Tuesday, August 31, 2010

Crime and Economic Development: who is lying with statistics? No one! But we should dig deeper when it is about Emerging Countries

The attached article from the Travel (!) page of The Economist is more than interesting for those of us interested in Emerging Markets. It claims that the murder rate in Mexico is far lower when you subtract the violence in four states along the US border, where a lot of the violence is drug-related; with Ciudad Juarez having the doubtful reputation of being the murder capital of the world.  

 Ciudad Juarez (MEX), murder capital of the world

Most people are not at all involved in any way with the activities of the dangerous drug cartels. This implies that they would normally - as long as they know where to travel - not be confronted with it. 'Murder' and 'Violence' are byproducts of an economic activity that - because of the country's economic and legal situation - is 
a) lucrative; 
b) interesting for those who have no reasonable other career at stake; 
c) calculate the downside risk of being caught as relatively low; and
d) are in businesses that are in demand (in this case demand for drugs from the US).  

One average is not the other
To a certain extent one could say that this type of danger is less dangerous for the average person than petty crime, where violence is more about being cool and lack of control in specific areas is creating an unclear picture of when to travel and where to go to. One of your principals has lived for a couple of years in Los Angeles and Chicago. And like other citizens you just 'knew' where to go and where not to go at specific times of day.  Normally most business travelers and tourists are safe, because their destiny is another one than where crime is concentrated. Even in Brazil, mentioned in the report as being worse than Mexico (with murder rates in excess of 25 per 100,000 people), most local people know where to go and not to go. And most foreigners do as well.  

Just looking at the average numbers is one thing. But we should incorporate some kind of additional indicator of lawlessness and a dispersion indicator (similar to the Gini coefficient that we use when analyzing income distributions?) to make sure that we draw the right conclusions.  Actually, when looking at the Gini Coefficient map of the world we can even see that there is a linkage between income distribution and murder rate!

What Gini Coefficients have to do with Murder Rates
(Source CIA Factbook 2009)

And now the Homocide Rates by Country
Homocide Rates 2008; 
Compare the darker blue and purple here 
with the purple, red and orange in the previous map

When comparing the two maps Russia seems a lawless outlier. Far above average in terms of homocide and still reasonable in terms of Gini coefficient. There are a few others but the similarities between the maps are more striking than the differences. 

Income distribution effects, behavioral economics and our strange interpretation of safety risks
But even then: these two graphs are both based on one number, with the first one being based on a dispersion indicator and the second just a mere average of states, regions, cities etc. But crime and safety are more than just homocide rates. We did therefore never believe that Mexico as a country wasn't safe enough to travel to or do business with. People have a tendency to exaggerate and overreact to risk when it is further away from home. Behavioral finance teaches us that the relationship between rationality and risk perception is a strange one, and that is a euphemism.

It is just that those of us who are used to the situation in let's say Europe or the USA need to be careful. But believe me: even those Europeans that do not belong in specific parts of Amsterdam, New York or Berlin around 11-12 at night could easily be shown areas where things are definitely not totally controlled by police.  Countries with higher crime rates are often countries where certain parts of it are not controlled by the government, neither during day nor night. And as long as the ECONOMIC situation stays the way it is it is highly unlikely that governments are capable of changing things. 

Compare Columbia. Former president Uribe's success in Medellin did only start after he got sufficient help from the US and other foreign governments to provide people with a reasonable alternative. 
 Former Colombian president Uribe
Only winning against crime when the US started to help
in a more constructive manner

As long as the reasonable alternative is missing and those in crime are running a lucrative business sector, it will be hard to bring those numbers down. Once again, economic development and income redistribution in a way that makes life better for the poorer classes of society is the only way out. People are not necessarily interested in those ''bad industries'' for the sake of being able to be criminimal and violent. When the economic conditions are such that it is lucrative to be in that sector, people will. OK, not all, since different people have different moral issues.  But it is naive to think that we can fight these tendencies as long as income distributions and economic prospects are as skewed as they are.  

Mexico is a country with good potential. That is why Goldman Sachs labeled them as one of their Next-11. 
 Goldman Sachs' Next -11
Emerging Countries with big potential
But also with still above average crime rates

The other way round it is actually hurting the country when we classify it as 'bad' and 'dangerous' due to what is going on in states where crime still rules, knowing that a lot of it is related to demand from...yep, Western countries.  Safety for the average business traveler or tourist is an important indicator, just as much as it is important to know about neighborhoods in the travelers own country. Travelers do understand that principle. It is just that the one dimensionality tends to lead to wrong decisions and projections when it is about specific foreign countries - where numbers basically relating to a smaller area are easily extrapolated -, whereas we never hear about foreign people completely refraining from international business or tourism in Amsterdam, New York or Berlin because of the Zuidoost or Bosch en Lommer (Amsterdam) situation, or the Bronx (New York) or Kreuzberg (Berlin).

From safety risks to investment risks; what investors and travelers have in common
And what we deduct here for 'safety risks' can be easily translated to the investment world. Experience in 2008/09 indicated clearly that Emerging and Frontier Markets struggled at least as much with their returns as Western markets did, notwithstanding the fact that the Global Crisis was mainly a problem of Western banks. True, when it came to exports and imports by firms and consumers from Western nations, these went down and did thereby hurt economic performance in Emerging nations. However, their banks weren't going into technical bankruptcy at a similar scale as witnessed in the Western world. And the rebound after the crisis was indicative of this overreaction to bad news. As soon as the worst part of the crisis was behind us, we started buying again and only then did we realize that those nations did have bigger pockets this time round (larger foreign currency and gold reserves) and better economic outlooks. But then again: the simple fact that we know far less about them created a 'we don't know' feeling similar to what we see nationally when comparing return behavior of blue chips vis-a-vis SME stocks. We tend to translate less information into more danger, forgetting that on financial markets things are in the end all relative.

Example: suppose that we can measure information availability in some unit called INFO. Every individual private investor in the US or Europe knows a lot about Apple. And even if they don't they can easily find additional info about the company somewhere on the web, or get it via their bank or broker. So assume that a private investor has 500 units of INFO about Apple at his disposal. Even without going in detail and asking ourselves the question 'Is this information correct or to some extent flawed?' do we understand that this level has to be compared with that of the average investor in Apple to know if our investor is a knowledgeable insider or outsider. If the average amount of information that investors have at their disposal is 5000 units, our investor is in big danger of losing out whenever their is new important news about Apple or market factors that might affect Apple. 

Now, if this same investor holds 100 units of INFO about Emerging Markets (either direct or via his Global Emerging Market Fund manager) and the total available information level if 300 units, he is relatively better off. Again, he is an outsider but with proper support by an adviser and/or patience and discipline to not sell when others are panicking, he can still do well. The problem is however, that the bulk of investors will translate the absolute level of information into a general feeling of 'risk' when it comes to Emerging Markets investments that exceeds that of Apple to quite some extent. This is only true up to a certain level. Result: a behavioral trigger to sell small caps at home and every cap abroad and the more so, the more exotic the country. Investors and travelers do therefore have a lot in common. 

Click here for the original report in The Economist

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