Modeling geopolitical risk

February 20, 2016 09:00 AM

The year 2015 was marked by powerful geopolitical and economic events, some foreseen and some unexpected. Terrorism rocked soft Western targets, raising the stakes on how the world combats ISIS. Falling crude prices continue to threaten economic stability in oil-producing nations, while the Swiss National Bank fueled the collapse of several hedge funds by lifting its peg to the euro. 

With so many challenges facing the world, Modern Trader sits down with Christopher McKee, CEO of PRS Group, which provides country and political risk forecasting from a quantitative-based perspective.

Modern Trader: Explain your firm’s models and how they are different from a more qualitative approach to risk.

Christopher McKee: PRS uses two proprietary models for assessing risk. One of the models, Political Risk Services (PRS), was developed almost 40 years ago in conjunction with the Central Intelligence Agency (CIA), the U.S. State Department and several professors from Syracuse University. The other model, the International Country Risk Guide (ICRG), began as a well-known publication called International Reports in the 1980s, and was widely read by investors interested in emerging markets.  Over time, both methods have been modified to reflect new and emerging country risks, and both have been backtested by a number of independent sources for their predictive value and correlation with various asset classes.

A good portion of both models incorporate widely accepted economic and financial data and in-house modelling, so the qualitative element naturally is absent here. However, when it comes to assessing political risk, the qualitative element is disciplined by a range of probabilities, risk bands and qualifying criteria. As such, PRS provides regime forecasts using probability analysis and assigns letter grades to the likelihood and impact of 11 types of government intervention on business and investment. ICRG focuses on [more than] 20 political risk metrics, combined with quasi-Type II forecasts.  The forecast periods range from one to five years.

MT: One of the most important geopolitical events over the last decade was the Arab Spring. How well did you anticipate events across the Middle East?

CM: The Arab Spring was an event where my firm appeared to be ahead of the curve.  Our analysts were sending us reports of disturbances in parts of Tunisia that were related to unemployment and government corruption that were then reflected in ICRG’s quasi-Type II forecasts. Over time, more countries in the Middle East began to reflect this trend and our ratings and forecasts were adjusted accordingly. So we had a built-in mechanism for registering these apparently ‘minor’ incidents that ultimately had a significant impact on the political and economic complexion of much of the region. 

MT: One of 2015’s biggest shockers was the Swiss National Bank electing to remove its peg from the euro. How can you assess possibilities of events that no one seems to anticipate? 

CM: We track currency movements for all of our 140 countries and focus on those factors that tend to influence those movements. Given where the euro was going and given the nature of the Swiss economy, what the central bank did was not too surprising.  Historically, currency pegs have been removed quite often, especially during times of significant economic dislocation. We saw it during the Asian crisis of the late 1990s, and later during the commodity boom of the mid-2000s when a number of countries were openly toying with discarding their peg with the U.S. dollar as the greenback was losing ground against other hard currencies.

MT: Earlier this year, Jim Rogers suggested that North Korea and South Korea might unify during this decade. How do you quantify such an event probabilistically? 

CM: We would look at the probability of reunification the same way – and using the same risk metrics and data – as we would any other significant political event.  For the most part, events such as these tend to have stages or ‘building blocks’ that direct our conclusions. It’s also important to note – and our methods capture this – that political and economic events can operate at opposite ends of the risk spectrum, as it were, with countries displaying rather favorable economic risk characteristics but very unstable political risk features.  And this can carry on for some time. 

What is happening in the Koreas – perhaps this is what Jim was referring to – is that you have a well-developed economy residing next to one that appears to have considerable potential given its proximity to China and other Asian economies. However, the political levers need to align themselves to, in some ways, give a sense of political legitimacy to what has been happening in the voluntary sector.

MT: Explain how economic and political risks are assessed differently.

CM: Politics and economics don’t necessarily work in tandem. Many countries in our universe have very low risk ratings as it affects their economies: Growth is generally good, inflation is benign, they don’t run huge budget deficits and external foreign debt is manageable. However, these same countries often display very high risk scores when we look at their political systems: There are ethnic and religious tensions, they [don’t have Democratic institutions], dissent is not permitted, etc. But they can have very strong, perhaps dictatorial, governments that contain these pressures. At least for a time.  The nature of our rating and forecasting methods forces us to be aware of these nuances. The media often miss these differences.

MT: Give examples of countries that have low economic risks but risky political profiles.

CM: There are quite a few that come to mind. In the Middle East, Algeria and perhaps Saudi Arabia; in Africa, Cameroon and Gabon have relatively good economic and financial risk profiles but less-than-ideal political risk ones. And in Latin America, both Paraguay and Cuba appear to fit the bill.

MT: It’s war-torn and politically unstable countries like Libya that are difficult to get reliable information on. How do you go about collecting data, analyzing it and ensuring you have the complete picture?

CM: The data collection is no different for Libya than it is for any other country. We rely on our analyst reports and in-house expertise. Some of our clients have exposure there and they provide us with feedback. For parts of our risk assessments we rely to some extent on official documents and reports from international agencies, [non-governmental organizations], and so on. But that is just part one of two steps. 

Obviously, we don’t take every perspective at face value. What we look for in our analysts are highly educated political scientists, economists and financial analysts that also have experience ‘on the ground’ as it were. They must have dealt with various financial transactions, foreign direct investment, lending, for example. What’s key is how our analysts interpret the data and events before them and how they make it meaningful for our clients, whether they be hedge fund traders, bond portfolio managers or corporate risk managers.

MT: What risks are tied to Libya?

CM: At the moment, the country is pretty much ungovernable – at least to the extent that there is no real, effective central authority that can exercise control over the entire territory.  A civil war has been going on for some time, territories being held often shift. This does not make for a predictable or stable investment climate.

A summary of McKee’s China Risk Assessment, “Big bubble in brittle China,” can be found on page 37. McKee also provides a summary of his Libya risk report, (see “Libya: Peace Talks in Jeopardy,” page 36). 

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About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.