Frontier markets – Can the returns outweigh the risks?
Over the last five years, capital – both via corporate investments and as portfolio capital – has flowed into Asia’s frontier markets, from Mongolia to Sri Lanka, and from Bangladesh to Cambodia. Frontier markets, which exhibit a low correlation with the US market, and many of which are growing rapidly, are becoming part of the wider investment discussion about where to look for alternative sources of return.
Much of the interest in these barely emerging markets has been encouraged by onging turmoil in the developed markets. Such difficulties, combined with more recent concerns about whether growth is faltering in the BRIC economies, are leading investors to consider new and unfamiliar investment locations. At the same time, some of Asia’s newest markets have been transforming themselves rapidly.
In little over a year, Burma went from a pariah state, isolated for half a century, into a leading destination for potential investors. Over the last 12 months, President Thein Sein’s regime has relaxed its grip, released political prisoners and experimented with economic reforms. Aung San Suu Kyi, icon of the West, has joined the government, and international trade sanctions have been suspended.
There are many reasons for investors to look favourably at Burma. The country is rich with natural resources, including oil and gas, timber and minerals as well as having potential for renewable energy, fisheries and agriculture. There is a tremendous need for infrastructure of all types. Tourism is a likely source of revenue in the short term, while over time, the population of 60 million (mostly young) people may well become an emerging consumer market, open to services including telecoms, improved housing and transportation, financial services and insurance.
Following the lifting of sanctions, the European Union is considering the removal of duties from goods imported from Burma, which would be a huge boost for the country’s export industries, especially lower value added goods such as sandals, which are now being sold to Italy. While opportunity abounds in the country, potential investors in Burma are concerned about the continuity of the government’s recent liberalisation moves, and cautious about the current lack of adequate foreign investment protection and incentives.
In addition to these important concerns, investors can identify a range of sustainability issues, which might be additional arguments against allocating capital to the country at this time. In the areas of environmental and social protection, for example, there has for several years been controversy in Burma about the building of large hydro-electric dams along the Salween and Irrawaddy rivers. These developments often displace local populations and, moreover, will supply power mostly into Thailand or China (when one in four people in Burma does not have access to electricity).
In March this year, the government gave the go ahead to six dams on the lower Salween River, involving companies such as China’s Sinohydro, China Three Gorges Project Corporation and China Southern Power Grid. This region is home to a number of ethnic minority groups, as well as being one of the richest ecological areas in Asia, and there are serious concerns that the dam building will lead to increased militarisation, human rights abuses, environmental damage and loss of local livelihoods.
After China, Bangladesh is the world’s second largest garment exporter, employing some 3.6 million people, most of them women. Duty free access to Western countries, combined with low wages at home, have helped create a $19bn per year garment industry, with 60% of clothes going to Europe. The region is becoming increasingly popular with Hong Kong manufacturers as they seek cheaper alternatives to the Pearl River Delta, their traditional hub.
Exports provide a critical source of foreign exchange for Bangladesh, and many credit the industry for lifting people out of poverty, even given the very low wages typically being paid.
However, it is impossible for investors with concerns about sustainability issues to ignore the appalling health and safety record of manufacturing facilities in the country. The latest tragedy, the collapse in April of a building housing several factories making clothing for North American and European consumers, has reinforced the need for action on working standards and compliance. Over 400 people are known to have died in this disaster, which follows only five months after a different factory fire that killed 112 garment workers.
Representatives of many of the sourcing companies, including Walmart, Li & Fung, Tesco and JC Penney, have responded with offers of compensation for victims’ families or promises to take action on safety – although, given the history, there has to be a question about how effective that action is likely to be. Perhaps more meaningful are reports that the European Union is considering trade action against Bangladesh to pressure the government to improve standards.
ESG approach to mitigate risk
Arguably, the nature of most frontier markets makes them particularly susceptible to ESG risks. Many of these economies are heavily dependent on commodities, both mineral and agricultural. The extraction and development of these assets inevitably raises many environmental challenges (pollution, agricultural land degradation and desertification) as well as social problems. As we see from the example of Bangladesh, intensive manufacturing for export in these markets creates jobs, but may also generate problems of health and safety, equity and unsustainable wage rates. Finally, at both national and company levels, governance often fails to meet international best practice standards.
Investors who place a priority on understanding the ESG issues and challenges inherent on doing business in newly industrialising countries are likely to be better protected against social and environmental failures. In these earliest of developing markets where transparency – and liquidity – cannot be taken for granted, a rigorous approach to ESG research and analysis may be of paramount importance.
Alexandra Boakes Tracy is Chairman of ASrIA, the Association for Sustainable & Responsible Investment in Asia.