This is the last topic in our rather exhaustive list of articles on fundamental analysis, but political stability is a very important point to understand. Political stability is important for currency pairs, economies, and capital flows.
When investors look for new ways to make money, they have to consider the risk, and also the reward. With higher risk comes their desire for higher returns, and with lower risk comes their tolerance of lower returns.
Think of two people that you know, one who is good with money, and one who isn’t so good. If you had to lend each person your money, what interest rate might you charge them? The person who would get the lowest rate would be the person with low risk, right? Right.
Thinking about political stability
To understand why political stability is important, we have to think like investors and business people. Let’s say we own a manufacturing company and we want to build a new factory. Our factory is a very long-term investment, and we need to put it somewhere safe—somewhere we don’t have to worry about what might happen to the economy or the business environment.
Some places aren’t necessarily good places to open a business, whereas other places are much better for business ownership.
Take Russia, for example. In Russia, whole companies have been confiscated by governments overnight. This doesn’t happen very often (or at all) in the United States, Japan, Australia, Britain, or a myriad of other places. The larger economies are generally those with political stability, while smaller ones tend to have less political stability.
In Russia, companies don’t sell for very much money. An oil company in Russia that makes $100 million dollars each year might sell for $700 million on the stock exchange. That same company would sell for $1.2-$1.8 billion dollars if it did business in Australia.
There is no difference between the companies other than where they do business. Investors don’t want to go buy a piece of a company if there is a possibility they won’t own it the next day. And if they do invest in a risky country, then they want higher returns. In Russia, investors earn $1 for every $7 they invest, whereas the same investment in a politically stable country would require $12-18 for every $1 in earnings.
The Importance of Looking Into the Future
Investors fear nothing more than uncertainty. They want to be able to look into the future and know that nothing will change dramatically in their plans from day 1 to year 50. Looking out into the future and making projections about their business and the economy is very important.
The same is true for business owners. Business owners want to put their company in a place they can “see” farther into the future. It makes more sense to invest in something where the risks are known, and can be accounted for.
Countries with poor political stability tend to lag the world in economic growth because they lack direct investment. Countries with strong political stability tend to lead the world in economic growth because they attract foreign direct investment.