The Unknown World of Emerging-Market Risk

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Political risk, rarely mentioned in the developed world, is alive and well in the developing world. The biggest challenge to investors is not that political risk, such as social unrest and regulatory change, exist. It is the unpredictability of when they occur. This is because data from public and private sources is unreliable or unavailable.

The World Bank lists 162 developing countries. This article will focus on the large developing nations with independent seats at the G20, which amounts to the BRICS, plus 5. In order of economic size, this includes: China, Brazil, Russia, India, Mexico, Indonesia, Turkey, Saudi Arabia, Argentina and South Africa.

Data is often unavailable in developing countries because the informal economy does not produce records -- in addition to income taxes and worker benefits. In South Africa, 65% of workers are estimated to work in the informal economy. In India, it is more than 85%. The World Bank estimates that in general, informal workers outnumber formal workers in developing countries.
In India, more than 85% of workers are estimated to work in the informal economy.

High rates of corruption are another impediment to accurate data. Who reports on illegal acts? And how often is recorded data tainted by underreporting made possible for a fee. This might not be a concern if corruption wasn't a serious problem, but in the developing world it is. According to Transparency International's Corruption Perceptions Index all countries that scored less than 5, the benchmark for a serious corruption problem, are developing countries plus Italy. Indonesia, Argentina, Mexico, India and China scored less than 4. The 2.1 score for Russia puts it in the kleptocracy category, which is an ominous sign for government stability.

The 2011 Political Risk Atlas prepared by Maplecroft added Russia to its "extreme risk" countries. To put this in perspective, other extreme-risk countries include: North Korea, Myanmar, Democratic Republic of the Congo, Afghanistan, Zimbabwe, Somalia and Pakistan. How reliable, though, is data from these independent rating services? Don't they suffer from the same data limitations? In the Economist Intelligence Unit's Political Instability Index for 2009/2010, the U.S. was ranked more unstable than Egypt, Libya or Tunisia.

Informal economies and corruption are not the only sources of unreliable data. Poorly functioning government institutions play a role. The Financial Standards Foundation rates the soundness of country financial systems. A sound system complies with standards and is transparent and regulated. None of the G20 developing nations was rated with a high level of compliance.

Russia, Argentina, Saudi Arabia and China were rated with a low level of compliance. Brazil was on the cusp of low to medium. One important variable is the IMF's Special Data Dissemination Standard (SDDS), which provides for the publication of sound macroeconomic statistics. China and Saudi Arabia said they had no intention of complying with the SDDS. At least they aren't pretending.

Argentina who says they are committed to SDDS was recently castigated for subtracting 15 percentage points from its officially reported inflation rate. The rebuke inspired the Argentine government to impose huge fines on firms disputing official lies, excuse me statistics. That's one way to make sure data remains unreliable.

It's no coincidence that China and Saudi Arabia also rank extremely poorly on press freedoms, as compiled by Reporters Without Borders. Russia, Mexico, India and Indonesia aren't far behind and Argentina appears to be catching up. The implications of compliant-adverse governments and the lack of a free press that can shed light on what is really going on makes gauging risk a near-zero science. To this point, here is a useful tip: in China an official denial is said to be the indicator that something is true.

The lack of validating sources is especially troubling because the governments of developing countries are notoriously unpredictable. Further counting on the justice system to remedy surprise unfair actions would be like wishing on a star. Law enforcement and the judiciary in many developing countries are at the crux of their corruption problems. In India, the problem of corruption in the judiciary is matched by the time it takes for a court case to be heard and resolved. The Times of India reported that it would take 320 years to clear the backlog of 31.28 million cases.

Lack of transparency and/or variations on legal interpretations are also common, and surprise interpretations are often unfavorable to foreigners. I'm sure the Australian Rio Tinto executives convicted in 2010 on corruption charges in China were surprised to be going to prison for conducting what seemed like business as usual.

The developed world's lack of experience dealing with some situations is another source of unknown risk. The developed world has no absolute monarchies, like Saudi Arabia, or Communist countries like China. The entire working of their political systems function like a black box that occasionally lets out what it cares to let out. These two countries have a knack for surprise decisions, like rate hikes and military intervention.

A year before the latest financial crisis the Economist was making assertions, using fuzzy logic since data was incomplete, that the new math behind collateralized debt obligations (CDOs) and credit default swaps (CDS) didn't make sense. We now know that the new math was influenced by greedy animal spirits and wishful thinking. Today a similar conundrum exists with developing countries.

If research data on a developing country conflicts with anecdotal or qualitative indicators, don't take it to the bank yet and don't let research get stuck on lots of people and high economic growth rates. These countries are called developing for a reason. Their foundations remain vulnerable to shifting, often unpredictable, politics. Remember, too, that in recent history Argentina was a developed country and Russia was a superpower.

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