Political risk may come to the fore

The dogs of the night have not barked. During the past few days a number of events have taken place which suggest that the world has become a more dangerous place. Most obvious has been the heightening of the stakes in Bosnia. But there have been others: growing concern about North Korea's nuclear capacity; rising tension in South Africa in the run-up to the election; the sealing-off of the Gaza strip for Palestinian workers; the threat of more street riots in France; political paralysis in Japan; and only a few days earlier the assassination of the principal candidate for the Mexican presidency.

And of course others would add further concerns, some of which may prove more destabilising. Yet financial markets have taken these concerns calmly: they are less worried about civil war in South Africa than they are about US interest rates. In particular, the commodity, oil and gold markets, usually the first to signal alarm, have been silent. Oil, for example, remains in real terms close to the level before the first oil shock of 1973-4. Why?

FOCUS ON TACTICS

There are at least three possible explanations. The first is that the growing sophistication of financial markets has led investors to focus on tactics rather than long-term substance. The enormous preoccupation with US interest rates and the implications for other financial markets have monopolised investors' minds, so they are failing to think sufficiently about the implications of political forces for the world economy as a whole.

There is a justification for this lack of interest: the events leading up to the Gulf war, which potentially posed an enormous threat to world oil supplies, had only a very short-term impact on the oil price. If the world can have a war in the Middle East without any apparent general damage to the world economy, it can be argued that the world economy could also cope with chaos in South Africa, Mexico or the former Yugoslavia.

The second way of explaining the world's indifference to political risk is slightly different. Instead of saying that investors have become too myopic, it would be to argue that though there may well have been some overall rise in such concerns the rise is not large in relation to the big financial force of lower inflation, which has dominated the markets for at least five years.

If we are returning to a world of more-or-less stable prices then short-term political tensions are unlikely to do the sort of damage to the world economy that they did in the 1970s. An oil shock now would be infinitely easier to manage than it was in the 1970s when inflation was not only very much higher, but was also on a rising trend. Financial markets, and for that matter commodity markets, tell us about financial forces, not geo-political ones.

But that line of argument can lead on to another, and rather different, conclusion. The third explanation would be to show that financial markets are very bad at assessing political risk. Bankers have long been proved hopeless at country risk, lending money in the early 1980s to countries that they could hardly find on the map. The pain of the mid to late 1980s was the result.

EMERGING STARS

That cavalier attitude to risk has now spread to equity investment: countries that are written off one minute are suddenly elevated as the new stars of the 'emerging market' funds. At least risk is better managed in equity funds, with a wide spread of investments, than it is in bank loan portfolios, but the lure of fashion is much the same.

And so it may be that the markets are wrong. They are failing to spot the way in which the quite serious political tensions might feed back into the world economy, perhaps by way of an unwanted trade war.

To make this last point is not to be particularly alarmist. It is simply to observe that while a vast amount of time is spent analysing economic and financial risks not a lot of attention is being paid to political risks. Yet these have surely risen recently. Something will, on the balance of probability, soon shake this complacency.