Why are economic and financial actors indifferent to geopolitical tensions?

Michel Foucher highlights that geopolitical risks reveal an unconnectedness between the real economy and the financial sphere.

October, 2014, by Michel Foucher, in CFJC-investments: “How do geopolitical risks affect investment choices?”

Words carry meaning, particularly when they are spoken by the President of the European Central Bank. He delivered his plea for a more active and coordinated budgetary policy, backed up by a European political union to drag the continent out of stagnation, at the annual summit of the world’s top central bankers in Jackson Hole (Wyoming, 22 August 2014); his criticism of overzealous austerity certainly made people sit up and take notice. His appeal was echoed by Benoît Coeuré and Jörg Asmussen (in a joint piece published in Paris and Berlin on 19 September). In his previous speech (Frankfurt, 7 August) Mario Draghi had mentioned “heightened geopolitical risks” which “may have the potential to affect economic conditions negatively, including through effects on energy prices and global demand for euro area products”. In both cases he continued his strategy of “forward guidance” for investor expectations” by presenting criteria for monetary policy, expanding them for the very first time to include a factor that is neither economic nor financial. In its report on Regional Economic Prospects, the EBRD also emphasised the threat to the peace dividend resulting from the end of the Soviet Union should Russia’s neighbouring states react to the “new geopolitical risks” with a significant increase in military spending. Lastly, the OECD highlighted in its interim report (15/09) the short-term “geopolitical risks” that could have a negative effect on the economic upturn in the Eurozone: tension in Ukraine and the Middle East, and uncertainty in Scotland. What are investors to make of the fact that Europe’s core institutions have identified the rise of these risks in concert? Are we to judge that naming these geopolitical risks is sufficient to curb them? How should we interpret the seemingly paradoxical indifference of economic and financial actors to geopolitical tensions, as if the two spheres – the real economy and the international political system – were unconnected? No sooner had the uncertainties been resolved in Scotland than they shifted to the quarrel between Madrid and Barcelona over the legality of the upcoming referendum. The ink had barely dried on the comprehensive free-trade agreement signed in Kiev on 16 September when Karel de Gucht, the EU Trade Commissioner, Alexey Ulyukaev, the Minister for Regional Development of the Russian Federation, and Pavlo Klimkin, the Ukrainian Foreign Minister, agreed four days later in Brussels to delay its implementation until the end of 2015. The Kremlin has thus formalised its right to intervene in Kiev’s policy towards the European Union. Even the constant tensions affecting oil-producing countries in the Middle East (Iraqi Kurdistan, eastern Syria) and Libya, as well as Iran and Russia (via sanctions), have not stopped the slide in the crude oil price, with the market in overproduction due to the economic downturn and the decreasing dependence of the United States (estimated at 30% in 2014 compared to 60% on 2005). The financial sanctions imposed on Russian oil companies will take some time to bite. In the past the interaction worked in the opposite direction. Major geopolitical changes had a positive effect on the economy: the transformation of China beginning in 1978, followed by its membership of the WTO; the rise of eastern Europe after 1989; and the end of the Latin American dictatorships. Over the last two decades or so, the markets have responded primarily to economic shocks and stimuli instead (the 2008 crisis and the policies of the Fed and the ECB).

Yet geopolitical change is underway, sparked by economic change. The pursuit of the Chinese dream so dear to President Xi Jinping is evident in its ambition to establish a new China-led regional order in East Asia. One manifestation of this are the maritime tensions between China and Japan – between a revisionist power and a country fretting about a loss of status – which has resulted in a 50% drop in direct investment in 2014 and a fall in exports by Japanese companies. Japan is now actively looking for new markets and investment opportunities in India, Africa and … Europe. Russia, whose reputation is tarnished by its weak legal system, its tendency to resort to armed interventions and forecasts of declining foreign (western) investment, is examining economic models based on greater self-sufficiency to make up for a lack of imports, which have been hit by the Kremlin’s counter-sanctions and retaliatory measures. To circumvent Western sanctions Russia is turning to China, Turkey and Brazil. In the Eurozone the ECB began its first attempt at large-scale loans (at very low rates of 0.15%) to the banks in early September, but the initiative has not met with the expected uptake. A second offer of 400 billion euros will be launched in December 2014. Mario Draghi sees this as a decisive moment and he hopes that the banks will show greater enthusiasm this time around (hearing before the European Parliament’s Economic and Monetary Affairs Committee in Brussels on 22 September 2014). The ECB cannot do everything on its own, however. What EU member states can do to back up these unorthodox measures, which have proved so effective in the United States, is to implement structural reform policies and an economic stimulation package designed to curb deflationary risks. A political pact on these two issues between Berlin and Paris would be very helpful. The United States are expected to raise interest rates in mid 2015, a few months after the end of the Fed’s asset purchase facility (this October). If, on the other hand, the European Union cannot emulate its American ally’s economic recovery, remaining mired in persistent deflation due to a lack of concerted and coherent economic policy by its largest members and the new European institutions, it will be difficult for the EU to act as a geopolitical force at a time of mounting challenges on its borders. We are witnessing a fragmentation of the global economy into less cooperative regional groupings, and this can only be harmful to global economic growth. Should this process continue, investors would be well advised to adopt less risky strategies. The Eurozone states may show weaker growth than elsewhere and they may have some disputes with their neighbours, but they do offer an internal political stability that is favourable to long-term investment (notably in R&D and infrastructure); that is equally true of the integrated North American area (United States, Canada, Mexico).