Pricing in Politics? What recent financial market losses signal about political risk in emerging market economies

23 May 2006
Lauren Phillips
Comment
Yesterday global financial markets faced their worst sell of since the Russian default and Asian crisis of 1997-98.   The Brazilian and Mexican stock markets – two of the largest in the developing world – closed massively down, as did those in Turkey, Russia, Indonesia and India (“Emerging markets lead global decline” 22 May and “Equities tumble worldwide” 23 May, both www.ft.com ) .   What are the implications for this renewal in financial market volatility?  What will its impact be on Latin American economies and polities?

Cheap access to international capital and a commodity boom have together generated new possibilities for Latin American nations – power for resource rich states (e.g. Venezuela), financial independence for previously highly indebted emerging market countries (e.g. Argentina and Brazil who have paid off their debts to the IMF early), suggestions of new possibilities of regional trade relationships (an expanded Mercosur with Venezuela as a member instead of the FTAA) and the possibility of enacting policy which was previously impossible given Washington’s stranglehold on the range of policy debate in the region (e.g. Bolivian nationalisation of the gas sector).  

Some economists have argued over the past months that the economic conditions underlying these policy and political changes signified a structural break – that the international economy had reached a new equilibrium point where commodity prices would remain higher and greater sophistication on the part of emerging market investors would mean that risk rates would stay lower (when coupled with the regions improving macroeconomic performance).  Caution, as always, should have been the order of the day, as the recent fall in equity prices and flight out of emerging markets has shown.    Latin American spreads, unfortunately, have no where to go but up.  The same can be said of other emerging markets, as the performance of Turkish assets has shown in the past several days.  Since market behaviour is driven, many would argue, to a large extent by psychology – the collective feeling that things have been too good and volatility and risk must return to the markets – it would not be surprising in the least if the current sell off continues, and spreads to different assets (including commodities) and countries (including many in Latin America).

Does this mean that the policy and political changes these economic conditions have facilitated will change?  Not necessarily and not immediately, though one very likely outcome is that Latin American politics will again become a major driver of financial market volatility and risk.  With the region on tenterhooks awaiting more news on the electoral prospects of left / populist parties and decisions by recently elected governments on nationalisation and energy policy, the falling risk appetite of global investors is exceptionally problematic.  Political events and domestic politicking have an unusual capacity to channel contagion and generate a strong market reaction because of the unpredictability of political events and the instability that politics generates.  For example, in the past week, domestic politics in Turkey facilitated Turkey bearing the brunt of reduced investor appetite for emerging market assets.  Latin American politics, especially at the present moment when the realm of policy debate is so broad, is likely to strongly affects financial market volatility, and longer term measures of credibility (see ODI Opinion by Lauren Phillips in January 2006 www.odi.org.uk/publications/opinions/index8.asp ). 

Lauren Phillips