Losing Frame, Geopolitically

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Nation states and non-state actors work together, or bump into each, ignore each other, or fall into conflict. Behind much of this interaction is the geopolitical order, or “framework”, or system. The world’s current version is becoming frayed. It’s still working for the most part but has become a bit more halting. This means more event risk and real-time adjustments in store for cross-border lenders and investors.

In the Wall Street Journal this past week, the writer Walter Russell Mead ruefully observed that, “As readers of this column know, the most important international development on President Biden’s watch has been the erosion of America’s deterrence…”

A baleful comment. Mead is on to something, though. We share his view, and we note an erosion of confidence in the geopolitical order or “framework” in which we all live and work, whether we like it or not, whether we’re even aware of it or not. Yet, we posit that the framework is still serviceable, for now.

Adam Smith once noted that there is “much ruin in a nation”, or something roughly like that. What he meant is that a thoroughly established and broadly functional undertaking – like a prospering nation – can get a lot of things wrong, before things truly go awry. That insight might be applicable to the current geopolitical order: many things recently have gone wrong; a lot of things still work, rather well. But there is some fraying, and with that comes additional, nebulous event risk.

Last year, we introduced our Geopolitical Risk Framework “Tear Sheet” and qualitative grading approach for the geopolitical risk environment (i.e., “the framework”). Our approach gauges the four key qualities, we believe, of that environment (which we define as confidence, deterrence, transparency and reciprocity). In last year’s effort, we scored the geopolitical environment to be at a “good/fair” level of robustness and coherence. For reference, the top score would be “optimal”, which it wasn’t then and presently is not. In fact, we recently updated our approach and our present conclusion shows the quality level to be worse, or just “fair” for the geopolitical framework or environment. We’ll elaborate briefly on that.

But first we should define terms and the approach. The geopolitical environment, “system” or “framework” arises and is fashioned among interacting states and non-states. It represents the modus vivendi among all the different players.

Importantly, a system which is working well is one which is largely “predictable”. It is predictable almost in the sense that a contractual arrangement is – the different parties observe the terms of the contract to receive the expected results. Just so, the working geopolitical system demonstrates a positive sum environment, reflected even to the extent when the weak are obliging and the strong are forbearing. Players are incented and execution in the environment is largely “predictable” because there is mutual advantage.

When a geopolitical system does not work, the players – again, state and to a degree non-state actors, do not perceive mutual advantage: The players dispute the system, and the way it’s arranged. The weak and the strong, for example, do not acknowledge each other for what they are; the players do not recognize the benefits and bridle against the system in place. Such a system is prone to break down and is prone to volatility.

If a geopolitical system is clear and in balance, so to speak, it is working and offers “predictability”. For the global investor or lender, such a working system holds out the prospect for reliable compounding returns – although, an important caveat, a working geopolitical framework or system does not invalidate the credit cycle, exogenous shocks or different forms of financial mania.

The “faulty” system – the “disputed” system – however, holds out prospects for correction and volatility, as the different players seek to adjust the system toward a generally acknowledged new working order. For the lender or investor, this faulty system can yield speculative opportunities for those who are adaptive and nimble.

As noted, the MMD approach is to measure and grade the key characteristics determining the stability of the geopolitical framework or system i.e., whether it is working or not.

Briefly, we look at the extant level of confidence in the system. That is, whether or not states and non-states perceive that the practices, features, systems and relations describing the existing framework are working – that they merit confidence. In our recent update, we downgrade the score for confidence to just “fair”. Knock-on effects from the Russia-Ukraine conflict have exacerbated a fissure between states, with Russia, China and elements of the “Global South” contemplating divergent international arrangements and institutions. This is worrisome, and could become problematic to the current order.

The Hamas invasion of Israel this October is yet another example of rogue behavior and adventurism, potentially enervating the level of confidence in the current geopolitical system. We also note that deterrence and transparency only grade at “fair” levels as well. As Mr. Mead notes, the US ability to evoke deterrence suffered in the wake of the abrupt Afghan “skedaddle”, which signaled feckless behavior. The Hamas October attack and the Russian invasion of Ukraine show deterrence to be more threadbare than perhaps earlier, and international actors – states and non-states – more opportunistic.

Transparency suffers now from interstate rivalry between the US and China, and we continue to assign just a “fair” grade to transparency.

On a more positive note, we still consider framework reciprocity to be “good”. This characteristic is, in a sense, the most foundational aspect of the international order.  To cite one example, the sovereign secures public order through its issuance of a national currency; the currency holder benefits from the store of value and fungibility of that currency. What the issuer and holder receive benefit each other, engendering reciprocity. The ongoing durability of the US dollar as the world reserve currency reflects global currency holder confidence in the underlying institutions that support that demand for the US currency, and the US currency’s perceived merit as a store of value and medium of exchange.

As of year-end 2022, according to the International Monetary Fund (IMF), total world central bank reserves were denominated in US currency amounting to USD6,441 bln vs. reserves denominated in euros at USD2,118 bln. Central bank reserves denominated in Chinese renminbi amounted only to USD296 bln, reflecting that currency’s lack of easy convertibility and capital controls.

To conclude, the global framework is still largely functional, but not altogether smoothly. It has become more prone to dispute, rival agendas, and at times flagging confidence. The event risk from such a situation is more palpable than not.

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