different risks. Companies would benefit from engaging risk experts for advice on this, and on what risk events are worth considering. External experts can help a company to think about what kinds of scenarios could be plausible in the countries where they operate—for example, what problems might affect the infrastructure in Indonesia? There is a lot for risk departments to consider, especially as many are not flush with staff, so external risk experts can help them understand where to focus their resources.
How should companies manage these risks?
After you have identified the different risks, a company needs to prioritise them. At the EIU we take two angles—we think about the likelihood of an event happening and how bad it would be if it did happen to come up with an overall risk intensity of how we rank those risks. There are millions of possible risks so we try to identify the five main risks in a particular country.
Once these have been identified, companies need to come up with an actionable plan to be ready for these risks. It is useful to think about warning signs—what are the signals or chains of events that might play out to lead to risk eventuating? Companies should set up a monitoring system to get an early signal of where risk is morphing into something we expect to happen, and plan out different scenarios to think about what the impact would be if risk did eventuate, and what they could do to mitigate against that.
How do risks vary in different countries?
There are big differences in the risks in different markets. For example, the risk that you cannot get money out of a country is very low in Europe in general. Although it is a bit higher in the UK at the moment with uncertainties around Brexit and the integration of the UK financial markets. But this risk is much higher in emerging markets in Asia, particularly Indonesia, Vietnam and India.
On the other hand, political instability can be low in some emerging markets because they are dictatorships, so the government has more control over what is going on. So some countries like Vietnam or Laos have fairly low levels of security risk because the government has such a tight handle over the country. So companies have to think about different categories of risk and what matters to a particular firm—the outcome will be affected by financial, tax, security, policy and the effectiveness of public institutions.
Do you have an example of a higher risk market?
At the EIU we have assessed that Myanmar has one of the highest levels of business risk in Asia. Companies are often required to carry out environmental assessments out before doing business in Myanmar, but these have now become a political proxy battle between the Burmese majority in the capital and the central region of the country, and ethnic groups on the periphery. Investment from Chinese firms is particularly sensitive—the Burmese government is encouraging more Chinese investment, because these investors place less emphasis on the country’s human rights record and the treatment of the Rohingya people. But at the local level, groups opposed to the government are using their power to withhold environmental assessment licences.
Foreign firms have got caught up in this proxy battle. So firms should prepare by understanding the relations between the different ethnic groups and the centre, understand local attitudes towards the environment, look at the history of projects which have gone well and badly in the area, and look at what country investors are from—for example, Chinese investment has a higher risk.
What are the risks in more developed markets?
This year, political risk has become much more focused on developed markets. Risks caused by political instability have risen with the election of Trump, the Brexit process and the rise of populist parties in Europe, so the risk of losing money from political instability have turned out to be a lot higher in the US, UK and the rest of Europe than in emerging markets.
Emerging markets are generally still riskier but the value at stake there is a lot lower and companies operating there are used to higher levels of risk. At the EIU we have five risk categories where we rank countries from 0 (low risk) to 100 (high risk), and we now place the US, UK and Germany in the second lowest risk category—that’s between 20 and 40. That is the same as the emerging markets of Malaysia and Chile, who you would normally expect to be lower risk. But rising political risks in developed markets are having an impact.
Do you think an understanding of economic risk can help a business achieve sustainable growth?
The answer is yes! Understanding economic risk is essential for achieving sustainable growth, especially for businesses operating internationally. Companies can have parts of their businesses completely turned upside down by events that bring economic risk. For example, they might not be able to transfer money out of a country—many firms lost a lot
of assets through the Arab Spring in countries which previously seemed extremely stable, like Egypt, Libya and Algeria.
Of course, it was a surprise that the Arab Spring happened—it was set off by idiosyncratic actions like a protest in Tunisia that ended up snowballing, so you could not predict exactly when and in what way it happened. But rising dissatisfaction of young people across the Arab world, a lack of economic opportunities and social pressures leading up to it could have realistically been on people’s agendas.
So it’s not about being ready for exact changes, but thinking about possible consequences and how to protect yourself. For example, in the countries where the Arab Spring happened, it would have been useful to companies to have had security measures in place and to have been more engaged with the local communities.
Are there any examples you would point to?
One company that takes economic risk seriously is [Chinese telecommunications firm] Huawei. They operate in many countries and global telecommunications is highly regulated, so they think about these issues seriously and give them attention at the highest level of the company.
This doesn’t mean their international expansion is trouble-free and nothing unexpected happens, but issues of economic risk give them fewer surprises than in some other companies.