David Lineham, Political and Financial Risks Underwriter — AEGIS London.
Heisenberg’s uncertainty principle, popularised by the famous TV series Breaking Bad, is one of the most famous ideas in physics. It tells us that there is a fuzziness in nature, a fundamental limit to what we can know about the behaviour of a particle. The most we can hope for is to calculate probabilities on where things are now and how they might behave.
From the vantage point of a political and credit risk underwriter in EC3, the wider world has not looked this uncertain for some time. North Korea’s nuclear brinkmanship, a seemingly revanchist Russia, Brexit, heightened Middle East instability, rising US interest rates and the winding down of quantitative easing in the US - the list could go on. So, with these themes in mind, where in 2018 might we look for opportunity? And does political uncertainty necessarily mean losses on insured risk?
Prognosis is complex
When it comes to corporate and sovereign debt, which now constitutes the mainstay of PRI market income, the prognosis for 2018 and beyond is complex. In some respects, the commercial political risk and credit markets came of age in the wake of the Global Financial Crisis (GFC). Significant claims activity saw the key non-payment products thoroughly road-tested, enhancing their appeal in the eyes of bank clients in particular. It also broadened the client base, with government and state agencies increasingly active once they became aware of the commercial political risk market’s capabilities and appetite.
Ironically, it is this area that is now most vulnerable to pressures building in the system. Rising US interest rates bring potential for increased stress on emerging market corporate and sovereign balance sheets. Recent high-profile defaults in Mozambique and Azerbaijan point to the pressures already being felt as a result of a prolonged commodity price slump. Angola too has recently made noises about renegotiating its debt. Should interest rates rise significantly in the coming year to 18 months, it’s hard to see others not joining their ranks.
Why is this?
Post GFC, investors attracted by the higher yields in emerging markets were keen to lend, leading to significant capital in-flows to emerging markets. But rising US rates and improvements in treasury yields may well reduce that flow to a trickle. Combine that with higher US$ debt repayment costs as local currencies devalue against a stronger dollar, greater re-financing risk as lenders get better yields closer to home (and the potential for a strengthening dollar to depress commodity prices thereby reducing hard currency earnings) and it’s surprising that more countries aren’t defaulting; the Tequila and Asian crises of ’94 and ’97 stand as ominous precedents.
Markets more resilient but China is the swing factor
Potentially, these “missing defaults” are because emerging markets may have become more resilient: a structural shift resulting from less pro-cyclical policies resulting in less aggressive credit boom and asset bubbles. Also, prolonged low and stable interest rates have been supportive of debt-servicing nations. Another factor at play here is that much of China’s bilateral debt does not feature in World Bank data and thus defaults or longstanding arrears may simply be disguised. Whatever the answer, what is less clear is whether or not such seemingly benign default activity will survive a hike in US interest rates.
It seems inescapable that a meaningful hike will bring additional pressures. How destructive they are remains to be seen and will depend on the other imponderable at work here: China.
Since the GFC, China alone contributed around a third of global growth and its dizzying growth – driven largely by investment – almost single-handedly drove the commodity “super-cycle”. Perhaps with an eye to the recent Chinese Communist Party’s quintennial congress, GDP has been maintained at a solid 6.8% in 2017.
If China pulls off the trick of re-balancing its economy towards consumption and avoids its “Minsky moment” what will this mean for commodity prices? Would the twin impact of rate hikes and a slow-down in China growth be the tipping point for emerging market sovereigns and corporates? As was clear from the scale of the policy response to the GFC, governments and regulators have powerful levers they can pull to moderate the impact of such trends. Even so, it seems unlikely that Africa in particular will come out unscathed.
Demand rising as market rebalances
Looking beyond payment risk and debt markets, widespread political turmoil and uncertainty has driven renewed interest in investment insurance. Cross-border investments and trade are seen as increasingly vulnerable to capricious government action and the threat to fixed assets from the overspill of political violence is keenly felt by multinational corporations.
As a result, demand for political risk products has been on the increase, and yet encouragingly, this has not necessarily led to a corresponding spike in claims. For example, the imposition of sanctions on Russia and the cooling of relations has not led to either expropriatory behaviour or financial default on cross-border obligations. As always, the headlines tell only part of the story in this class and opportunities remain in spite of sometimes fractious political relations.
Against this backdrop, the market now has access to a broader range of business, both in terms of product type and geography, ranging from supply chain finance to 15-year project finance by way of real estate. Facultative reinsurance of export credit agencies and multilaterals, always a feature of the market, has matured and grown significantly. As a result, whilst commodities will continue to loom large in most portfolios (and we are witnessing something of a pick-up in key sectors), we believe the potential is there for the market to re-balance somewhat towards OECD credit and contract frustration and away from over-dependence on particular regions or sectors.
As Heisenberg theorised, it’s all about calculating the probabilities.
First published in Insurance Day 16 Jan 2018.