As a foreigner, it can be difficult to parse what's happening on the ground in a particular emerging economy. As an investor, how can you analyze the risk in a foreign market and determine if a country is on a sustainable growth path -- or on the road to ruin?
A recent study of financial crises provides a unique and powerfully applicable insight: political "booms," or a rush of popular support for the government, could be the indicator you most want to keep an eye on.
The political boom
Using data from over 60 countries and 113 crises since 1984, economists Helios Herrera, Guillermo Ordonez, and Christoph Trebesch find that political booms are eerily accurate at predicting financial crises in emerging markets -- even more accurate than using data on credit booms.
What's a political boom? The authors use the "government stability" indicator in the popular (well, among academics and the like) International Country Risk Guide database. This metric looks at government unity, legislative strength, and popular support, capturing changes in public opinion and the government's ability to carry out its agenda. Its simplicity makes it easy to use, and its components make it very accurate at uncovering popularity and voting intentions over time.
The incentives facing emerging markets politicians
So, how does political popularity affect the economy? Governments in emerging markets face peculiar incentives and risks compared to their peers in more developed countries. In general, emerging markets governments are less popular, and the popularity they do enjoy is more volatile.
To make matters worse, when these governments try to impose regulations, voters typically react negatively. In other words, when an already unpopular government tightens the rules, its popularity sinks even more.
On the economic side of the equation, say you're an emerging market leader and your country is growing. Great news! But while expansions driven by productivity growth are good, other expansions -- like credit booms -- tend to end badly. In the case of a credit boom, the reasonable thing to do would be to regulate in order to prevent the speculation from getting out of hand. On the other hand, if you regulate, you might find yourself faced with angry voters.
Thus, in the face of booming economic growth, emerging market leaders are more likely to find themselves in a bind: Regulate and lose popularity, or let the bubble go and enjoy public support.
What do you think most leaders do?
Letting the bubble ride -- with detrimental results
Because of these incentives, emerging market leaders are much more likely to let unsustainable growth go -- with detrimental results, according to the study: "A one index-point increase in the government popularity (year-on-year) increases the probability of a crisis by nearly four percentage points."
When you add in credit boom data, the model is even stronger.
In other words, political booms magnify credit booms, meaning the long-term impact of a credit boom is magnified by the presence of a political one.
It's an unfortunate statistic, but it makes for some fascinating data, and a killer leading indicator. On average, government popularity increases by over 53% in the five years before a severe crisis. Banking crises aren't exempt, either: Government popularity increases 12% in the years before a big one.
Putting unfortunate data to good use
So, how do you apply this?
When looking at an emerging market economy, pay attention to how the government is doing. Are people rallying behind their leaders, voting them in with huge majorities? Are government officials talking about the high level of unity, and pushing through their agendas? If political popularity is increasing significantly over time, and you're also noticing a rapid economic expansion, be aware of the fact that this could mean a higher risk of crisis later on.
The facts on the ground are always unique, but this paper's finding gives a powerful perspective on the relationship between governance and economics -- and the extraordinary impact that one can have on the other.
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