I have just finished reading the article describing the Brazilian debacle in The Economist (first issue of 2016). I am always very surprised by how we fail to see countries going into trouble due to political reasons before it is too late. Emerging economies keep having ups and downs and investors and analysts seem to be the last ones to find out. A few years ago everybody was talking about the BRICS, nowadays they do not look that solid any longer. How come we could not anticipate the changes that were behind the corner? Which is the next country that will disappoint us? How do we know that Peru, Chile and Colombia (the current rising stars in Latin America) are not going in a similar direction? Do we really understand the drivers behind political risks?
Firms invest significant amounts of money in emerging economies assuming the boom (or at least the stability) will last over time. Or maybe they are just underestimating the potential downside they are facing. I understand that companies need to open new markets and diversify into new –mostly emerging- markets, but I think that most of the times they are just running blindfolded through a potentially mined field. Things go well until they fail. In my opinion we could do a much better job if we could gain a deeper understanding of the political risks faced by the emerging economies, and getting to know their determinants. Oftentimes the determinants of the political risks are sociological and demographic issues that tend to be neglected by analysts and business people in general.
How often do we ask which are the factors that trigger political risk events? A whole country going into political trouble and instability cannot happen overnight. It takes a lot of time and early warning signs are usually out there, the problem is that we usually fail to see them, because we are not looking in the right direction.
There are two typical moments in which Emerging Markets tend to have significant political changes, these are: (i) election times, and (ii) times when there is a significant macroeconomic or social shock or downfall (these two are usually correlated). In these moments the probability of a change in the country’s public policy is higher. It is crucial to understand the signals provided by reality before events actually develop.
I would like to propose some groups of potential indicators that we could follow and would probably provide useful signals early warnings of political risk that should trigger further investigation.
Institutional quality is an indication of how easy is for somebody to steer the country away from rationality. In a country with poor institutions the President can do almost anything, generating large swings and throwing away years of efforts. It is not easy to measure institutional quality with a single indicator, but it could be done using several variables. Some of the indicators that could be used to approximate this are: the independence of the judiciary system, the legislators and the Central Bank from the central government; the efficiency of the justice; the perception of corruption in the government; the number of years that a single party has been in power; the quality of corporate governance; the freedom of speech for individuals and the press; etc. There are several independent indicators of institutional quality of a country; most of them are generated by well-respected and trustworthy independent sources.
Social wellbeing of the population is another important factor that we need to consider. If people in a country are struggling with unemployment, high inflation, high mortality rates, lack of satisfaction of their basic needs, etc. there is a higher probability of social instability. There are several indicators that help measuring this. Some of them are economic, like the Gini Index that measures the distance between the richest and the poorest percentiles in a society; an indication on the evolution of the wealth of the poorest sectors of the economy (independently from the distance to the richest); indicators of the levels of inflation and unemployment; the spread between active and passive interest rates; the level of use of the banking system in the population; and the level of capitalization of the local capital market; among others. Some other indicators are plainly demographic ones, like child mortality; life expectancy; number of people living in cities; level of literacy; etc. Another set of indicators that captures the social sentiment of the population is also needed: number of strikes; roadblocks; union activism; crime statistics, etc.
Another important determinant of political risk is the country’s level of infrastructure. Countries with more and better hospitals, schools, highways, airports, etc. are supposed to be more stable than countries that are struggling with lower levels of investment. There are several indicators that could be used to measure the levels of infrastructure, and most of them are easy to obtain from independent sources. Examples of these indicators are: number of hospitals (or hospital capacity), kilometers of paved roads, Internet access, quality and availability of 3G and 4G access, number of people with internet connection, etc.
As anybody can imagine, most of these indicators are easily available for almost any country. The problem is that firms are not used to a systematical collection and study of the data. Constructing a well-balanced index using some of the indicators proposed in this post, and following its evolution over time, should provide a fair sign on the evolution of the political risk in a given economy or region. It is extremely important that companies start taking these signs seriously, using all the available data in order to anticipate the future social and political situation of a country. The resulting information will generate a warning system that will help investors and analysts to understand the reality of the countries in which they are investing and the probable direction of their government decisions (or elections).
