Report from global asset manager also highlights complexities of assessing sovereigns from a sustainable investment perspective.
Political freedom, or the lack of it, ought to be ranked as a sustainable investment factor alongside carbon emissions, food security and energy transition, according to global asset manager Candriam.
Despite repeated claims of “unmissable” investment opportunities in autocratic states, such countries under-perform in the medium term, said Candriam in a new analysis of sovereign risks.
“An autocratic country cannot be sustainable,” said Kroum Sourov, Lead Sovereign ESG Analyst at Candriam. “It is hard to have the freedom of thought, expression and assembly in a dictatorship that is needed for economic development.
“We saw this in the Soviet Union and the Warsaw Pact.”
Candriam’s Sovereign Sustainability Report 2022 quantifies the underperformance of assets acquired in autocratic and semi-autocratic regimes. It uses the classifications of the US government-supported think tank Freedom House to divide countries into “free”, “partly free” and “not free”.
It applies these divisions to the JP Morgan Emerging Markets Bond Index – Global Diversified. The results from 2006 to the present found that free countries outperformed the broader emerging market universe, while partly free and not free countries lagged the index for most of the period. “However, none of these two country groups had consistently outperformed the other.”
When examined on an annualised basis, free countries outperformed the index by 0.31% a year over the 16 years, while the partly free countries under-performed by 0.61% and the not free countries move broadly in line with the index, out-performing it by just 0.09%.
While this may suggest un-free countries are a better bet than those that are partially free, the report adds: “If we use an equally weighted index to avoid biases related to index weights, the differences in performance are more pronounced in times of market stress. This is mainly due to the ‘flight to quality’ that is characteristic during such periods.”
Here, the results per annum over the 16-year period show free countries out-performing the index by 0.51%, the partly free countries under-performed by 0.15% and the not free countries under-performed by 0.47%.
Once major Middle East oil producers, including the United Arab Emirates and Saudi Arabia, are excluded, then the performances of the partly free and not free countries move into line with each other, with both under-performing this modified index by 0.37% per annum, while over the same period free countries out-performed by 0.59%.
As well as highlighting correlations between mode of government and returns, the Candriam report explores how investors should balance sovereign investment risks with sustainable investment priorities.
It argues that transition to a more sustainable economy is more likely to be achieved in democracies as it requires coordinated efforts by public and private stakeholders, including investors channelling capital to support government decarbonisation initiatives.
The report says the multiple risks and impacts facing investors due to a mix of geopolitical tensions and sustainability crises “can be addressed directly and the exposure to them managed better by directing investment flows towards countries that want to play a positive role in the international community, uphold democratic norms and human rights, and deal with the climate crisis”.
To identify the sovereigns most likely to reward investors seeking to achieve such sustainable returns, Candriam has updated its investment framework, using a natural capital score as a multiplier. The framework evaluates countries on the efficiency with which they create well-being – in the form of human, social and economic capital – while accounting for potential “depletion of or damage to” the natural environment.
Candriam’s rankings give several of Asia’s biggest nations – including China, India, Indonesia and Malaysia – a less attractive outlook for sustainable investment. In particular, Asia is one of the lowest scorers within the natural habitat and biodiversity component of the natural capital pillar, with China, Malaysia and Indonesia being ranked outside the top 100 countries.
“By relying on strong convictions about what constitutes sovereign sustainability, and by striving to support solutions for today’s global challenges, investors can make a real difference,” said the report.
“The awareness is there”
In terms of the investment under-performance of autocracies, the report also refers to the work of Luiz Martinez of Chicago University, who used satellite images of the growth of lighting at night time as a proxy for economic expansion. He found that autocracies exaggerated their GDP growth by up to 35%, which meant that, over the long term, such countries could be reporting double the real rate of growth.
Adds the report: “Interestingly, autocracies seemed to overstate their economic growth only once it exceeded the maximum eligibility level for international assistance programmes.”
The report highlighted the increasing problem facing investors such as Candriam that seek to base decisions on reliable, independent data. “It is more difficult to do because information warfare has increasingly penetrated a huge variety of media channels. Various disinformation campaigns targeted developed societies, aiming to promote polarisation, deepen divisions, nurture conspiracies and confusion.”
Sourov said: “We are using satellite images to monitor de-forestation and water pressure. Beyond that, we believe that having more than one source is better than relying on one source that is supposed to be ‘the truth’.”
Candriam has been in the minority in terms of taking account of democratic accountability when selecting sovereign debt, but there are some signs of change, said Sourov. “I am hoping that, after people’s recent experience with Russian investment, lessons will be learned. The awareness is there, but how it is applied can vary between different industry participants.”