Politics hardly matter to the markets

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The Independent Online
Do politics matter to markets any more? Provided that the local polls are within certain limits - that there has not been some political earthquake - the markets will ride the result with equanimity. Of course they are just local elections, of marginally more importance than the Euro-elections perhaps, but not of great significance to the outside world. But 15 years ago such elections would have been read with great interest for signals of the next change of government. Now, no one seems to care.

One could extend the point by looking at Japan and Italy, both of which have been struck by seismic political change in the last few months. The parties that had run these countries for most of the post- war period were defeated, which ought to have created great political uncertainty - we are always told that uncertainty is what markets fear most. Yet markets in Japan and Italy seem hardly to have been affected at all. From the markets' point of view there are lots of interesting (and worrying) things happening in both countries, but political change is not one of them.

What has changed? Several things. For a start, there is a much greater degree of agreement on economic policy: most governments in the developed world agree not just on the broad outlines of macro- economic policy, but on large areas of micro policy too.

Such convergence of policy is reinforced by financial markets being much more international than they were even five years ago: the longstanding discipline of the foreign exchanges has been reinforced by the discipline of the international investment community, as cross-border investment in bonds and equities has boomed. All governments seeking to run a deficit, as they all are at the moment, must accept that their debt (and by implication, their fiscal policy) has to compete against the debt offered by other governments. No one is forcing investors to buy gilts, for those investors can buy any number of alternative government securities from other countries instead.

There is an interesting example this week of governments' concern for the views of the international investment community - and incidently, of the way politics can still affect markets in the short term. Spain is experiencing a bout of political scandal, one effect of which has been to widen the spread between Spanish bonds and German equivalents from its 'normal' 2.5 percentage points to more than 3 points.

This deterioration in Spain's investment standing is seen as a powerful reason for wanting to clear up the scandal. The discipline on governments to be seen to do the right thing comes as much from global markets as from domestic voters.

Granting central banks greater independence is one way a country can make its debt more attractive to the markets. Some politicians may have a deep-seated desire to increase the independence of central banks, believing this is the best way of securing low inflation. Others, more cynically, may accept that this is the mood of the hour and they had better accept it. Whatever the motive, the effect is to make the markets pay more attention to the views of the central banks and less to the views of politicians. Take the responsibility for setting short-term interest rates out of politics and political change becomes less important to the world of finance.

Further, it may be that markets are becoming more mature about political risk. This is a by-product of the boom in investment in emerging markets, where countries are finding themselves ranked by analysts in much the same way that companies are judged.

Investors don't mind investing in what is perceived as a 'risky' country, provided the risk is appropriately priced. If investors see themselves as managing a portfolio of different risks, they are much more likely to be prepared to ride out the odd political upset. Governments being overthrown present opportunities as well as threats.

Finally, the sheer range of new technical instruments makes it possible to be more sanguine about political risk. Some would worry about a Labour-led government in Britain in 1996, which might reverse anti-inflationary policies and so undermine the gilt market. Whether such a perceived risk is accurate, or even fair, is irrelevent: one simply lays it off by selling contracts on the futures market.

That market, incidently, can, by looking at the present cost of money and the slope of gilt yields, give a snapshot of the expected base rate in 1996, which is around 9 per cent.

Too high? The Chancellor would argue that it was; as he complained this week, the markets were being too pessimistic about inflation prospects. But what they are actually saying is that they reckon he will be too lax on inflation, fail to increase base rates early enough, and that if he is replaced, his successor will be no sounder.

From the point of view of the markets, then, there is no need to be worried about political risk in the UK: quite a lot of risk is already in the present market price. So the truth is that politics do still matter to markets. But they matter less than before because the markets are both more powerful and more sophisticated. Political risk is merely one input among many, and the job of the markets is to make judgements about the fine changes in risk that continually take place.

They will not worry about the UK local elections any more than they worry about, say, the oil price. They do worry about the Bundesbank and the Fed.

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