The Empire strikes back – UK business responding to increased political risk?

In a transforming world economy…

The world economy is in the midst of  a once in a generation transformation driven by several developments:

  • the  reduced  availability of credit as a result of the financial crisis means that for many companies  it is more difficult to invest across borders than it previously was;
  • the maturing of many previously low labour cost markets such as China and India has seen their labour costs rise and hence they have become more attractive as markets to sell in but less competitive as production locations;
  • policy change in China is driving a shift to consumption from investment and export led growth with implications for countries exporting either commodities or industrial goods to China;
  • the possibility of exit by the USA from  Quantitative Easing through tapering has already started to disturb the post-crisis economy with money flowing our of emerging markets, impacting currencies and stock market valuations.

…UK business is responding by changing its portfolio…

UK companies and investors are starting to adjust their behaviour and the latest EY Capital Confidence Barometer, the 9th in all, highlights the following trends in UK M&A intentions since October 2011, the time when concern over the Eurozone crisis was reaching a peak:

  • A reduction of  intended M&A activity in the Eurozone by 40% over two years;
  • Increased attention to the USA (up 50% since 2011) and Africa ( a massive sevenfold increase in 2 years) has taken up most of the investment previously intended for Europe;
  • The focus on the BRICS has remained reasonably constant between 2011 and 2013, with a  slight drop off in 2012 from which has bene reversed in 2013;
  • Within the BRICS’ grouping, investment intentions  in South Africa and India have grown over the two years at the expense of Brazil and China;
  • The Middle East has edged up slightly and Latin America and non-BRIC Asia has slipped back.

UK business is adjusting its international  portfolio by increasing its exposure to countries  such as North America, India, South Africa and the Middle East – locations where Britain has had a strong relationship historically. These moves reflect changing economic expectations, such as the recovery in the USA and the continuing problems of the Eurozone, and long-term strategic moves such as the continuing interest in the BRICS despite clear short-term challenges, but they also reflect a changing political environment.

…because political risk is now a major factor in international investment decisions

Capital is , if anything, more likely to be redeployed rapidly today  than prior to the financial crisis. The trends above reflect developments over a two-year period but we have seen significant shifts in-between times as companies monitor economic and financial developments extremely closely. At times in the last year, interest in Europe has recovered then slumped and the BRICS have gone out of favour and then back.

There seems to be  a new force at play: globally, 38% of business leaders have told us that increased political instability is  a major risk – the highest economic risk to investment identified in our CCB survey.

When we drill into the EYCCB findings, we see political risk firmly back on the list of business concerns. In the UK, boardroom focus on corporate governance has increased by 25% in the 6 months and on regulation by nearly 20%. By contrast the focus on growth has fallen. This undoubtedly reflects recent developments such as the political debate over taxation globally and high-profile corruption incidents, and closer to home, the current debate over energy prices and profits.

But it is not just political interference into specific areas that is driving this new attention to political risk. When the world economy was growing rapidly, structural economic weaknesses were either masked or were not issues that investors were not unduly worried about. As the world economy emerges from the financial crisis, growth will be lower and harder to come by and it is this new paradigm that is serving to heighten political risk.

Firstly, governments have less flexibility to deploy resources to buy off certain interest groups and hence head off any social unrest. Popular tools such as fuel subsidies, tax breaks or new flagship projects are now more difficult to fund. We have seen outbreaks of social unrest in 2013 and this has served to remind investors of the risks they may have been less diligent about that they should have been.

Secondly, it is clear that many economies now need significant structural reform: a process than can be both difficult and painful to execute. The most obvious case is the Eurozone but the consensus is that many economies such as India, Russia, Brazil and South Africa all need major reform. So a potential investment cannot be evaluated solely on how value can be added by direct management, acquirers and investors need to evaluate the potential for government to drive reform that will enhance economic growth and hence provide additional incremental growth to any asset.

More diligent diligence

We expect to see more rigorous evaluation of investment opportunities going forward. Businesses tell us growth is on the agenda but it is clear that caution remains high. This is understandable as we enter a new economic age and the consequence will be both more detailed and broader analysis of opportunities, with more consideration of the interplay between political and economic risk. 57% of Uk companies plan to apply more rigour to their analysis of opportunities in emerging markets.

UK business is responding by shifting its portfolio to markets it knows best, those where the UK has strong historic ties and probably more scope to understand the political environment: it is a case of the Empire strikes back.

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