Brexit, political risk and emerging markets

26 June 2016

Emerging markets have long suffered from a fundamental flaw. They do not offer sufficient political, institutional and constitutional continuity. That has made investing there to be perceived as more risky. Regime shifts, ad hoc changes to the rules of the game, coups all have contributed to the perception that emerging markets are unreliable and unpredictable. The U.K. now offers a similar treatment. Political risk is now greatest in Europe.

The U.K.’s referendum result to leave the E.U. (Brexit) affirms that populist movements in E.U. member countries pose considerable risks to political stability. Brexit means a profound change to prevailing rules, conditions and benefits of investing in and conducting business with the U.K. The long held view that disruptive changes due to political risk are largely confined to emerging markets no longer holds.

The process of implementing Brexit threatens to be an arduous and time-consuming affair. The new regime for the U.K has to be known promptly. Otherwise, Brexit will unduly prolong uncertainty exacerbating investor sentiment generally. The separation process from the E.U. should therefore start immediately. The wait for a new Prime Minister to be elected at the Conservative Party Conference in early October already poses an unacceptable delay. The E.U. also has to signal swiftly that lessons will be learnt from Brexit and that needed reforms are under way.

Brexit is unambiguously bad for the U.K. and the E.U. It may therefore lead to a general retrenchment of investor risk appetite in the short term. It may now delay the global economic recovery. In the short term, this is likely to undermine in particular investments in emerging markets.

In the medium term, Brexit should lead investors to recalibrate perceived risk of emerging markets relative to advanced economies. If emerging markets are not riskier politically then prevailing risk premia on emerging markets relative to advanced economies are too high.

The direct effects of Brexit are similarly likely to be positive for emerging markets. As the U.K. has been running large trade deficits with the E.U. above all and is unlikely to be able to sustain those after the regime shift implied by Brexit, needed payments adjustments will affect the E.U. significantly more than the rest of the world (see also February 2016 Newsletter).

Brexit for all its foolishness may help teach a vital lesson, namely that advanced economies like any other economy are susceptible to considerable policy errors. Brexit brought forward the convergence between advanced economies and emerging markets from an ungainly direction. When it comes to political risk, Brexit is the new benchmark.