What are the emerging global risks directors should be wary of, and how should they respond? IoD Chief Economist Tej Parikh explores the strategies business leaders can utilise to stay ahead of the curve.
The COVID-19 pandemic has shone a light on vulnerabilities that were growing in the global economic system for decades.
The rapid rise in the cross-border flow of trade, people, money and ideas has been facilitated by ever-growing complexity, efficiency and interdependence. Car components are forged across continents, elaborate financial instruments are used to gain or hedge exposures to international developments and hyper-lean production lines deliver customised products to buyers thousands of miles away – in just a matter of days.
In any normal state of the world, that is a supreme vehicle for profit, growth and innovation, which has even shown its resilience amid geopolitical flareups and natural disasters. But when global tail risks do occur, they can trigger a domino effect that can crash the entire system, and even send it into reverse. The 2008 financial crisis was the first such warning sign that global contagion risks ought to be accounted for. Banks have now been encouraged to hold more capital and conduct regular stress-tests, while regulators have sharpened their tools and oversight. With COVID-19, business leaders will need to do similar.
Global economic disruption
The pandemic is radically reshaping the rules of the global economic system. Risk professionals will need to work smarter to help boards navigate unpredictable risks and take new opportunities quickly as they arise The 2008 financial crisis was the first warning sign that global contagion risks ought to be accounted for. The pandemic has brought global disruption on a scale not seen since the Second World War. The International Monetary Fund expects the Great Lockdown to shrink the global economy by around 5 per cent over 2020. That dwarfs the 0.1 per cent annual contraction at the time of the global financial crisis. Indeed, the impact of the pandemic is far more wide-reaching than the banking crisis. Now, advanced economies and emerging markets are both in a tumble, whereas breakneck growth in China and lofty commodity prices provided some fallback for the latter in 2008.
In developed nations, alongside weak consumer confidence, the scars of unemployment and corporate indebtedness, incurred during the trough, has dispelled any notion of a “v-shaped” recovery. Many advanced economies are not expected to return to pre-COVID-19 activity levels at least until the end of 2021. In emerging markets, debts have grown as money has been dished out by governments and central banks to stave off defaults and currency runs, leaving many on a precipice. The emergence of a global consumer class will also be set back with World Bank estimates suggesting at least 70 million could be pushed into extreme poverty.
All this is before any potential new waves of COVID-19 are even factored in. For boardrooms of international businesses, it paints a particularly challenging picture. The World Trade Organization estimates that global trade could fall by up to a third in 2020, with almost all regions suffering double-digit declines in trade volumes. Supply chains will continue to face snags as demand remains patchy and businesses attempt to adjust to the new risk environment by rebuilding stocks and reducing regional exposures. Investor appetite will also dry up, as growth prospects remain unclear. The United Nations estimates a 30 to 40 per cent contraction in global foreign direct investment flows, with the steepest cuts expected in the transport, hospitality and manufacturing industries. Tapping into the international workforce will also be complicated by ongoing travel restrictions.
Even as economies begin the long road to recovery from the lockdown period, uncertainty alone will likely keep a rein on business activity. The global Economic Policy Uncertainty Index, which aggregates sentiment on the economy through newspapers, reached its highest during the pandemic. It remains above peaks reached following 9/11 and the 2008 financial crisis. The most pressing uncertainty for firms is the prospect of further outbreaks, lengthening the downturn. New waves have been evident in many major economies, including Australia, China and Germany. So far, a rise in cases has been largely handled with localised actions, limiting economic damage. While nations have now built up more experience, and resources, to handle a rise in infections, businesses and investors will remain wary of a return to lockdowns.
If a vaccine is found, it may take considerable time before it is in use universally. Meanwhile, the damage incurred over lockdowns will also add to uncertainties about the domino effects it may trigger. Risk specialists surveyed by the World Economic Forum rank a surge in bankruptcies, among both large firms and SMEs, alongside a prolonged recession as the most worrisome risks for business. Last year, corporate debt had already reached record levels in China and the US. With businesses across the globe turning to government loan schemes and other bridging finance, recoveries will be hampered by interest repayments, and interconnected production chains will remain vulnerable to contagion if key businesses struggle to stay afloat.
Countries will face similar challenges, raising uncertainty for global business operations. Emerging markets will remain vulnerable to low commodity prices and depreciating currencies as debts mount. Significant social unrest is also likely given potential increases in poverty, unemployment and inequality. Meanwhile, as public debt in advanced economies balloons to 122 per cent of GDP this year, it may hold back governments’ ability to support firms’ recovery. Indeed, national responses to the crisis will also affect firms. Austere measures may cut growth prospects, while populist policies may drive profligacy.
It is likely that anti-globalist sentiments may gain more sympathy, and some governments may be driven toward protectionism, raising tariffs and protecting strategic industrial players. This dynamic was already playing out between the US, Europe and Australia, in relation to China. And regardless of who is in the White House come the end of 2020, a focus on domestic challenges and economic nationalism across the world will limit any momentum behind a multilateral approach to global growth. For businesses operating in multiple jurisdictions, this heightens the risk of tax, trade and regulatory barriers emerging on cross-border operations. Domestic governments may even be more sceptical of foreign enterprise, with potential implications for merger and acquisition activity, visa eligibility, technological collaboration and data flow.
The new abnormal
It is clear the pandemic has exposed a powder keg of knock-on exposures that are now at risk of being ignited. With so many complex and interdependent moving parts, it will become even harder for businesses to react to changes in the new global economic risk landscape. Evaluating the vulnerabilities and building a risk register will be the first step, as firms with an international footprint will need to get to grips with potential pressure points in their business. Market, supplier, staffing and geographical exposures will all need to be looked at with extra suspicion. Going the extra mile to obtain in-depth and accurate market intelligence will be a differentiator. With the rapid news cycle and evergrowing sources for global analysis, the need to be even more discerning with information will be important. Special risk-monitoring working groups, across business lines, could help avoid internal blind spots and ensure all departmental perspectives are taken into consideration.
Clear mapping of exposures, and understanding of their potential implications, will be a crucial base for many firms in understanding where to build resilience. The growth, trading and regulatory assumptions underpinning just how global economic and political dynamics might impact those vulnerabilities will then need to be stress-tested. More frequent engagement with boards in a time of heightened risk could be important to ensure strategic plans are fresh and the results of stress-tests are well understood across the organisation. Boards should also play an important role in the horizon-scanning necessary to build out various scenarios to test finances, alongside challenging management teams more generally on contingency planning and operational resilience.
Firms will need to understand just how their organisations may look in “all bets are off” scenarios. What may happen if expenditures double, or entire markets became inaccessible, or key product regulations change? With the pandemic shattering many existing assumptions on what is possible, businesses may consider it sensible to assume the ongoing health and economic dynamics precipitated by the virus will continue to leave many outside-the-box scenarios on the table for the time being at least. This modelling should help determine the shape of the business plan and necessary financial reserves for the year ahead – and it should kick-start discussions for continuity arrangements and plans Bs should worst-case scenarios come true.
Above all, in a global economy liable to change and particularly with so much uncertainty in official forecasts, firms will need to embed a culture that regularly monitors risks, updates compliance procedures and adjusts business models to fit the dynamic climate. Strong communication will be essential to this. The success of rapid business transformations will rely on how well managers and key staff are kept in the loop and aware of evolving responsibilities. This will hinge on effective leadership that keeps an eye on future developments, with a view to adapting the business model today. Throughout it all, technology will be crucial. Real-time business data, enterprise risk management systems and productivity-enhancing ICT will play an important role in spotting and diagnosing pressure points.
Just in time vs Just in case
For many global firms, the new risk environment will ultimately see a shift from a “just in time” mindset to one of “just in case”. Where low inventories and specialised production chains fostered end-toend supply chain efficiency, firms may now want to build in more slack and generate long-term resilience. This may mean holding more stock should shipping operations jam up again, reducing the complexity of supply chains, and diversifying suppliers and labour forces, even at a cost, to hedge against potential tariff and visa restriction changes. With the precise size of downside risks complicated by several intersecting factors, businesses may not see resilience as an inefficiency, but as a necessary short-term speed bump to support long-term competitiveness. No doubt, investors will also be wary of fragile business models.
But just as businesses will need to engage more frequently in strategic oversight to mitigate risks, unearthing opportunities will become all the more important – and lucrative. Less-trodden geographies – such as eastern Europe and the Balkans – may become more popular for European-headquartered businesses as they seek to spread risk from more extensive global value chains. With the fiscal pursestrings loosened, policymakers will also be eager to stimulate business investment to drive economies forward, which could support R&D, technology and green opportunities. More generally, with the pandemic itself reinforcing a trend toward digital platforms and working from home, global businesses will need to keep their fingers on the pulse of rapidly evolving consumer trends, which will dictate market entry and new product decisions.
The pandemic presents a challenge like no other for business leaders. The global economic system has received a sharp jolt, and there is little clarity on when and where it will land. Disruption is here to stay. Businesses risk losing more than 40% of annual profits once a decade in a complex global economy threatened by trade wars, cyber attacks, pandemics, and climate change, according to Mckinsey. The firms that will succeed will constantly be on their toes, building long-term resilience and strategic risk management into all processes. It is the directors that work on their business, and not just in their business, that will thrive.
This article first appeared in the Institute for Risk Management's Quarterly publication.