Why Investors Should Prefer Democracies...

In my Money Week column this week, I've been looking at why investors should prefer democracies to autocracies. Here's a taster....

For anyone investing in the Middle Eastern markets, the last few weeks have been a heck of a ride. The Dubai market, one of the more developed in the region, plunged all the way back to 2004 levels during the past month. The Saudi market was shakier than a palm tree in a hurricane. The Egyptian stock market closed as the country ousted its long-serving President Hosni Mubarak, and won’t re-open for another week.
Right across the world, investors have pulled back from emerging and frontier markets. The darlings of the global investment community until a few weeks ago, they are now about as popular as Colonel Qaddafi in Benghazi.
There is a lesson to be learned from that. It is far better to invest in democracies than autocracies. In the last few years, the markets have fallen for the idea that autocratic governments are more stable and more efficient. There may be some truth in that in the short-run. In the medium-term, however, a revolution will destroy your investment. In practical terms, that means avoiding China and much of the Middle East, staying suspicious of Russia, and focussing instead on India, Eastern Europe and South Africa as well.
Before the tidal wave of change swept across the Middle East investors could be forgiven for believing that the nature of the regime didn’t make much difference to the case for putting money into a country. True, the people in charge of a country might be a shady bunch of gangsters and thugs, but so long as oil was being pumped, minerals dug out of the ground, and new factories getting built, it didn’t matter very much.
Emerging and frontier markets have been booming for the last ten years, pretty much regardless of whether the government in question was stable or not. According to calculations by IJ Partners, the Pakistani market rose by 449% in the last decade, measured in dollar terms. The Egyptian market rose by 430% over the same period. That was a better performance than gold or oil, and way better than traditional stock markets. The FTSE-100 was only up by only 12% over the same period and the S&P 500 by just 2%. And yet Pakistan is widely regarded as a failed state. And the Egyptian government has just collapsed.
The premium that investors used to demand to invest in emerging markets all but disappeared over the 2000s. We all know the reasons for that. Growth has largely ground to a halt in the developed economies. It was only by taking on more and more debt that the illusion of prosperity was maintained. The frontier markets offered far better prospects. They were growing fast, they had healthy demographics, and usually high savings ratios and low deficits as well. They looked a far more attractive home for your money.
But investors forgot the one thing that in the past kept them out of emerging markets – political risk. After all the 400%-plus gains you might make in a market such as Egypt don’t count for much if the bourse then gets shut down, and a new revolutionary government seizes foreign assets. You can only invest where there are secure property rights – and that ultimately depends on a stable government.
That lesson is being re-learnt very quickly. Globally, investors poured $95 billion into emerging markets funds during 2010. In the first week of February alone, as the Middle East crisis broke, they pulled more than $7 billion of that back, the biggest withdrawal in more than three years. Where once investors were piling indiscriminately into new territories, now they are abandoning them just as rapidly.
Neither is the right response.
What investors need to do is discriminate between stable and unstable emerging markets – and remember that in the medium-term it is only democracies that offer security.
There is a temptation to look at an autocracy and think it is rock solid. After all, a leader such as Mubarak hung around in power for three decades. Dictators are usually pro-business and anti-union. There is none of the messy business of populist politicians demanding tax rises, or threatening to take control of foreign investments.
But it is an illusion. Under the surface, terrible tensions are always building up. When they break to the surface, there is violence and chaos. A very radical, anti-capitalist regime can easily emerge.
It is far better to focus on the democracies – and avoid the remaining autocracies. True, the democracies might appear messier. But so long as there is a commitment to free speech, fair elections, and property is protected, over the medium-term they are far more stable. It is very rare for a democracy to be thrown out by a revolution – and it is very rare for an autocracy not to be.
So, be wary of China. True, it has great growth prospects. But it is still ruled by an authoritarian Communist Party that shows little sign of relaxing its grip on power. There are tensions between regions that are growing at very different rates. The whole of the Middle East looks off-limits as well. States such as Saudi Arabia and Dubai will face their own revolutions in time, no matter how wealthy they might appear to be. And stay suspicious of Russia. It is slowing slipping from democracy back towards autocracy, and that will make it less stable in the medium-term.
Against that, India has been a remarkably successful democracy for a very long time, particularly considering its size and relative backwardness. Brazil is a reasonably free country and so are South Africa and Turkey. Nearly all of Eastern Europe, although its markets have not shone in the past couple of years, is far more democratic than anywhere in the Middle or Far East.
There will be bumps along the way, and elections that hit the markets. But over the medium-term, it is only countries that have already created functioning democracies that offer any chance of decent returns.