What is geopolitical risk?
This is the risk posed to businesses and investors by unexpected developments relating to political, military or security issues around the world. The phrase also covers risk arising from major natural disasters and policy responses to them. And some analysts would also include the threat posed by state-sponsored cyber attacks. In recent years, for example, the shock election of an openly mercantilist US president, rumbling tensions between Russia and Nato, and the Japanese tsunami and Fukushima disaster (which has led to a partial or total withdrawal from nuclear energy in many countries) are all instances of world events that have dramatically changed core assumptions in particular markets. At its most extreme, geopolitical risk includes the threat of political violence or regime change, resulting in expropriation of assets or currency inconvertibility. The greater interconnectedness of the world economy in the age of globalised supply chains and markets and instantaneous communications have massively increased the importance of being aware of geopolitical risk, especially as it relates to currency markets.
Why are currency markets so affected?
Currencies are issued by nation states and ultimately derive their legitimacy and value from the assets and stability of nations and governments. As such, they are naturally highly sensitive to political shocks: in broad terms, investors typically fear that political turmoil will lead to a weaker currency. The other crucial factor is that currency markets are by their nature exceptionally liquid and therefore fast to react to events and that investors have an almost unlimited range of choices to make in response. Sometimes, the currency movement resulting from a political shock is easy to understand: sterling slumped when the UK voted for Brexit because investors anticipated economic and political weakness going forward. Sometimes, though, the movement is more complex. After a US missile strike in Syria in April this year hit an airbase with a significant Russian presence, the Japanese yen surged. Why? Because Japan's current account surplus of over 3.5% of gross domestic product makes the Japanese yen a perceived safe haven at times of heightened geopolitical tensions.
What kinds of events pose the biggest potential risk?
Traditionally, geopolitical risk was chiefly associated with emerging markets the kind of political turmoil currently affecting Venezuela or Libya, for example. But the most striking thing about today's geopolitics is that many risk analysts would rate the number one geopolitical risk issue as the threat of US withdrawal from the global system. Whereas the West used to be a paragon of stability it is now the source of risk, including not just US isolationism but also European fragmentation and Brexit. Indeed, three of the biggest current geopolitical risks facing markets all involve America: the possibility of the North American Free Trade Agreement (Nafta) collapsing; the US stand-off with North Korea over its missile programme; and tense relations between the US and rising superpower China. This change in focus when it comes to political risk from emerging markets to the core of the global economy is a key reason why it is an increasingly important issue for investors and businesses.
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How might all this affect small businesses?
Any UK small business which has significant costs in euros but earns its income mainly in sterling (for example, any import-driven business or one with European suppliers) knows exactly how important geopolitical risk can be and how painful. When the UK shocked markets by voting on 23 June last year to leave the EU, sterling lost more than10% of its value in two days, crashing from $1.49 to $1.32. But the time sterling bottomed out in January 2017 it was down to $1.20 an astonishing peak-to-trough slump of just under 20% and it's still trading far below its pre-referendum value. (Exporters, of course, have benefited, since their goods are cheaper for overseas customers.)
Clearly, the shock of Brexit is an extreme example of geopolitical risk. But it has concentrated minds. Businesses, increasingly, are working on quantifying and mitigating political risk and associated currency risk whether that is through political risk insurance or by working with currency experts on hedging strategies. We may not see another shock like Brexit any time soon, but we can be certain that fresh uncertainties are just around the corner.
Ask the expert
Jake Trask, FX research director at OFX
Is there anything on the horizon to compare with the shocks of Brexit or Trump?
Barring nuclear war between North Korea and the US, major geopolitical risk-events seem to have passed for now. A complete collapse in Brexit talks or a deterioration of the situation in Spain, since Catalonia's unofficial independence referendum, could potentially hit markets however the likelihood of these events transpiring seems remote. The euro's resilience since the Catalan referendum and sterling's gains against the dollar over the past six months illustrate this point.
Does Catalan separatism pose a genuine risk to Europe?
It seems unlikely, unless the situation should worsen drastically. There has been no dramatic sell off in the Euro since the crisis began and it seems unfathomable that Spain, and the EU as a whole, will allow the situation to deteriorate to a point that the integrity of Spain would be called into question.
Why is the Japanese yen seen as a safe haven when its economy is so sluggish?
The Yen has huge foreign asset reserves, the second biggest in the world after China. It is very stable geopolitically and economically (if an underperformer in the latter) like the currency of another traditional safe haven, Switzerland. It's also embedded in investors psyche, that in times of unrest (even with events that affect Japan directly, such as North Korea's missile tests and the 2011 Tsunami) you flock to the yen. Whether you are importing from East Asia, or closer to home in euros, at OFX, we recommend forward buying currency as an essential tool for import-driven businesses. It protects profit margins and makes budgeting for international goods more predictable and sustainable.
Do you think it is a good idea to hedge currency risk with gold?
Gold like any other asset is volatile and can appreciate/depreciate depending on geopolitical and economic events. However, gold is a traditional safe haven (like JPY and CHF) and can appreciate dramatically in times of economic woe. Most small businesses who deal with overseas suppliers should be far more concerned with forward buying currencies to pay those suppliers in kind. Involving commodities, like gold, is likely to be far too much effort for small and medium sized business and could be more hassle than it's worth.
What should you do if you own a property in a foreign country where the currency is falling?
Everything comes down to personal circumstances. If the property is going to contribute a chunk towards your retirement fund into old age then you may wish to consider selling it sooner. Should you be lucky enough to have enough money to see you through retirement, and you're happy to carry on using it, then there really isn't an urgency to sell in the short term.
Should investors factor in geopolitical events and act accordingly, or stick to their long-term investment plans and ignore any currency fluctuations?
Investors and businesses need to take into account the potential impact currency fluctuations could have on their profit margins. Those businesses who didn't forward buy currency before the Brexit vote most likely experienced the cost of importing from overseas increase by 10% overnight. At OFX, we recommend forward buying currency as an essential tool for overseas importers. It protects profit margins and makes budgeting for international goods more predictable and sustainable.
For more information from OFX on protectionism and other money matters, please click here
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