Socio-economic factors have a strong influence on an emerging market’s competitiveness and ability to generate economic growth over the long term, writes Joseph Mariathasan
At a glance
• Environmental, social and governance factors are important as they underpin economic growth in emerging economies.
• Some countries, notably Thailand, are moving in the opposite direction.
• There is a trade-off between democracy and economic performance.
• From an investor’s perspective, benevolent dictatorships can provide the best results when they work.
How important are the ‘feel good’ factors in managing emerging market debt? In this context, they can be described under the heading of environmental, social, governance and political factors (ESGP). It is an issue that many investors are increasingly taking on board. Standard Life Investments (SLI), for example, is seeing interest from institutional investors in continental Europe and from Australia, while in the US, they find a clear split between institutions with some, such as CalPERS, the California state pension fund, clearly keen.
Jan Dehn, head of research at Ashmore Investment Management, argues that ESGP factors are important because they have direct implications for the risk and the return that investors get from their investments. Even leaving aside the moral aspect, it is argued that it makes business sense to consider such factors. Ricardo Adrogué, head of Babson Capital Management’s EMD team, even contends that the relative value of ESGP factors is higher than balance sheet figures. Ultimately, good management is more important than having a lot of cash in hand. “You can use cash up very quickly. A country with a lot of reserves and low debt ratios doesn’t mean it is a good credit,” he says.
A country’s creditworthiness is clearly dependent on its competitiveness and ability to generate economic growth over the long term. But Kieran Curtis, EMD portfolio manager at SLI, points out that the ability to sustain economic growth depends on socio-economic factors. These include the level of inequalities, education, health systems, the quality of infrastructure and the environment, as well as resource constraints.
Institutional weaknesses and social issues can amplify macroeconomic fragilities. This is why ESGP issues are important within an emerging market context. The question is how ESGP factors can be incorporated within an investment framework.
As SLI finds, environmental sustainability is a challenging aspect to assess in emerging markets. This is partly the result of the poor availability of data and partly because different degrees of industrialisation and development among emerging countries can significantly and sometimes unfairly penalise the ESGP score. Social indicators are, at the same time, an outcome of past development policies and a catalyst or impediment to future economic development. As such, social indicators are strongly intertwined with government and political factors. Governance indicators assess the quality of democratic institutions and the stability of the political framework.
Emerging markets are often characterised by poor governance caused by a lack of the institutional framework that is seen in developed markets that may have evolved over decades or even centuries. It includes factors such as the strength of the rule of law, government effectiveness, the ease of doing business and the level of transparency of central government budgets. For investors in emerging market debt, SLI finds that even identifying the use of proceeds from bond issues can be challenging.
“When you look at an opportunity, when you look at the risk, the returns, the microeconomic fundamentals of the trade itself, you also look at the policy environment in which that company or sovereign exists”
Finally, political indicators need to incorporate factors that could pose a threat to national security and democracy. These can include the prevalence of corruption in the public sector and factors that favour the outbreak of violence and conflicts. Even for developed markets, the UK Brexit vote has dramatically illustrated the impact of political developments on financial markets. Curtis argues that politics is a key aspect for EMD investors as it drives economic policy and growth in emerging markets much more significantly than in developed economies. Along with transparent policy-making and sustainable growth comes a greater likelihood of debt repayment.
For EMD managers, as Dehn argues, ESGP factors are taken into account by explicitly examining each investment opportunity by reference to a set of criteria that are ESG-related. “So you actually go through an exercise where, when you look at an opportunity, when you look at the risk, the returns, the microeconomic fundamentals of the trade itself, you also look at the policy environment in which that company or sovereign exists.”
SLI has begun attempts to adopt a more quantitative approach based on a scoring system using data from a variety of sources covering the four criteria. Intuitively, it would expect deterioration in a country’s ESGP score to be accompanied by a widening in its credit spreads. Several research papers have found that non-financial factors influence spread movements. SLI’s own empirical research backs up that intuition, suggesting that ESGP can be a useful tool for investing in EMD, says Curtis. The problem it faces, though, is that the economic data being used may well be a year or more out of date and will not be reflecting current conditions. But, as Curtis argues, the results so far obtained show some value over a three to five-year time frame.
Many countries are moving to embrace ESGP but, as Adrogué points out, some in each region are moving in the opposite direction. In Africa, Tunisia is struggling after initially looking the most advanced in terms of the 2011 Arab spring. The Ivory Coast has come a long way, and the next step should be a peaceful transition of power. Nigeria has gone way ahead of many other countries.
Thailand is the most difficult case of all. The country does not have enough political and social consensus for any government and that is why it has a military administration every time. It is going backwards from an institutional perspective but has enjoyed political stability for the past two years. What is clear, is that there is not sustainable management if it is dependent on one person in charge and Thailand needs to decide what kind of political administration it wants.
There is a trade-off both for investors and for the populations, though. “Russia has a strong balance sheet but from a governance perspective it is sub-optimal. Because it is ruled autocratically, strategy can be changed very quickly and investors like ourselves could very well be the last to know about it. So having good governance means we can have more conviction on which direction the country is heading,” says Adrogué.
But Dehn has no problem in investing in Russian sovereign debt. “Why should I?” he asks. “What is it that Russia is doing that no one else is doing? Russia is unpopular because there is Western sympathy for Ukraine. But Russian sovereign debt is not covered by sanctions.”
Even in China, the third-largest bond market after the US and Japan, concerns over human rights and freedom of expression are raised regularly. Yet the implicit bargain between the population and the ruling Communist Party is an acceptance of restrictions in return for the huge rise in living standards.
For EMD investors, as well as populations, benevolent dictatorships may well be able to provide the most successful leaderships when they work. But, as the excesses of Mao Zedong in mid-twentieth century China show, the costs can be unacceptable.
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Pay heed to ‘feel good’ factors