whythawk ratings: measuring effective development

Development organisations and multinational donor agencies are the biggest investors into poor and undeveloped nations. The objectives of their "investments" differ from the sorts of returns that private companies look for in their business dealings. Corruption and mismanagement of fund leads to a diminishment of the funds themselves, as well as in the health, welfare or environmental metrics that the funds were meant to address. These are worthy concerns but they are not of relevance to real investors.

Private companies certainly require a stable, honest and healthy nation in which to do business, but these are not ends themselves. What investors require is that a market be, not just stable, but able and willing to produce or purchase the goods that the business aims to sell. That implies the following criteria, used throughout the Whythawk Emerging Market Risk Curves:

• Poorest 20%: Market Opportunity: potential for social and economic mobility, as well as the prospects for engaging the poorest 20% as a direct market
• Productivity + Cost of Workforce: politics and legislation aside, the efficiency and determination of the workforce to work
• Prospects for Importing / Exporting Goods: the ease and cost with which goods can cross the border
• Wealthiest 20%: Quality of Life: the standard of living of the wealthiest, and the distribution of wealth beyond the political elite
• Governance + Independence of Law: the support that investors receive from government and the law
• Prospects for Local Production: the ease and potential for local business investment

There are many ways to interpret and read the information presented in the graphs. Below are a few of the commonly seen curves. Should you require additional interpretation - or regional analysis - then please contact us.

The following sections provide additional guidance and analysis:

• Scenario 1: High-growth emerging market
• Scenario 2: Nation controlled by narrow political elite
• Scenario 3: Migration leading to skills shortage and capital flight
• Scenario 4: Two nations in one country
• Variations
• The basket of emerging nations forming the benchmark

Scenario 1: High-growth emerging market

This is the scenario that investors should be looking for.

• Poorest 20%: there is high degree of social mobility as the poor improve their lives through vast amounts of new work opportunities;
• Wealthiest 20%: there is a small, but growing, middle-class as wealth is spread out and away from the political class towards the new merchant and employment class.

Wealth creation amongst a socially and economically mobile lower class does not imply that political governance is good, democracy is present or that the courts work or are independent. There is no requirement that democracy and reform come first, although it certainly does help if private property is respected and some rule of contract is available. However, sometimes social mobility is so great that it can overwhelm even weak systems.

Disruption Triggers: No economy is performing so well, and no society is gaining wealth so rapidly, that its growth cannot be derailed. A political elite, fearful of losing their advantages and dominance over the rest of society may choose to reverse the reforms. Large companies could be nationalised or "stolen" through dubious legal sleights-of-hand. Growth can exceed the capacity of critical infrastructure (such as energy) and result in sudden collapses. Asset-price over-valuation may result from too much money chasing too few opportunities. These markets are awesome places to invest, but there are also risks and investors must be prudent.

Scenario 2: Nation controlled by narrow political elite

The classic "bow-tie" shape of the curve to the left is a typical feature of many emerging nations. Analysis of the curve reveals the following directly:

• Poorest 20%: there is little social or economic mobility for the poor; i.e. a person has little prospect for improving his or her opportunities or quality of life if they are poor;
• Wealthiest 20%: there is also virtually no middle-class or business class to speak of.

With this type of income distribution, it means that real wealth resides within the state - and control of the apparatus of the state. There is little opportunity for any ambitious person within that economy unless they are able to secure employment within the machinery of the state.

The economy may grow; it may even be a regional power-house. The weakness is that growth is likely to be resource-based and reliant on foreign innovation and investment.

Inherent instability arises from the tension between those hoping to secure opportunities within the state, and the incumbents who already use the power of the state to protect their own interests.

Disruption Triggers: Any transition of power - even to a carefully selected successor - opens up opportunities for the conversion of social tension into anarchy or instability. Even nominally democratic societies and open are not immune where such limited opportunities for personal improvement exist.

Scenario 3: Migration leading to skills shortage and capital flight

As in Scenario 2, there is social tension between the limited opportunity for economic transformation for the poor, the lack of any significant private-sector business class, and the concentration of wealth in a political elite. However, in this scenario, an additional factor presents itself:

• Productivity + Cost of Workforce: the labour-force wants to work and is - relative to their skill level - a cost-effective work-force; this desire is at odds with current economic and political policies.

The tension that exists between the low opportunities for advancement and the high level of initiative and desire for advancement that is presented by the labour-force will result in economic migrancy. The most capable and valuable members of that society will migrate first. They will also take with them capital assets as well as know-how. As their leaving becomes more significant - and if no significant political change addresses the weaknesses in local economic opportunities - then the overall productivity and cost of the workforce declines.

At the same time, the country now has a large emigrant population who may send remittances home. These act to introduce liquidity into the economy resulting in local inflation, but also acting as a social net for those who remain. This can act to stabilise the tension identified in Scenario 2.

Disruption Triggers: Should a government act to limit migration, or foreign governments to prevent immigration, then that ambitious workforce must remain in the country. This could increase the levels of frustration locally and act to trigger conflict or instability.

Scenario 4: Two nations in one country

This is an unusual curve.

• Poorest 20%: there is little social or economic mobility for the poor; i.e. a person has little prospect for improving his or her opportunities or quality of life if they are poor;
• Wealthiest 20%: there is a relatively large, socially- and economically mobile middle class that relies on a stable private business environment.

In reality there are two nations present in this country. The first is that presented in Scenario 2. The second is a wealthy, educated, urbanised middle-class that has little to do with the larger impoverished population. One indication of this is a high level of income inequality (GINI coefficient). General economic policy is still poor and much of the essential infrastructure (energy, telecommunications, physical infrastructure) is likely to be in state hands. Some quirk of that nation's history has allowed this wealthy private-sector elite to emerge. The likelihood is that the wealth will be concentrated in the hands of a visible minority which has little political representation. Its existence is likely to fuel popular resentment. There are two approaches for the political elite to consider:

• Punitive: the state may introduce redistributive policies based on "affirmative action" will attempt to "spread" the wealth; this is likely to result in capital and skills flight;
• Harmonisation: the state may introduce liberal policies that enhance minority rights and enable capital mobility; new business opportunities gradually lead to increased social and economic mobility for the poor.

Disruption Triggers: This is a very unstable situation. If the political class make extreme promises beyond their capacity to deliver then the attraction of blaming the wealthy minority for that failure becomes overwhelming. That wealthy class is highly mobile. If targeting becomes too severe then the result is capital and skills flight, extreme social disruption and the society very rapidly collapses to that of an impoverished nation controlled by a narrow political elite (Scenario 2).

Variations

While the above scenarios have concentrated on the relative wealth and opportunity of the poorest 20% and wealthiest 20% of a society, it is important to consider the influence of the other factors on that nation's growth prospects:

• Governance + Rule of Law: if these are weak, no matter how good other scores are, it will act to undermine other aspects of the economy. If an act of law advantages some people more than others, then it introduces an asymmetry that will promote corruption. If corruption is tolerated then it will reduce the overall effectiveness of all institutions. A society can only function as well as the rights it allows to everyone.
• Importing / Exporting Goods vs Local Production: if there are better opportunities for importing or exporting products than for local production, then the society will suffer from high debt, and an overvalued currency. This will serve to further reduce opportunities for local production and so decrease the social and economic mobility of the poor.

The larger a nation (in terms of population-size) the better for it. It acts as its own common market. Where nations are small and poor investors should form regional trade promotion zones and facilitate free-trade between them in order to create a larger market.

The basket of emerging nations forming the benchmark

The benchmark blue line (set at 1) is relative to a basket of 30 emerging markets. These are as follows: Argentina, Botswana, Brazil, Chile, Estonia, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Lithuania, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Taiwan, Thailand, and Turkey.

The risk indicator red curve is a set of dimensionless variables that indicates a score relative to the benchmark. This is an indication of the level of risk presented by the nation represented in the curve relative to the risk of the benchmark. It must be recognised that this does not imply that the benchmark is stable, or not prone to risk.

The scores offer a probability of the nation so represented being a better or worse investment risk than the benchmark, and no more.