Unpacking Frontier Market Geopolitical Risk: Understanding its Drivers, and, how Direct Aid Shapes its Dynamics

"If one marks off a belt a couple of thousand miles in width encircling the earth at the equator one finds within it no developed countries. . . . Everywhere the standard of living is low and the span of human life is short."

— John Kenneth Galbraith

What Kenneth Galbraith is essentially saying in the quote is: the welfare of people in the tropics, i.e. the region of the Earth that lies between the Tropic of Cancer (23° 26′ 16″ N) and the Tropic of Capricorn  (23° 26′ 16″ S), is poor in both absolute and relative terms.  The red overlay in Illustration 1, below, demarcates the tropics:

Illustration 1 (click on illustration to zoom in)

This begs the question of why "tropical" economies; i.e. the economies that satiate the needs and wants of 40% of humanity, are generally poor. Obviously, (part of) the answer to that question would be climate: most tropical nations are hot and moist (practically) all year-round. These weather conditions create an interesting mix of constraints in frontier market economies, including: 

1. The Heat Constraint: In The Wealth and Poverty of Nations, David Landes wrote: "Three quarters of the energy released by working muscle takes the form of heat, which the body, like any machine or engine, must release or eliminate to maintain a proper temperature. Unfortunately, the human animal has few biological devices to this purpose. The most important is perspiration, especially when reinforced by rapid evaporation. Damp, 'sweaty' climes reduce the cooling effect of perspiration—unless, that is, one has a servant or slave to work a fan and speed up evaporation. Fanning oneself may help psychologically, but the real cooling effect will be canceled by the heat produced by the motor activity. That is a law of nature: nothing for nothing; or in technical terminology, the law of conservation of energy and mass. The easiest way to reduce this waste problem is not to generate heat; in other words, keep still and don't work."
2. The Parasite Constraint:  Cold winters are the greatest vermicide of nature: In The Wealth and Poverty of Nations, David Landes asserts that "tropical countries, except at higher altitudes, do not know frost; average temperature in the coldest month runs above 18°C. As a result, they are a hive of biological activity, much of it destructive to human beings... We now know for example that many people [in tropical regions] harbor not one parasite but several; hence are too sick to work and are steadily deteriorating."
3. The Precipitation Constraint:  In The Wealth and Poverty of Nations, David Landes also reflects that "tropical areas generally average enough rainfall, but the timing is often irregular and unpredictable, the downpours [are] anything but gentle. The drops are large; the rate of fall torrential...In such climes, cultivation does not compete easily with jungle and rain forest: these treasure houses of biodiversity favor every species but man and his limited array of crops... Clear and plant, and the unshaded sun beats down; heavy rains pelt the ground—their fall unbroken by leaves and branches—leach out soil nutrients, [and] create a new kind of waste. If the soil is clayey, composed in large part of iron and aluminum oxides, sun plus rain bakes the ground into a hard coat of armor. Two or three years of crops are followed by an indefinite forced fallow."

The above-mentioned constraints create a limiting set of initial conditions, that, in turn, shape the politics and development trajectory of most frontier market economies. Further, these constraints create an eclectic mix of risks for the frontier markets investor.

In this blog post, I will discuss a framework which I created. It can be used to dissect the unique set of risks that frontier markets investors are exposed to. The said conceptual framework was inspired by Bruce Bueno De Mesquita and Alastair Smith's riveting text entitled The Dictator's Handbook: Why Bad Behaviour Is Almost Always Good in Politics.

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In the preceding paragraphs, I demonstrated that the geography of frontier markets creates the following developmental challenges:

• An unproductive, morbid population with a low life-expectancy (owing to infestation by parasites).
• Poor food security (owing to an uneven pattern of rainfall) that has a diminishing effect on the quality of human capital.
• A "poor working environment" (owing to the great heat) that essentially taxes productivity.

Otherwise put, in frontier market economies the public goods that have the greatest demand are; basic healthcare, nutrition and shelter from the blistering heat. Succinctly; the lower Maslovian needs, i.e. Physiological needs, tend to be predominant in frontier markets. Generally, most frontier market governments have failed to adequately provide the said public goods. And, direct aid organizations, like The Carter Center, UNICEF and The Gates Foundation, have stepped-in to meet the demand for basic public goods.

By and large, most types of aid fail to achieve their envisaged objectives. However, direct aid, i.e. aid which focuses on the provision of basic public goods, has registered a number of monumental successes. For instance, The Carter Center's Efforts to combat the guinea worm in Africa and Asia has reduced the number of affected people from 3.5 million people (in 1986) to approximately 3,000 people in 2009.

Such successes shape the universe of opportunities in frontier markets, and, their risk profiles. Hence, a discussion of frontier market risk also has to incorporate the role that direct aid plays in shaping the risk factors, which the model in Illustration 2 does. The model principally expositions the types of political unrest that occur as a nation's health improves, and; as predominant Maslovian needs shift away from "Physiological needs" to "Safety needs".

Illustration 2 (click on illustration to zoom in)

In the next paragraphs, I will discuss the conceptual framework in Illustration 2. I will start by discussing the prominent risk factors that a frontier markets investor is exposed to when Physiological Needs dominate. And then, I will move on to discuss the risk factors that an investor can expect when Safety Needs dominate:


...When Physiological Needs Dominate

As I stated previously, frontier market economies have initial conditions in which the following constraints are active: The Heat Constraint, The Parasite Constraint and The Precipitation Constraint. These constraints generally limit population growth, people's quality of life and their life expectancy. In the early phases of their development, frontier markets tend to have a demographical structure that approximates Illustration 3 below:

Illustration 3 (click on illustration to zoom in)

Illustration 3 demonstrates that early phase frontier market economies tend to have:

• High infant mortality rates, owing to poor perinatal and maternity facilities. Thus, women tend to give birth to a lot of children to reach their target number of surviving children. Otherwise put, these societies tend to have high fertility rates.
• A life-expectancy rate that lies in the 30-50 years band.
• A morbid adult population that is unproductive, owing to poor health that stems from parasite infestation.
• A female life-expectancy that approximates the male life-expectancy; which signals the low status of women in the society. [1]

In such a society, the masses, including young adults, are generally ill and undernourished. Their productivity would be very low and the economy would be underdeveloped and highly informal. Thus, central government revenues from taxation would tend to be anaemic. If the country has a military, it would generally be under-funded and mutinous, i.e., unless the government has access to non-tax revenue (i.e. mineral royalties and debt funding) that can be used to fund military expenditures.

The greatest risk in such societies is the risk of a military coup, as Quadrant 1, of Illustration 2 demonstrates. If the coup has the support of all the members of the military, the incumbent leadership would be deposed quickly, and a military junta would administer the society. Any change of government carries a high risk of total impairment for any investor, and in scenarios in which power is seized forcibly and the treasury's resources are anaemic, resource expropriation is almost certain (i.e. expropriation risk is high).

However, if a minority of the military's members "becomes rogue", there is a high likelihood of guerrilla warfare or terrorist activity. The duration of the conflict would depend on the rogue network's ability to secure popular support and resources: If the rogue network manages to secure popular support, it could leverage that support to enlist recruits and to husband resources to spearhead its efforts.

In such a scenario, the length of the conflict would be inversely related to 1) The rate at which the conflict depletes the resource pool of the central government and 2) The degree of support that the rogue network attracts.

If the rogue network fails to win popular support (read: resources), it would conduct its warfare using less costly tactics like terrorism. And, it would have to scavenge for resources by either: tormenting the morbid masses; kidnapping influentials for ransom extraction; forcibly recruiting minors - as they would tend to be more obedient, and, healthier than adults (owing to the impact of direct aid programmes); counterfeiting and trading contraband items, and; seizing a key resource that can produce a high return of output per unit of unskilled labour per unit of time. Otherwise put, the following types of investors would have a high risk of impairment:

• Investors who are in a joint venture or PPP type arrangement with the central government - Facilities and staff would be terrorised, and the magnitude and frequency of the attacks would be directly related to the amount of revenue (as a proportion of total government revenue) that the government earns from the venture.
• Investors in mines that produce minerals that can 1) be extracted using labour intensive processes and 2) Smuggled easily.
• Plantation and Ranch Investors - Rogues, like everyone, need to eat, and any farm, ranch or plantation that produces protein and carbohydrates is certain to lose the majority of its produce to theft (i.e. if the security on the property is high) or seizure (if the security on the property is low). Producers of cash crops that 1) have a high black market value and 2) Can be smuggled easily would also lose their produce.

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If a country has a strong government and military, there would be a low risk of a military coup, but the risk of terrorism by disaffected pockets of society cannot be ruled out, as Quadrant 2 of Illustration 2 demonstrates. The stable conditions that would be prevalent in such an environment would allow direct aid organizations to operate in an unfettered manner, which would, in turn, satiate the society's needs for the basic public goods of healthcare, shelter and primary school education.

However, the fertility rate of women would remain elevated, in the short to medium term, while the infant mortality rate falls: i.e. there would be a baby bulge that would cause an immediate surge in the dependency ratio. The high dependency ratio would be burdensome to the society in the following ways:

• The population of, healthier but still morbid, adults would demand higher wages. Their productivity would register a slight increase, owing to healthcare improvements. But, the productivity increase, would, in most cases, not warrant the extent of the wage demand, which would almost certainly be high. As one would expect, these pressures would deter further inward investment.
• Government would have to provide subsidies to families, and, cut taxes for middle-to-working class families. Thus, the tax burden would have to be shouldered by a declining number of entities in the society. This would, in turn, increase the government's reliance on foreign aid, royalties from a resource endowment or debt. Increasing indebtedness would, in turn, increase the risk of a future tax increase for frontier markets investors.

...When Safety Needs Dominate

Within a decade or two fertility rates in the society that benefited from direct aid would have fallen, drastically, and the infants who had access to public goods like healthcare, shelter and education would become a growing proportion of the workforce. The demographic structure of such a country would have the profile in Illustration 4, below:

Illustration 4 (click on illustration to zoom in)

Safety needs would be predominant, and the most prominent of them would be job security. If the "bulge generation" is met with increasing foreign direct investment, a growing economy, growing export markets, increasing employment and rising incomes; effective demand would rise, which would in turn, bolster aggregate demand and fuel a growth spurt. Otherwise put, a "demographic dividend" would be earned by investors in the economy. Such an economy would have a very low risk of strikes as Quadrant 4 of Illustration 2 demonstrates.

However, if the "bulge generation" is not met with a growing economy and rising incomes, youth unemployment is certain to increase which would, in turn, increase the risk of political unrest in the economy.  If the incumbent government does not suppress essential freedoms (free and fair elections, a free press, free speech, and freedom of assembly) it would be deposed in a democratic election.

And, the worst that would occur in the period leading-up to elections are peaceful protests or strikes. The risk of these events would be remote as Quadrant 4 of Illustration 2 shows. In such a scenario, the only risks that investors in the economy would face are:

• The risk of tax increases - Increased taxes would fund a social security buffer that would reduce the risk of unrest in the near term. However, if the tax burden becomes too onerous, investors would divest, and, the economy would tailspin in the medium turn. This would increase the risk of future unrest.
• The cost-push inflation risk - Increased minimum wages would push-up costs and erode margins in labour intensive industries.
• The risk of onerous "societal demands" on businesses.

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If essential freedoms are suppressed mass uprisings would occur as Quadrant 3 of Illustration 2 shows. If the incumbent government responds forcefully, civil war would eventuate. This would create an eclectic mix of risk factors for frontier markets investors, that depend on a confluence of unique factors in each frontier market economy.

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[1] In most normal societies, female life expectancy is higher than male life expectancy. Why? Because women generally take fewer life-threatening risks than men.