Risks multiply in a divided world

Strong economic growth in emerging and developing markets relative to more developed economies since 1980 is transforming the global geopolitical landscape. This transition is challenging the status quo established in the latter half of the 20th century, with a wide-range of state and non-state actors looking to establish their identity in the emerging new world order, and acting as a catalyst for new geopolitical risks.

“For the first time since the 18th century, the west is no longer the only center of the world, the west has lost its monopoly of models,” Dominique Moisi, a political scientist and Senior Counselor to the Institute Montaigne, told delegates at Zurich Insurance Group’s Global Risk Management Summit in Edinburgh in September 2017. “We see something like the torch of history passing from west to east. There is a major evolution taking place, an order is giving way to something else.”

To put the extent of this shift in context, in 1980 advanced economies accounted for 63.5 percent of global GDP on a purchasing power parity (PPP) basis, with emerging market and developing economies making up the remaining 36.5 percent, according to the International Monetary Fund (IMF). At that point, China’s economy made up just 2.4 percent of global GDP. By October 2017, advanced economies’ share of global GDP had shrunk to 41.3 percent, while emerging and developing markets constituted 58.7 percent of the world’s economy and China had grown to be the world’s largest economy, accounting for 18.3 percent of global GDP (on a PPP basis).

Over that period, the European Union (EU) has declined from 30 percent of global GDP to 16.5 percent, while the U.S. has shrunk from 21.8 percent to 15.3 percent.

An escalation in geopolitical risks

This trend has been mirrored by rising geopolitical tensions in recent years, with China becoming more assertive in Asia Pacific, the collapse of several Middle Eastern states following the so-called Arab Spring, soaring migration, tensions between Russia and Ukraine, the UK voting to exit the European Union, the rise of strong-man leaders in several countries around the world, a growing nuclear threat from North Korea, and a generalized increased in nationalism and protectionism in many markets.

The Global Risks Report 2017, published by the World Economic Forum in collaboration with Zurich Insurance Group and other stakeholders, identified five factors aggravating global geopolitical risks. These include a decline in international cooperation on issues of global importance, growing interconnectivity between key risk factors, declining trust in international relations, technological innovations that can be potentially be weaponized at low-cost by state and non-state actors, and the accelerating pace of social and technological change which often outpaces the ability of governments and institutions to react.

Nowhere is this growing tension more evident than in cyberspace. Carl Bildt, a former Prime Minister of Sweden who is now Chair of the Global Commission on Internet Governance, recently warned that, “One country after another has begun exploring options for bolstering their offensive capabilities in cyberspace, and many other countries have already done so. This is a dangerous escalation. In fact, few other trends pose a bigger threat to global stability.”

The space between perception and action

These tensions are already being reflected in the perception of geopolitical risks. As shown in The Global Risks Report 2017, failure of national governance is placed by executives in 37 countries in the top-three highest risk to doing business. That finding was replicated in the World Economic Forum’s proprietary Executive Opinion Survey (EOS) of 12,411 executives across 136 countries conducted between February and June 2017. Nevertheless, there is some evidence that businesses and investors are underestimating the risks they face.

In a May 2017 article, Whistling Past the Geopolitical Graveyard, economist Nouriel Roubini observed that: “Even with geopolitical conflicts proliferating around the world, global financial markets have reached new heights. But while there are many explanations for why investors might be underpricing today's risks, there is no good reason for them to ignore the possibility of another "black swan" event on the horizon.”

In exploring the reasons why investors may be discounting the mounting geopolitical risks, Roubini arrives at the conclusion that: “It is well known that markets can price the “risks” associated with a normal distribution of events that can be statistically estimated and measured. But they have more trouble grappling with “Knightian uncertainty”: risk that cannot be calculated in probabilistic terms.”

As an example, there was almost no way in which investors could have predicted the attacks on the U.S. on September 11, 2001, or anticipate the effects of an escalation in hostilities between North Korea and the U.S. and put a meaningful value on the likely economic impact of such an event. As a result, this kind of risk is often discounted or ignored.

Building resilience to the unknown

Faced with such unquantifiable and potentially uninsurable challenges, governments and businesses need to develop mechanisms to help mitigate the emerging risks.

For states, that means building international consensus around geopolitical challenges and highly correlated issues like climate change, cyber security, mass migration, food security, water scarcity, and trade. Increasing protectionism, for example, will only heighten tensions and act as a catalyst for identity politics.

Businesses, meanwhile, need to take a far more holistic view of their global risks, including geopolitical risks. This would include:

• Bringing the risk management function into the board room and c-suite, to ensure that it is integrated across the entire business and that all risk factors are considered in the overall strategy
• Using contingency planning and scenario analysis to assess risks and their potential impact on the business and its customers and suppliers
• Where possible, diversifying exposure across suppliers and markets
• Building ties within the communities in which they operate to reduce the potential for direct action such as strikes, vandalism or forced expropriation against the business.