FIM Partners Fund Manager Matthew Vogel highlights the importance of integrating ESG into sovereign risk analyses, especially in emerging markets.
ESG factors are central to country risk assessment, and are causal in movement of sovereign credit spreads, currencies, and local markets. While macroeconomic factors create vulnerabilities, the triggers are often emanating from within the scope of ESG. A review of major asset price movements in emerging markets (EM) would likely show a pattern of macroeconomic trends that led to pressures building while asset prices did not adjust, and that a governance or social event triggered the correction in asset prices. Indeed, as you pass from developed to emerging to frontier markets, one will find bigger impacts on financial assets – yet the typical investor might ask: what the most critical of factors are when performing ESG screening on a target market, and once you have identified them, how do you use them?
Governance comes first
A foundational point is that governance must come first. Run a country well, and you get good results – you conduct transparent and orthodox policies, have institutional strength and flexibility to face challenges, and have a sense of social contract that works for the long-term benefit of the population and achieves sustainable growth. However, it’s no secret that the worst freeze in France’s wine region this century can be dealt with via government support, but a drought in Kenya may lead to civil strife, significant budget pressure, and increased questions on fiscal consolidation.
Nigeria provides a preoccupying example of the impact of poor policy choices and governance. Population growth has exceeded GDP growth since 2015 – they are in the seventh year of a per capita recession, and projections show them remaining in this recession for the coming 3-4 years (barring significant reforms). Flawed policies to stimulate domestic agriculture by banning the importation of staple products like rice and edible oils, as well as chemical fertilisers, have been catastrophic. Domestic agricultural production is not responding and food price inflation has soared to over 20%.
The vulnerable ‘South’
In the scope of environmental factors, climate risks are self-explanatory – the ‘South’ seems more vulnerable to increasingly adverse weather conditions. Kenya is a country which has been rapidly running up a large debt burden, and as with so many frontier economies, the contribution to GDP growth rely on services and agriculture. The country is experiencing more frequent droughts, has recently endured a locust infestation, and with the outlook for global warming, the incidence of these climate events may persist. Of course, farmers can be funded to plant more pest-resistant plants and water conservation can be improved – official creditors will be there to fund these efforts.
But with the country running such large fiscal and current account deficits on a persistent basis, some risk premium for these climate risks is increasingly important. Besides weather-related factors, investors would also be wise to assess carbon intensity – countries which are either misusing natural resources or are heavily biased towards dirty energy technologies – and carbon dependence, which refers to those countries reliant on natural resources to finance growth, and must adapt their models to diversify.
The social sphere
In the social sphere, we consider the social contract essential. Perhaps it is not so important if the population experiences high real wage growth and life expectancy. Chile’s extreme income inequality was not a problem until it was a problem, and the Chileans are now trying to make a new social contract – one which has important implications for its economic model. We find the concept of subjective well-being as a useful complement to the metrics of income, life expectancy, education and health, in that it can provide greater understanding about whether people believe the government acts in its interests, to feel safe and taken care of.
Saudi Arabia is a case study viewed as uninvestible for some investors due to human rights issues, but we are seeing some encouraging developments very recently, for example, with the decision to withdraw from Yemen under pressure from the US; and the country seems receptive to the Biden Administration’s focus on human rights issues. There is a long way to go, but what is happening domestically in the area of social reform is, lacking a better term, remarkably empowering to the vast majority of the population, especially youth and women. A number of reforms in the kingdom mark a giant leap forward from a low base, but the resultant change for millions of Saudis is real. We think these measures, combined with economic reforms, are mutually reinforcing to stimulate investment, innovation, and job creation.
A necessary step
All in all, savvy allocations to emerging markets should always include the integration of ESG factor analysis. The increasing adoption of formalised ESG frameworks is a necessary step towards ESG integration into EM investment decisions and we think that the institutionalisation of ESG investing will keep investors honest – reducing the risks of greenwashing and helping all stakeholders work towards achievable sustainability targets. In an increasingly ESG-aware world, and one in which those ESG factor risks are rising, a high conviction and active investment approach will greatly diminish drawdown risks and lead to better investment outcomes.