Helene Williamson outlines the complex process of assessing political risk in emerging markets and warns investors they ignore this risk their peril
Investors in emerging market (EM) debt are typically well-versed in the inherent credit, liquidity and market risks as well as, increasingly, currency risk. What is often of more concern to them is political risk - the risk where an investment’s value is affected by political change or instability.
This greater concern is partly because other asset classes, such as equities, do not have the same discernible political risk, and partly because political risk is not easily measurable or quantifiable. However, simply because this type of risk is difficult to quantify does not mean that it should be ignored, or that asset classes involving political risk should be avoided. Successful investment in emerging market debt involves detailed analysis of political risk, as is increasingly done in the case of European, Japanese or US sovereign debt.
Why is EM debt perceived as an asset class with high political risk? For many investors, ‘political risk’ in emerging markets conjures up pictures of 1980s Latin American military dictators in sunglasses, the orange revolution in the Ukraine, Boris Yeltsin’s bargains with oligarchs in Russia, or the civil war in Sri Lanka. Such political realities and events can change a country’s economic environment, the willingness to pay its international debt and its credit quality. But are emerging market debt investments affected by the same political risks, and to the same degree as they were 10 or 20 years ago?
Emerging market countries, as a group, are much younger democracies than the US or Western Europe. Some are ‘managed democracies’, such as Russia, or even authoritarian systems to varying degrees, such as China. As late as 1980, most Latin American countries were still ruled by military juntas (with the exception of Mexico and Colombia). Only over the following 20 years did this region start to change, with Brazil, Argentina, Chile, Peru, Uruguay and Panama making their move towards democracy. In Asia, Indonesia and the Philippines also moved from military regimes to democracy during the same period. It was not until the 1990s that Eastern Europe and the Commonwealth of Independent States (CIS) started their transition from communism to democracy and from centralised planning to free market.
These relatively recent structural political changes have meant that the institutional framework in emerging markets is not as strong or well established as it is in the ‘old’ democracies. Central bank and the judiciary are typically not independent from the executive, with the result that legal and regulatory outcomes can be less predictable. Similarly, political parties and their programmes are not always the key drivers of policy and the electorate often does not vote for a party but for personalities, who tend to be more powerful than the party they are supposed to be representing. Vladimir Putin and his United Russia party is a good case in point.
How politics affect markets
This situation may create more uncertainty during election periods as the scope for economic policy change is both larger and often opaque. This was evident in the 2011 election of the left-wing Peruvian president Ollanta Humala. Investors questioned whether he would continue the market-friendly policies of his predecessor, as the left-wing former president Lula de Silva had done in Brazil, or whether he would attempt radical changes in economic policy, as president Hugo Chavez had done in Venezuela.
When, in 2002, de Silva and his Workers’ Party started to look as though they might win the election, there was a massive flight of capital from Brazil because of market fears of a default and far-left social policies. Spreads of dollar-denominated debt spiked to 24% and the Brazilian real came under pressure. However, after his election, de Silva abandoned most of the radical rhetoric and his government’s conservative fiscal and monetary policies triggered higher growth rates.
Trade liberalisation brought rapid rises of imports and exports. By the end of de Silva’s second term, income equality had improved and the economy became much more open as Brazil was one of the key beneficiaries of globalisation. And, perhaps most importantly, de Silva established a broad consensus of economic thinking, so that the risk of a dramatic policy change has become remote. In the eight years from 2003 to 2011, Standard & Poor’s has upgraded Brazil’s foreign currency debt five times - from a highly speculative B+ to an investment grade rating of BBB.
While de Silva created a broad political and economic consensus, president Chavez has polarised the Venezuelan electorate. His government nationalised wide swathes of industry and implemented price controls that discourage investment. Import controls, transfers of international reserves away from the central bank to entities that are outside of budgetary and capital controls have undermined market forces in the Venezuelan economy. The risk premium of Venezuelan bonds has consequently risen over the past 10 years, as the market priced in the unpredictable policies of Chavez. Only since the announcement that he is ill has the risk premium decreased as investors price in a potential political change.
Clearly, a lot of value can be added through a correct assessment of whether taking on political risks in certain times is likely to be compensated by prospective returns. But how can it be done?
How to assess political risk?
There is a plethora of rankings of countries by social, educational or health indicators and by income inequality or their integration into the global economy. Other research focuses on the ease of doing business in countries, property rights, or the degree of transparency and corruption, to arrive at a political risk ‘score’. These indicators provide an idea of the level of development countries have attained and how attractive they are for foreign direct investment. The history of these indicators might signal a trend of improving or deteriorating conditions in a country. But there is clearly not a single indicator for the level of political risk an investor is assuming when investing in a country. Ultimately, an assessment of political risk is a complex qualitative judgment based on many inputs.
Some of these indicators can tell you how high the potential is for political unrest, conflict and change is. For example, a sharp deterioration in income inequality or persistently high and rising inflation and unemployment, ceteris paribus, increase the potential for social or political unrest. The Egyptian uprising in 2011 has shown that long-term political stability (Hosni Mubarak was president for 30 years) does not imply low political risk. The Arab Spring also illustrates the impact of demographic factors as well as social media on political risk.
Advanced economies, amplified risks
Before 2008, investors perceived EM countries as having much higher probability of political change, uncertainty and risk than developed countries. The 2008 financial crisis represented a major structural break in developed country macro-economic management. From 2007 to 2011, advanced economies experienced a huge rise in the average gross government debt-to-GDP ratio, from 73.4% to 102.9%.
Since the crisis, we have seen extraordinary political interference in markets in the developed world; countries have nationalised large banks, central banks are buying unprecedented amounts of bonds and significant regulatory changes are being imposed on banks. With large-scale ECB purchases of euro-periphery bonds and quantitative easing programmes in the US, Japan and the UK, macro-economic predictability in the developed world is no longer as high as before. In its justification of the US downgrade to AA+, Standard & Poor’s noted that policy-making in the US was becoming less stable and predictable - hardly a surprising comment given the near-default due to political wrangling over the debt ceiling.
This process of medium-term fiscal adjustment amid high unemployment in the developed world is likely to be accompanied by more political changes and uncertainty. That prospect is starting to be reflected in the risk premia or spreads of sovereign debt. And with debt-to-GDP ratio becoming one of the most powerful explanatory variables for spreads, the distinction between emerging and developed markets has all but disappeared since 2008. The market now prices in deteriorating fundamentals in the developed world and improving fundamentals in emerging markets, with debt-to-GDP ratios for EMs currently at 38% versus 104% for advanced economies.
After 2008, investors ignore political risk originating in the developed world at their peril.
Helene Williamson is head of emerging market debt at First State Investments