COMMENT: (Mis)understanding risk and the flight to (un)safety

By bne IntelliNews September 12, 2011

Marcus Svedberg of East Capital -

The renewed turbulence in the global economic and financial system has triggered a flight to perceived safety. I say perceived safety, because while investors are piling money into American and German bonds and the Japanese yen, that is actually where the real problem lies. It is the debt levels and souring budget deficits in the western world that constitute the real problems in the global economy, and it is the inability by the politicians to tackle these issues that triggered the last round of turmoil. The facts that the dollar is the dominant global reserve currency, that Germany remains a relatively solid economy and that the Japanese debt is primarily domestic make the discrepancy slightly smaller, but it does not change the underlying notion that something is terribly wrong.

It is also important to look at the other side of the table, ie. what assets investors are dumping in favour of western debt and currencies. It is normally assets perceived as risky, like emerging market equities and currencies, that are sold at times like this, and it has been no different this time around. Again, I say perceived, because the emerging world actually has substantially lower debt and higher growth than the developed economies in the West. But what about inflation? It is often brought up as a big problem in emerging markets and it is certainly higher than in the West - and it should be, since growth is so much higher - but has come down quite dramatically during the past few years and cannot be described as a general risk today.

People used to argue that policies were much better in developed economies, but few would argue that American or European decision-making has been impressive lately, while many emerging economies have sorted out their economic imbalances in rather impressive ways. Emerging Europe has, for instance, cut their budget deficits from an average 6% of GDP in 2009 to an expected 2.5% in 2011, without significant public discontent. One fundamental difference is complacency. American and European politicians believe they can afford to delay the inevitable in order to score simple political points, while politicians in emerging economies do not have that luxury. And to some extent they are right, because investors keep giving western politicians the benefit of the doubt while the opposite is true for leaders in emerging economies. That is warranted in some cases and to some degree as the political institutions are more stable and transparent in the West than in the East, but there is an underlying and serious flaw in the mentality that is based on sentiment rather than fundamentals. This flawed mentality can be illustrated by comparing some key indicators in the three largest economies in Eastern Europe (EE3: Russia, Poland and Turkey) and the three largest Eurozone economies (WE3: Germany, France and Italy).

Exhibit One: Growth and Inflation

The EE3 have grown substantially faster in real terms over the past 10 years and are expected to continue to do so over the next five years. The differences are even starker when looking at nominal growth, which is more important for equity markets, or the growth of standard of living (measured as GDP/capital). Meanwhile, inflation has been more or less constant in the developed economies while it has dropped and will continue to fall in the emerging economies. Average inflation was approximately 2% in the developed economies in 2000, and is expected to remain around that level in 2015, while the number has dropped from 10% to 2.5% in Poland, from 20% to 6.5% in Russia and from 55% to 5% in Turkey between 2000 and 2015.

Exhibit Two: Debt

The EE3 have substantially lower public debt levels than the WE3, and the difference is expected to increase over the next five years. The WE3 had an average weighted public debt level in 2010 that was 90% of GDP, or more than 30 percentage points above the rule they set for themselves in the Stability Pact. Sadly, this is only expected to fall with 1 percentage point over the next five years. In sharp contrast, the average weighted public debt level in the EE3 was more than 30 percentage points below the 60% benchmark and is nevertheless expected to drop more than the developed ratio over the next five years.

Exhibit Three: Politics

The political systems in the developed economies are arguably more advanced and stable than in the emerging ones, but there are factors that make the differences smaller than commonly perceived. First of all, governments that have experienced crises in recent history tend to better prepared to handle new crises. Both Russia and Turkey have been going through several crises over the past decade, and it seems that they have learned some important lessons. Public finances have improved tremendously and the central banks have become more proactive and important institutions. The current government in Russia was not around in the late 1990s, but seems to have learned from the 2008-09 crisis, while the Turkish government has been in power since 2002 when the Turkish economy was deep in recession. The developed economies, on the other hand, have not been through any major crises (at least not one where public or private balance sheets had to be consolidated) in a very long time and the public sense of entitlement is arguably much higher.

Secondly, Polish politics has developed very impressively over the past decade, and scores better than all three developed economies on political stability and is better than Italy in five out of the six governance indictors (political stability, government effectiveness, regulatory quality, rule of law and control of corruption) measured by the World Bank.

Thirdly, one aspect of political stability is continuity, and all of the surveyed countries have had elections or will have elections in the 2011/12 period. The AKP government in Turkey was re-elected very comfortably in May and received its own majority.

The ruling Civic Platform in Poland is widely expected to be re-elected in the general elections in October. And little is expected to change in Russia in the parliamentary and presidential elections in December and March respectively, as the current elite is expected to remain in power. The situation is radically different in the developed economies as the governments led by Merkel, Sarkozy and Berlusconi will find it difficult to be re-elected, while their personal approval ratings are at or close to all time lows. And this is before they have started to implement the domestic fiscal consolidation programs and agreed on how to solve the crisis in the Eurozone.


Taking the growth, debt and political factors together, it seems that rating institutes and the market alike have got something seriously wrong.

The largest economies in Western Europe do not seem overly "safe", while the largest economies in Eastern Europe do not seem overly "risky" as the market suggests. That Germany enjoys the highest rating ('AAA') is perhaps understandable, but it seems strange that France also has it and that Italy enjoys the fifth highest rating ('A+'), while Poland only has the seventh highest ('A-') and Russia the ninth highest ('BBB'). That Turkey has the 11th highest ('BB+') and is not even rated as investment grade is perhaps even more bizarre. This is important as ratings are not only about status.

Investors look at these ratings carefully and there is an effect on the cost of borrowing.

Marcus Svedberg, Chief Economist, East Capital

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