Should Crumbling Regimes Worry Investors?

Some had already considered democracies a safer bet than autocracies, and the recent events may drive others to assume the same.

590 yemen protest AP Muhammed Muheisen.jpg

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, 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 be associated with 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?

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 proposed sovereign 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.

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 likely 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/Muhammed Muheisen