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Arab Spring: The return of geopolitical risk

Investors are learning to price in factors such as autocracy premia and remembering that oil and democracy rarely mix easily.

Geopolitical risk is back on investors’ minds, and so it should be. The most geo-strategically sensitive region of the world is entering a period of intense political and economic flux. And the wave of political change and instability could spread out of the Middle East.

The main question for global markets is what it means for the oil price, and consequently the dollar’s strength. What it means for the Middle East’s local financial markets is largely irrelevant to the rest of the world. External debt and foreign holdings in local equity markets are generally small.

Nevertheless, the events in the Middle East have added impetus to recent outflows of portfolio investment from emerging markets. There has been an element in recent weeks of what London brokerage Exotix calls an autocracy premium in bond pricing.

The Arab Spring is a reminder that emerging markets tend to have less-developed institutions; historically, that is what has primarily justified their higher yields.

The smaller and less-sophisticated nature of capital markets and profit-oriented banks in some emerging markets generally is linked to the democracy deficit. In other words, the idea is that liberal democracy in whatever form usually gives – and, perhaps as in Egypt and Libya recently, might result from – a more open, transparent and commerce-oriented financial and economic system.

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