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The war in Ukraine has crystallised the geopolitical risk premium

What’s behind this disconnect between political analysts’ diagnosis and investors’ decisions? The explanation undoubtedly has to do with the individual beliefs of decision-makers: ultimately these play a decisive role in long-term investment choices. Although the US-China clash had been noted and discussed, it was no doubt not completely credible to the whole of the business community because it was not yet (at least not sufficiently) reflected in the reality on the ground – apart from in the trade war and the ramp-up of economic sanctions (which you might think would be evidence enough…). So, while some industry segments in China were affected, the overall view of the country was not. Up until 2021, this slow increase in geopolitical risk was not enough to offset the appeal of the Chinese market for direct investors, with short-term gains helping drive long-term strategic priorities.

However, beliefs are now shifting fast: the war in Ukraine has starkly highlighted what is ultimately at stake when it comes to major geopolitical risks. Such risks have suddenly become a powerful tool for reshaping the investment universe, because what we are dealing with is no longer “just” a shock but a new long-term risk universe. In this way, the war is also shifting investment expectations worldwide, well beyond the bounds of Europe, simply by broadening the range of possibilities. The “what if” advocated by Max Weber in his practise of historical sociology is regaining its relevance as a risk assessment method. Ultimately, then, this war has (unfortunately) crystallised the geopolitical risk premium, which had previously been so difficult to clearly identify – except in the volatility of the sovereign spreads and exchange rates of certain countries regularly affected by geopolitics, Turkey being one example.

Beliefs and the effects of geopolitical bias have driven long-term investment choices

Behind the decision by most direct investors not to align their strategies with the signals emanating from the geopolitical sphere lie beliefs about how much stress geopolitical risk can really generate. However, undoubtedly also at play is the still widespread conviction that the US hegemonic cycle could be followed by a Chinese cycle. “China has already won”, wrote Singaporean political analyst Kishore Mahbubani in a 2020 headline. He explained how, in the competition between China and the US, while the latter retained its lead in many areas, China was scoring more long-term points because it was making fewer mistakes than its rival on the other side of the Pacific. The fact that a good number of western investors absorbed this underlying geopolitical scenario of a Chinese “win” into their collective beliefs was also underpinned by the world’s unquestionable demographic tilt towards an Asia that was seen as having China at its core – an argument which, at the time, won out over the weakness of Beijing’s growth model, however visible that may already have been.

Barely two years on, it’s worth cautiously questioning Kishore Mahbubani’s conviction, not only in light of the western strategic realignment that will henceforth influence companies’ choices (because, in the event of conflict, businesses will side with their own country) but also because of the obvious weaknesses of China’s economic and political model. To what extent could these factors eventually translate into a more lasting loss of power that would give the US the upper hand in the hegemonic struggle? While it’s still too early to answer that question, it’s clear that, in terms of the global balance of power, China is likely to emerge much weaker than expected from Covid. Furthermore, if investors adopt this idea and change their expectations in favour of the US, this could have a self-fulfilling effect on direct investment flows over the next few years.

Lastly, let us keep in mind a few lessons from history, in particular the idea that hegemonic transitions are always times of not only great uncertainty and growing global conflict but also strategic surprises. Consequently, the scenario in which one hegemonic power (in this case the US) is replaced by its designated competitor (namely China), for example on account of an increase in China’s share of global GDP, does not line up with either historical experience or the true complexity and slowness of a hegemonic transition… Shifts of power are about much more than something as simple as GDP because they involve both hard and soft power. So what we’re currently seeing could just as well be the birth of a new US cycle as that of a world divided into blocs or, above all, much more complex scenarios of fragmentation that will likely result in a multipolar global power structure.

Lastly, another lesson history teaches us is that there can be no lasting hegemonic transition unless the new dominant state is able to offer a new social contract based on choices, values and a collective imagination shared by a majority of citizens. After the war, it was as much the American dream as military power that served as the basis for the hegemonic cycle. Furthermore, it is in this area of dreams and individual projection that Russia – like the USSR before it – has always failed to offer an alternative. Building a hegemony involves positive momentum, not just a struggle for power. The dominant power needs a modicum of legitimacy to be able to impose its regulating standards and principles and thus restore a form of stability to the global system of international relations.

Controlled inflation thanks to subsidies

Compared with the rest of the world, inflationary pressures have been kept in check in Indonesia. Price inflation has quickened, rising from 2.1% year on year in February to 2.6% in March, very close to the level of core inflation (2.4% in March), which remains within the central bank’s target range (3% ± 1%), enabling the latter not to hike interest rates (4%) despite US monetary tightening.

In reality, this is the result of a policy of subsidies and price control for both energy (coal, oil) and food (cooking oil, sugar, soya, eggs). This policy, hitherto financed by the higher prices of exported commodities (coal, palm oil, metals), has enabled the country to consolidate its foreign currency reserves (enough to cover around eight months’ imports) and build up a record trade surplus ($39 billion).

The freeze on palm oil exports (which account for around 10% of Indonesia’s total exports) is thus depriving producers – and, above all, the state – of considerable inflows of foreign currency, while Indonesia is also dependent on the outside world for some commodities (notably oil, soya and wheat).

An imperative: the golden rule of fiscal policy

This is a difficult circle for President Jokowi – whose approval ratings have fallen sharply and who has a multitude of constraints to reckon with – to square. Supposing the export ban fails to bring down palm oil prices or inflation surges through other channels, the subsidy policy could also run afoul of fiscal principles enshrined in Indonesian law, which lay down a golden rule according to which the budget deficit may not exceed 3% of GDP.

While this rule was bent in 2020 to finance exceptional Covid-19-related measures, the Finance Act calls for the deficit to be brought back below 3% by 2023. In 2021, the deficit came in at 4.65% of GDP, well below the official estimate of 5.7%, thanks to a big increase in receipts linked precisely to the export sector.

Investors are keeping a very close eye on the country, long considered one of the “usual suspects” ever since the 1997 crisis and the rescheduling of both public and private debt. Another potential cause for concern is the overly lax use of monetary policy (monetary financing of the deficit), which raised questions among analysts during the Covid-19 crisis. The government is thus determined to do everything in its power to avoid setting up a vicious circle in which a reversal in the trade balance could put exchange rates under severe pressure, forcing the central bank to intervene.

Indonesia – which, relatively speaking, has less debt than its neighbours, with public and external debt of around 40% of GDP – is not the country most at risk of such a reversal. The fact remains, however, that such a nightmare scenario would further undermine the Indonesian economy, which still bears the scars of past crises.