The impact of economic crises in some emerging markets around the world, as well as a possible new financial crisis on the horizon, are causing great concern. Successfully managing credit and political risk is therefore high on the agenda.
Political risk has been high on the agenda for global companies for a while, but the risk is growing, and spreading to developed Western nations as the world moves towards a polarisation of politics, growing nationalism, protectionism, the growing gap between rich and poor, and issues such as immigration and migration, sanctions (especially in the US), and trade wars.
At the same time, there is talk of a new financial crisis brewing from the International Monetary Fund (IMF), among others.
The impact of austerity measures is still being felt globally, and together with issues such as Brexit and trade wars, the risk of suppliers and customers becoming insolvent is a growing concern.
Successfully managing credit and political risk has never been more important.
Key political risks
The world is currently faced with two major political risks: potential economic crises and social unrest. The two are often interlinked, says Eleanor Smith, Senior Political Risk Analyst at JLT Specialty.
“Economic problems are often linked with social unrest. Argentina is an example of this, where a government starts to implement measures to tackle economic imbalances, and then you get social unrest such as protests and strikes,” she explains.
In terms of specific risks, a common theme in requests seen by JLT is around access to hard currency and extrication of profits from emerging markets; contract repudiation by counterparties in developing markets looking to change existing contracts or reneging on payment obligations in the contract; and rescheduling.
Mark Wong, Managing Director, Credit, Political and Security Risks at JLT Asia, says key political risks affecting multinational companies include frustration of contracts arising from unstable/unpredictable political situations, structural economic weaknesses, under-developed regulatory systems and weak judiciaries.
He says these perils are particularly prominent in countries that have not previously been the focus of large-scale foreign investment, such as Bangladesh, Sri Lanka and Myanmar.
"In relation to China’s Belt and Road Initiative (BRI), increasing public awareness of the debt implications of related borrowing has elevated the risk of contract cancellation or renegotiation in key BRI countries,” says Wong.
“Shortly after Malaysia’s unexpected election result in May 2018, work on the country’s largest railway project, the $20 billion East Coast Rail Link, was suspended at the instruction of the project owner Malaysia Rail Link Sdn Bhd (MRL).
“Since then, the government has gone on to cancel several major projects. The danger is that this defiance will spread to other countries such as Sri Lanka and Pakistan, which are struggling to control soaring foreign debt.”
Political risk in mining
One industry that can be particularly affected by political risk is the mining sector.
Harry Floyd, Partner in the mining team at JLT Specialty, says the main risks are unjustified withdrawal of licence to mine, aggressive change to tax, royalty and tariff regimes, compulsory requisition of assets, exchange and border controls affecting ability to pay for/supply raw materials and repatriate profits.
As for countries causing concern as well as presenting exciting development opportunities for the mining sector, he points to Democratic Republic of the Congo (DRC), Argentina, Tanzania, Venezuela, Indonesia and Bolivia.
He also highlights the impact of the trade war between the US and China affecting market access and prices, and political and social instability in South Africa.
Political concern spreads in developed markets
There are a number of developing countries causing concern at the moment, notably Argentina, but also Turkey, South Africa, Brazil, Bangladesh, Pakistan and Sri Lanka.
Demand is always high from developing countries, whether it is across Africa, Latin America and certain pockets of Asia.
However, there is also concern spreading into developed markets, in particular Italy where JLT is seeing more requests coming in and capital flight from Italians leaving the country.
One of the key factors behind the spread of political risk into developed nations is the legacy of the financial crash of 2008.
“Some of the implications of 2008 have contributed to the emergence of political risk in developed nations,” says Smith.
“A lack of inclusive growth and a sense that sections of society, particularly in the UK and US, have been left out of the recovery have contributed to some of the political risk that we are seeing in terms of Brexit, the rise of the right across Europe, and the move towards more populist economic policies.”
Gayle Jacobs, Vice President, Credit, Political and Security Risk Practice at JLT Specialty USA, says: “Elections – depending on their outcome – can naturally lead to changes in foreign policy and, to this end, economic and defence priorities as well as relationships, which directly impact international relations and the global economy at large.
“There is a reason President Donald Trump has been labelled by some as the ‘Black Swan’ candidate – it isn’t just emerging markets that experience highly disruptive, unexpected events that cause significant impact.”
The US-China trade war is having a tangible effect on developed economies, according to Wong.
“Japan’s exports decreased in September 2018 for the first time since 2016 as shipments to the US and China fell away. A recent Reuters poll showed that a third of Japanese companies have been affected by the trade conflict.
“Economic upheaval will always elevate political risk, although this is less likely to be evident in developed countries,” he explains.
New financial crisis?
With some discussion of a new financial crisis on the horizon, are fears justified?
“Possibly, although a number of lessons have been learned since the last downturn in 2008, which should offer comfort here, depending on the political inclinations of the governing leadership,” says Jacobs.
“To the extent that there is cyclicality in the global economy, a recession of some degree may well be imminent, but there are a number of levers governments can pull to manage the impact and severity.
“The US Fed has raised interest rates eight times since December 2015 [even as the Trump administration has cut tax rates], although it has little room to cut interest rates should that become necessary.”
“I’m not sure that the crisis ever truly went away,” says Neil Duchesne, Senior Partner, Credit, Political and Security Risks at JLT Specialty.
“A lot of people got their houses in order, but this is the new reality. There are a lot of indicators that for certain pockets we are teetering on the edge of another shake up.
“Whether it will be as profound as 2008 remains to be seen, but I think that controls are now in place, which weren’t a decade ago.”
He believes that the financial institution industry is more savvy, more robust and better capitalised to withstand another financial crisis.
“It is not the same as 2008, in terms of financial institutions, but in terms of political risk, it is as high as it has ever been for certain exposures. There are certain parts of the world that will face a chastening experience over the next three to four years.”
He says lesson have been learned, especially in developed nations, but for some developing countries, he explains that there is often little they are able to do about it, as they are so impoverished, they have to try to raise cash: “They will get more and more indebted because of the needs of their country. So it is likely to be a more localised crisis, in certain pockets.”
In developed nations, despite government statements that austerity is over, corporate insolvencies are still growing and some sectors, such as retail, are in a very poor situation globally.
And the collapse of a big service provider or contractor such as Carillion in the UK has a huge knock-on effect, with a large number of companies reliant on these big contractors and providers for their lifeblood.
In the US, bankruptcies are down slightly from 2017, although the impacts of trade sanctions could continue to negatively impact certain sectors, particularly those targeted by the latest Chinese tariffs.
In Asia, corporate default and insolvency peaked in 2015/16 due to the commodity downturn in 2015, and in 2017 there was a recovery in corporate default and insolvency rates.
However, Asia is now starting to see the negative spill-over effective of the US-China trade war.
Managing political and economic risk
When it comes to managing the risks, it is all about a company having oversight of all its operations around the world, having access to relevant information on the political and economic risks in countries, and having good credit procedures.
“Most of the bigger multinationals are fairly sophisticated and will have very good oversight of their overseas operations, generally reporting into a centralised hub,” says Duchesne.
“Typically, a lot of them will have Export Credit Agency [ECA] support, and will purchase political risk insurance from the private market. The bigger multinationals will be attuned to the various legal and regulatory frameworks in the various markets where they operate.
“It is the smaller companies that tend to struggle with the oversight of their operations overseas and potentially could run into problems.
“Funds may have lots of little investments in a lot of countries, either directly or indirectly, and they may not have the visibility as to what they are actually exposed to.”
For larger companies, it is about having a structured, dedicated internal unit that will have a very precise knowledge of the countries in which they operate, he says.
Companies cannot mitigate everything, as political risk is often about the unforeseen events, but they can ensure that they are acting as a responsible international investor or operator.
The right insurance cover
In terms of insurance, trade disruption and credit insurance are available to protect against losses sustained by, or resulting from, impacts on suppliers and end customers.
Political risk insurance protects against losses resulting from host government expropriation, selective discrimination, licence cancellation and political violence, as well as protecting against losses from the inability to convert and transfer currency.
As Floyd explains, in the mining sector, multinationals can mitigate the political risks across their group through joint venture agreements with host nations, increased investment into host communities and responsible mining methods, and increased local employment as opposed to employing ex-pats.
He says pro-active management of supplier/counterpart exposure is vital to ensuring that key raw materials reach the mine and product is successfully exported, all underpinned by a well-structured insurance programme.
Wong at JLT Asia says: “With the US-China trade war, we have seen more engagement and mandates with multinational companies on their credit and political risk exposures arising from their international operations and the increased utilisation of credit and political risk insurance products.”
Managing the credit risk and keeping on top of suppliers and customers is all about having robust credit procedures and strong KYC policies, and exploring stresses and strains down the supply chain as far as possible, says Duchesne.
One of the most important elements in managing credit and political risk is for risk management departments to work with finance and credit management departments to come up with strategies.
As Duchesne points out: “For structured credit, we tend to engage with treasury or CFO, but for political risk it will typically be dealt with by the risk manager in consultation with treasury.
“To make it work in terms of mitigating the risks, departments need to work together closely. It needs to be a very collegiate approach when managing credit and political risk. This is not always the case and it depends how empowered the risk management department is.”
Jacobs adds that risk management departments should be working with finance and credit management departments.
He explains: “Risk management has a place in every facet of business, whether formally or informally.
“Credit teams exist to balance the risk associated with opportunity and loss, yet risk management often does not formally engage with the credit function, and it should.
"Accounts receivable are often the largest uninsured asset on a company’s balance sheet, to their detriment.”
World Risk Review
JLT can help its smaller clients understand country risk in more detail using World Risk Review, JLT’s proprietary country risk ratings platform.
World Risk Review provides risk ratings across nine insurable perils for 197 countries.
These perils include: expropriation; contractual agreement repudiation; legal and regulatory risks; currency inconvertibility; sovereign credit risk; country economic risk; strikes, riots and civil commotion; terrorism, and war and civil war.
At the heart of WRR are JLT’s country risk ratings, which are generated by a proprietary algorithm-based modelling system incorporating 277 separate indicators.
Ratings are updated monthly and provide a forecast of the risk environment in the short to medium term.
- Benchmark the risk environment in those countries of interest to them
- Compare and contrast the risk environment within a country across all perils
- Assess historical risk trends and benchmark the risk environment across multiple countries
- Extract the data and graphics generated by WRR to create succinct and bespoke reports; WRR’s format promotes clarity for board-level discussion on exposure to risk and whether insurance is needed.
For more information, please contact Ed Yauch, EVP, Head of CPS, on 914-358-0443.