Aon's Political Risk Quarterly 2017

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17th October 2017

We have seen an increase in the overall risk rating of Togo—whereas political violence has increased modestly, taking the overall score to high from medium-high.

Hurt in part by continued weakening of oil revenues and low ability to cope with the shock, overall risk in Chad has increased as the country’s external financing outlook has weakened. Chad is among several oil producers still facing financing challenges. Its risk score is now very high.

The Solomon Islands experienced an increase in political violence, taking its overall score to high from medium-high.

Barbados has also experienced an increase in its overall risk rating to a medium level, up from medium-low. Although the country’s institutions and governance remain strong, the fiscal outlook has deteriorated amid an increase in the debt and deficit. This has increased sovereign non-payment risk modestly.

In Egypt, the improvements we noted in some of the sub-factor scores have continued to materialise, particularly on the economic and financial front, as foreign investors flood into the country. Nonetheless, security risks remain high and the devaluation is adding to inflationary pressures and hitting consumer purchasing power.

Similarly, despite some domestic policy improvements, Iran’s political risks remain high, especially in light of challenges raised from the nuclear deal between both U.S. and Iranian officials. While abandoning the deal remains a risk rather than a likely outcome, the uncertainty surrounding policy implementation and the divergence between U.S. and other countries’ foreign policy toward Iran undermine the investment outlook.

Finally, the devastating hurricane season has confirmed the sizeable risks of supply chain disruption in the Caribbean territory – affecting countries such as Antigua and Barbuda, St Martin and Puerto Rico among others. While we haven’t changed sovereign risk ratings for any of these countries, the recurrent risks highlighted the importance of assessing resiliency to recover from shocks or to hedge risks. Wealthier countries with stronger institutions and governance differentiate the region. Supply chain disruption remains a meaningful regional risk even for the strongest countries, which tend to be reliant on imports. In the period of rebuilding, other sources of institutional and regulatory risk are likely to increase.

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Political risk ratings in Asia have remained stable overall, as increasing political tensions in Northeast Asia have been partly offset by a reduction in economic risks. This economic improvement stems in part from a revival of trade and economic activity.

We address some of the risks from the increasing tensions around North Korea in this month’s Special Feature. The intensifications in economic sanctions on businesses trading with North Korea, combined with military drills, have augmented the risk of strategic accidents and escalations. Businesses may suffer from increases in insurance costs.

China’s policy stance remains relatively stable as the government focuses on political consolidation ahead of the 19^th National Congress of the Communist Party this fall. However, the country’s focus on a short-term growth agenda, including construction, has increased the economy’s reliance on credit. This strategy brings a risk of economic deceleration in 2018 as debt service costs increase and political grievances rise.

Domestic political issues in Asia, while generally manageable, are dampening reform prospects in Malaysia, the Philippines and Indonesia, among other countries. Moreover, increased military spending and nationalist sentiment in East and Southeast Asia have the potential to escalate cross-border disputes.

In the Philippines, the Rodrigo Duterte administration has adopted largely supportive economic policies including targeted lending and other stimuli. These measures have come at the same time as a weakening of the trade outlook, contributing to a widening of the external deficit, which has left the Philippines more reliant on remittances and its past savings., Overall political risks have increased as a result of the crackdown on the illicit drug trade and environmental regulations remain a source of uncertainty for the mining sector.

Meanwhile, recurrent rounds of economic reforms in Indonesia have done little to alleviate foreign investors’ concerns about nationalism. The country’s growth rate remains moderate, but investment is lagging behind consumption. We expect a greater push from the government to encourage investment.

India remains a relative bright spot in the region, with the government moving towards implementing much-needed reforms and a focus on infrastructure in the current budget. The negative hit from the implementation of demonetization has faded, while the Goods and Services Tax implementation seems to have gone smoothly. The ruling Bharatiya Janata Party has increased its share of votes in various local elections, bolstering its position in the legislature. Despite its small majority, the government should still be able to push through key reforms, which could provide some certainty for investors.

There have been minor changes in the region’s country risk ratings, mostly positive, with the exception of Belarus. No country experienced an outright change in its risk rating. The high levels of political risk across most CIS and Caucasus countries will persist, mostly due to weak (albeit improving) economic outlooks, and despite the tentative settlement proposal for Ukraine’s crisis. Low oil prices will prolong economic strains, even as the large economies of Russia and Kazakhstan recover and become less of a drag on regional economic activity.

While they are unlikely to have much impact on near-term growth, the ratcheted-up U.S. sanctions on Russia will further undermine long-term financing in the energy sector and selected banks amid increased counterparty risk. The trajectory of sanctions will hit medium-term investment, weighing on oil output growth.

Russia’s exit from recession should shore up the income of CIS countries, with risk levels expected to improve further as investment and remittances recover. Stronger growth has already helped lower sovereign non-payment risk in Kyrgyzstan and Tajikistan, where exchange transfer vulnerability has also moderated. Reduction in inflationary pressures (and thus an increase in household purchasing power) will serve to lower political risk.

Ukraine’s economy appears to be improving but the slow pace of IMF-mandated policy improvements is sustaining the high sovereign non-payment and exchange transfer risks. Even before the High Court of London ruled against Ukraine with respect to its 2015 Eurobond default, the country’s debt looked unsustainable, suggesting that another restructuring might be required once the current IMF program ends in 2019. Meanwhile, beyond economic risks, persistent regulatory uncertainties could increase operating costs, and bank recapitalization perpetuates counterparty risk.

The loans from Russia are unlikely to solve Belarus’ financial vulnerabilities, which will continue to weigh on the banking sector and limit the government’s ability to provide economic stimulus. Political risks remain high, along with the high risk of doing business which is hitting investors.

Ahead of a busy election season, political risk is beginning to rise again in Latin America and the Caribbean despite recent institutional improvements in Argentina, Brazil and Colombia. In part, this increase in risk reflects weak economic growth, low investment and the political pressures these factors generate. The remainder of 2017 and 2018 will bring a series of extensive elections across most of the region’s economies, which will limit the implementation of reforms in the near-term. We see the ruling parties in Mexico, Brazil, Chile, struggling to maintain ground. There are some signs that upcoming elections will increase the government’s mandate in Argentina, which is looking to push through some reforms as part of its 2018 G20 leadership role.

On the margins, Latin America is engaging in some moderate institutional reform. However, external risks (notably U.S. trade and security policy), as well as the upcoming electoral cycle, suggest that the implementation of these reforms is uncertain. Only in Venezuela (already a very high-risk country) are political risks rising rapidly, exacerbating the country’s already weak credit quality.

In Brazil, President Michel Temer has been able to maintain his power despite being implicated in recent corruption scandals. These legal proceedings have implied delays in passing some of the government’s key fiscal measures. The Petrobras and other corruption investigations (such as the “Car Wash”) continue to threaten Brazil’s investment recovery at the same time that major parties are beginning to position themselves for the 2018 elections. This suggests that key reforms, such as the pension reform, may be watered-down, if they are passed at all.

Argentina’s country risk rating should also continue to improve as the government works to adjust the macro policy mix. Inflation remains high and the upcoming legislative elections suggest that major fiscal moves are unlikely until 2018. In turn, this will limit new investment, including in the energy sector.

In Venezuela, the already very high political risks keep rising, with domestic political stability deteriorating and economic risks increasing. Although President Nicolas Maduro has managed to cling to power and to make good on his debt payments, Venezuela’s lack of political and social stability keeps regime change a risk. This scenario has been even more exacerbated with the imposition of the recent constituent assembly by Maduro’s government. The new round of U.S. sanctions will add to financing pressure and will likely make the impending debt restructuring much more difficult. Government intervention and massive shortages make investment for foreigners a near impossibility already. .

Following the implementation of a peace deal and fiscal reforms, Colombia’s political risk has moderated. Growth remains weak, and there is little opportunity for the authorities to stimulate the economy. Colombia seems resilient to regional risks, including to the chaotic situation in Venezuela. Overall, we expect economic fundamentals to improve in 2018.

The MENA region contains some of the highest-risk countries in the world, with heightened political risk and elevated political violence (these include Iraq, Syria and Yemen, and also countries in North Africa) spilling over to neighbours, undermining trade and tourism. Slow climbs in oil prices will sustain economic vulnerability and reinforce sovereign non-payment risk, with weak government spending continuing to weigh on growth and consumption even as payment arrears become less endemic. These trends reinforce the importance for investors in assessing individual country risk amid rising levels of debt.

In the region’s richer economies, notably the GCC countries, economic strains remain. We expect economic and credit conditions to ease slowly only into 2018, implying continued pressure on the private sector. The dispute between Qatar and its neighbours has raised concerns about the country’s currency peg, lifting exchange transfer risk, despite Qatar’s large asset war chest minimises risk of sovereign non-payment or de-pegging. So far, the country has drawn on its existing financial assets and has been quite resilient, facing only modestly increasing political risk.

In Saudi Arabia, a material improvement in revenues is unlikely before 2018. Meanwhile, the country’s proximity to terrorism will aggravate domestic political tensions also as austerity lingers. In general, risks stemming from regional proxy conflicts will keep the government’s focus on military and security spending, albeit within budgeted limits—capital expenditures will remain slow.

Iran’s political risk remains elevated, with extensive government and military intervention in the economy weighing on investment. Although President Hassan Rouhani was re-elected, the push for economic reform will likely be upset, keeping the operating environment difficult for investors. Still, a rupture of the nuclear deal remains unlikely. While the economic benefits of the deal have been more modest than many in Iran hoped, we do not see Iran exiting the deal and we doubt a global consensus can re-emerge to force Iranian oil production offline. The broadening of sanctions by the U.S. administration will likely have limited impact on Iran, mostly due to lower new investment in non-energy sector.

Energy importers such as Egypt generally have high, but stable, country risk ratings and have benefited from the positive global mood toward emerging market economies. The IMF-supported reforms and associated external flows have boosted confidence in Egypt’s economy and its liquidity, giving the government some buffers to maintain reform momentum, although implementation may backslide if growth is disappointing. The phase-out of FX transfer restrictions should ease exchange transfer risk.

ISIS has suffered a major setback by losing its stronghold in Mosul, but the group has not been defeated and continues to be a highly unpredictable source of regional and global threats. Remnants of the group will likely seek new targets, with the politically fragile countries in North Africa, especially Tunisia—which was a major supplier of fighters—and Libya, looking particularly at risk.

Risk trends remain mixed across the region. As in MENA, low commodity prices will keep pressure on regional producers, prolonging the weakness in economic activity that started in 2016 and has pushed many regional economies into the arms of the IMF. Levels of country risk will remain generally high, reinforced by the complex threats posed by militant groups including Islamic State in West Africa, Boko Haram, Al-Qaeda in the Islamic Mahgreb and al Shabab. These trends will keep military spending needs high, weighing on tourism and increasing the possibility of event risks. The debt scandals in some countries of the region, such as Mozambique, suggest that foreign investors may look more closely before lending to other regional frontier markets.

Among the commodity producers, the slow rise in oil prices is weighing on Angola’s banking sector despite the country’s monetary devaluation process. The operating environment remains very precarious due to high government involvement in the economy. Investors should be prepared for legal or regulatory changes given the power handover from the long-time leader Jose Eduardo dos Santos to his defence minister, Joao Lourenco. In Nigeria, the tiered foreign exchange rate system perpetuates the country’s very high exchange transfer risk, with capital restrictions and an acute dollar shortage weighing on investor interest. The country will continue to prioritize military spending over infrastructure spending, which will likely be sluggish. Nigeria’s recovery from the recent recession is likely to be shallow. In Algeria, the upward trend in oil prices has lowered the country’s sovereign non-payment risk and aided the government’s ability to provide stimulus.

As for the southern part of the region, the South African leadership succession race remains the government’s main preoccupation, with president Jacob Zuma surviving yet another vote of no confidence. None of the possible successors will likely be able or willing to fully break from the current system of patronage and corruption, weighing on growth and investment. Zimbabwe is at risk of factional violence in the absence of a succession plan from Robert Mugabe, this will maintain the country’s very high level of risk amid a lack of reforms and FX inflows.

The nations in East Africa, which have recently received a lot of attention from financial investors and have been outperforming economically, have barely seen any change in risk. Despite the lifting of the state of emergency, the risk of political violence in Ethiopia will remain elevated due to the authoritarian nature of the government. Kenya remains a regional favourite for doing business, although jitters surrounding incumbent Uhuru Kenyatta’s victory in the presidential elections could weigh on growth and external resilience. Mozambique’s debt stalemate will remain a signifier of the country’s risk, as private borrowers write down their liabilities. The sluggish global outlook for coal and natural gas suggests investment will be slow to pick up.

Economic sanctions and other coercive economic policies, including boycotts, have become a frequently-used tool in diplomacy. In the last few months, the U.S. has passed new sanctions on Russia, Iran, Venezuela and North Korea, including secondary sanctions targeting foreign companies investing in these economies or banks providing finance. Meanwhile, Saudi Arabia and several other Middle Eastern countries have imposed economic restrictions on Qatar, forcing it to draw on its past savings and increasing transaction costs. Monitoring these measures and their links to the global economy is crucial for investment in these countries and in assessing the supply chains of key companies and banks in other countries. In particular, diverging policies between the U.S, Asian and European allies are likely to add to the uncertainty for long-term investors and may keep local borrowing costs elevated.

While economic sanctions have been used for some time, they have become more widespread in the last few years, as key economies have sought to influence foreign policy by limiting other economies’ access to financing and trade rather than by utilizing security tools. Thus, investors may monitor the resilience of targeted countries’ balance sheets to assess their exposure, looking at their banks, FX reserves, overall business environments and levels of political violence.

Further economic pressure is likely, as in all key sanctions cases, to affect the targeted countries themselves, and also those that tend to have pre-existing high levels of political risk. In North Korea, the companies investing in and facilitating its trade remains as the most meaningful risk to global and regional investors. Not only have chances of conflict increased, though war remains far from a baseline, but threats to sanction Chinese financial institutions and to engage in major trade restrictions could impact global risk sentiment. Already some reports suggest that insurance costs are going up across parts of the region.

The oil market is the main transmission mechanism for other key countries. Russia, with the lowest level of political risk is also most resilient to sanctions, in part because the economy has already adjusted itself to sanctions and to the oil price shock. However, sanctions have reinforced the inward turn of many Russian companies and have undermined the relative outlook for the private sector, exacerbating pre-existing challenges.

Continuum Ecnonomics' view is that Russia will see only limited economic and market impacts from the new sanctions, as they mostly reinforce previously implemented sanctions. This suggests little impact on the oil output in the near-term (the primary global link) and will keep some major companies struggling to access finance. This may restrain energy sector growth in the medium-term.

Similarly, Iran has adjusted on a macro basis to sanctions, but the measures only reinforce the vulnerabilities posed by weak governance, high non-performing loans and sizeable government and military intervention in the economy. Moreover, the tail risk of the Iran deal imploding and additional sanctions being imposed is rising. These measures will at best complicate and increase the costs for foreign long-term investors.

As for Venezuela, we expect economic pressure to increase, exacerbating its very high country risk rating, and imploding economy. New sanctions will make it even harder for an orderly debt restructuring of its unsustainable debt burden. Outages of oil output are likely to be offset by ample supplies globally.

The economic pressure on Qatar by contrast is fading. Qatar, meanwhile, has been quite able to deploy its cash reserves to shore up its banking system and pay for imports, at the cost of weakening its sovereign balance sheet. Globally, the stress could add to natural gas exports and add to the glut in supply.