Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Monday, March 03, 2014

realized political risk

MSCI classifies Ukraine as a frontier market, that is, an underdeveloped, underinvested, 'more emerging than emerging' market economy. This keeps it out of most indices and funds and off of most investors' radar. Lately, however, Ukraine has been in the news over large anti-government protests that reached a dramatic crescendo as the olympics died down.

Since the collapse of the USSR, Ukraine's economy has struggled. It used to have a large and diverse manufacturing base, but failure to invest since 1991 has led to declining output. Poverty and corruption are also a big problem in Ukraine, leading to a large underground economy. Bribery and onerous regulations make it hard for legitimate businesses to emerge. In the capital, Kyiv, this underground economy is in plain view in markets right alongside the high-end shopping and restaurants that dominate the center of the city. Enterprising individuals offer their cars as taxis or open up stalls to sell clothes straight from factories or simply sell food on the curb. 


While the economy has declined, it's underpinnings are still valuable. Current economic problems stem largely from underinvestment and the drag of corruption. The potential for growth and investible business is immense here.


This corruption also highlights the great political risks of investing in a country like Ukraine. The former president Viktor Yanukovych strenghened ties with Russia by borrowing money and getting subsidized fuel in order to try and prop up the struggling state. This took an explicit turn away from trade agreements with the EU. Protests erupted over this and other aspects of his government, resulting in Yanukovych fleeing Kyiv to Crimea - a semi-autonomous region with much deeper ties to Russia than the rest of Ukraine. Crimea is home to a Russian naval base, and Russia has moved troops on the ground, ostensibly to protect Russian citizens there. It appears that the region is on the brink of actual war -  Russia has a history of inserting troops into former SSRs, and Ukraine is clearly no exception.


Political risk be realized in dramatic instances like this, but it's true cost is much more insidious. Political risk leads to economies being underproductive and investments being undervalued. For countries that are moving towards a more open, fair economy, the opportunity can be great.  As the drag of corruption eases, these economies can grow closer towards their full potential. Generally optimistic, I see frontier markets as an overwhelmingly positive long term investment opportunity.