Risk and Resilience in a Changing World

ETHOS Issue 09, June 2011

GOVERNMENTS WILL FACE AN INCREASINGLY TURBULENT GLOBAL ECONOMY

After the relatively benign global economic environment of much of the past 20 years, the past few years suggest that the global economic environment is moving into a more volatile and uncertain period. Over the past few years, we have observed greater volatility in trade and capital flows, as well as GDP, commodity prices and exchange rates. The recent global financial and economic crisis has further reminded countries, particularly those with relatively open economies, that they are significantly exposed to variation in global economic performance.

There are structural forces driving this increased volatility. Globalisation has led to more significant uncertainty for countries, governments, corporations and households. There is also risk and uncertainty associated with the pace of technological change, new sources of global competition, the price and availability of core commodities, and so on.

Furthermore, there is significant, and perhaps unprecedented, uncertainty on many dimensions of global economic policy – such as those relating to external imbalances, fiscal consolidation, (simultaneous) concerns about inflation and deflation, and the future role of the US dollar.

This increased background uncertainty and volatility is exacerbated by the tectonic changes that are occurring in the global economy. The world is coming to the end of 200 years of Western economic dominance, the multilateral institutions such as the WTO are declining in influence, and the Washington Consensus, which placed free markets at the core of economic policy, faces real competition.

Periods of structural change are often coincident with periods of elevated risk and uncertainty. The US National Intelligence Council recently noted that “Historically, emerging multipolar systems have been more unstable than bipolar or unipolar ones…the next 20 years of transition to a new system are fraught with risks.”¹

This is not to say that there are no substantial growth opportunities, particularly in emerging markets. There are strong fundamental forces at work – demographics, urbanisation, technology, productivity catch-up – that provide some confidence that economic growth rates will be robust in these markets. But the distribution of possible outcomes is likely to be significantly wider.

For small- and medium-sized countries – say countries with populations of 20 million or less – which tend to be more reliant on the global economy, this uncertainty and volatility could well have a significant impact on economic performance. At a national level, countries are exposed to changes in investor sentiment and the withdrawal of capital, to the security of supply of food and other commodities, as well as variation in export demand from key markets. For households, this national risk exposure can cause employment risk, variation in the balance in retirement savings accounts, and so on.

In response, issues of risk and resilience will become an increasingly important dimension of economic policy. Risk exposure, and the allocation of risk within an economy, should be a deliberate focus of policy.

THE SIZE AND NATURE OF A COUNTRY’S RISK EXPOSURES CAN BE DELIBERATELY SHAPED BY THE GOVERNMENT

At a global level, the external risk exposures of many countries has increased substantially due to an intense process of global economic engagement. At the same time, there has been a general tendency to remove sources of protection against these shocks, in the pursuit of greater flexibility and efficiency. For example, capital controls have been largely removed, and the provision of social insurance has been reduced for households.

There has been a general tendency to remove sources of protection against shocks, in the pursuit of greater flexibility and efficiency.

So over the past few decades, the overall level of resilience has declined. Governments, corporations, financial institutions and individuals have taken on more risk in the belief that financial innovation allowed for increased risk exposure to be borne efficiently. Some evidence does suggest that there was a significant transfer of risk from governments and companies to households.

There is now a broadly-held view that this process may have been pushed too far. Indeed, a growing number of governments are taking steps to build national economic resilience to the global economy. For example, several governments have introduced capital controls and begun to intervene in exchange rate markets to curb excessive movements; long term contracts for energy and food supply are increasingly common; there are also attempts to rebalance the economic structures of economies that have been unduly reliant on either consumption or exporting to Western markets.

Of course, many economies in the Asian region too have been going down this path for the past decade or so, accumulating substantial foreign exchange reserves in order to protect themselves against foreign capital movements. But in general, governments seem less inclined to accept existing exposures to global markets and more inclined to take deliberate action.

So how should governments respond to the increased risk environment and build resilience into the economy? As a general proposition, risk should be treated as a deliberate subject of policy. Specifically, there are three steps that governments should consider taking (similar in spirit to the analysis that a corporation would seek to undertake).

First, is to understand the size and nature of the risk exposures that are faced by the country through a formal national risk exposure assessment. In a more turbulent economic environment, understanding the most material risk exposures, and the key drivers of these risks, becomes very important.

Second, once these risks are understood and sized, to determine which risks to take on, and which to seek to avoid or manage. Do the risks that are absorbed generate an appropriate return; is the economy on the “efficient frontier” in terms of the relationship between the level and resilience of its growth? Even small, open economies have options in terms of shaping their portfolio of risk exposures.

Third, strengthening the risk-bearing capacity of the economy by increasing the ability of the government and households to bear risk, and ensuring that risk is allocated to parts of the economy which can bear and manage that risk most efficiently (individuals, corporations, government).

These second and third steps are related: the amount of risk that is efficient for a country to absorb depends in part on the risk-bearing capacity of the system. The investments that are made in strengthening the risk-bearing capacity of the system make more sense to the extent that it allows the country to take on additional risks that generate an appropriate return (or reduce the costs of existing risk).

In general, large companies have more developed approaches to thinking about risk than do governments. However, given the changing global economic environment, governments need to be thinking more intensively about their risk exposures, how to shape this exposure, and how to build risk-bearing capacity.

Singapore is perhaps better placed than many governments in addressing issues of risk and resilience because of existing policy settings that give it a flexible economy, a managed exchange rate system, and substantial reserves. But there is scope for further progress to be made in terms of managing emerging exposures and building resilience, particularly among households.

Not all protection against risk necessarily depresses economic performance.

EFFICIENT RISK MANAGEMENT IS AN IMPORTANT SOURCE OF COMPETITIVE ADVANTAGE

There are, of course, better and worse ways to manage risks. One way to reduce risk exposure, for example, might be to disengage from the global economy – although this would come at a significant economic cost. And many are concerned that current attempts by governments to manage the risks associated with the current crisis (through deficit financed spending), will reduce the resilience of the economy and make a future crisis more likely and more costly.

Countries that build resilience efficiently will generate a competitive advantage, relative to countries that do not manage risk well. There are two sources of this advantage. First, external shocks will have less of a negative effect on individuals, corporations and governments. Second, there will be greater potential for these more resilient economies to take on additional risks, where these are growth enhancing, at lower cost. In other words, resilience pushes out an economy’s “efficient frontier”, which maps the trade-off between growth and volatility.

Not all protection against risk necessarily depresses economic performance. Arguing that bearing risk is important for sharpening incentives and that nothing ought to be done to manage this exposure is like arguing that investors should select the highest return portfolio irrespective of risk considerations, a strategy that few would follow. The challenge is to manage risk, resilience and growth in an integrated way.

Indeed, there can be a complementary relationship between the provision of insurance and innovation and risk-taking. Consider, for example, limited liability companies, one of the fundamental institutional underpinnings of modern capitalist economies. The security provided to shareholders by limited liability – that they will not be exposed to claims beyond their investment if their company floundered – has unlocked enormous sums of capital and put it to productive use.

The challenge is to manage risk, resilience and growth in an integrated way.

This notion is also common in the context of finance. Diversification allows investors to pool risks and reduce the overall risk of the investment. Indeed, a key function of capital markets is to allow investors to better engage in risk-sharing, by offering liquidity and diversification opportunities. This increases the attractiveness of risky projects to investors and accelerates investment and growth. The historical record shows that greater risk-sharing opportunities provided by financial development sparked economic take-off.

The challenge is to manage risks and build resilience in a way that does not compromise the growth potential of the economy. There are several ways in which this can be achieved: for example, encouraging self insurance (e.g. unemployment insurance accounts), promoting household savings, and ensuring that private insurance markets are working well. Singapore’s emphasis on using asset-based methods of providing household assistance provides a good platform to build on.

In sum, managing risk and building resilience need not require the insulation of the economy from the forces of change. Indeed, it can create a more efficient economy with higher levels of growth, innovation and risk-taking. In Joseph Schumpeter’s famous metaphor, cars can go faster because they have brakes. In a world that will become more risky and turbulent, adopting a structured and systematic approach to risk and resilience will pay dividends.

ABOUT THE AUTHOR

David Skilling is Senior Advisor to McKinsey & Company, based in Singapore, and Fellow with the Civil Service College, Singapore.

NOTES

1. National Intelligence Council, Global Trends 2025: A Transformed World, November 2008.

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