Why politics matters to ESG regarding emerging markets debt

With investors' interest in emerging markets asset classes growing as valuations start to recover, there is more attention being paid to understanding the impact of environmental, social, governance and political factors, or ESGP. These are increasingly being reflected in investment mandates as part both of the portfolio design and in ongoing risk management.

ESG factors traditionally form part of corporate analysis. Their introduction into the sovereign space is relatively new, and while similarities exist, the approach should be adapted to the peculiarities of sovereign analysis. This is why the addition of a politics pillar to the traditional ESG framework is necessary. Especially in emerging markets, politics plays a predominant role in shaping industrial policies and social outcomes and in determining the quality of governance.

Formalizing an ESGP analytical framework for emerging markets investments has several advantages. The integration of rigorous ESGP research into portfolios can complement the analysis of traditional macroeconomic variables. Since ESGP factors are an important aspect of sovereign creditworthiness, a robust framework can contribute to clearly identifying potential mispricing and emerging trends.

A country's creditworthiness is fundamentally dependent on its competitiveness and ability to sustain economic growth over the long term. To assess this, investors traditionally look at a range of macroeconomic variables, including public debt, inflation, fiscal deficits and current account balances. Along with political and governance factors, these are enablers of economic development and elements of a country's willingness and ability to repay its debt.

In addition, the ability to sustain economic growth depends on socio-economic factors, such as 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. As such, ESGP factors can be useful in assessing sovereign creditworthiness in a more holistic manner.

ESGP factors can act as either catalysts or impediments to economic development. Socio-economic factors are often intertwined and mutually reinforcing. Poor education and health systems can increase inequality and hamper economic growth, which in time can threaten political stability. An unwillingness or difficulty in addressing environmental and social challenges can constitute a major obstacle to long-term growth. For instance, following years of rapid industrial development, higher levels of air, water and soil pollution might become a constraint of future Chinese gross domestic product growth. In contrast, countries with good ESGP performance should be more resilient to external shocks, such as natural disasters, financial crises or geopolitical instability.

ESGP considerations are potentially even more relevant when investing in emerging markets compared to developed economies. Emerging countries are a diverse group, ranging from low-income economies highly dependent on subsistence farming to middle-income countries home to high-tech manufacturing centers. Differences in levels of socio-economic development, the degree of political stability or the entrenchment of the rule of law can often vary significantly from one country to another. This has important implications for sustainable economic growth, competitiveness and the ability to repay debt.

In order to integrate ESGP considerations into an investment process for emerging markets, the starting point is indicator selection. Thankfully, a plethora of data is provided by international organizations, think tanks and non-governmental organizations. A careful selection is therefore needed to isolate those indicators that are the most relevant from an investment perspective.

Environmental sustainability is a challenging aspect to assess in emerging markets, partly due to the trade-off that often exists between air quality and rapid industrialization that can lift many from poverty. Besides climate change, the extent to which populations have access to clean sources of drinking water and basic sanitation has been flagged as a key prerequisite to sustainable development.

Social indicators are at the same time an outcome of past economic policies and a catalyst or impediment to future economic development. As such, they are strongly linked to governance and political factors. Among the variety of social indicators, four dimensions in particular are related to the potential for economic development: economic and gender inequalities, the quality of infrastructure, access to education and access to basic health care.

Governance stands for the quality of democratic institutions and the stability of political frameworks. It is embodied, for instance, in the strength of the rule of law, government effectiveness, the ease of doing business and the level of transparency of central government budget. For investors in emerging markets debt, assessing the use of proceeds from bond issues can be challenging. This is where indicators of fiscal transparency can help evaluate these risks to some extent.

Politics is a key aspect for investors as it drives economic policy and growth in emerging markets potentially more significantly than in developed economies. A key challenge for many emerging countries is corruption in the public sector; it distorts decisions to the detriment of the public good and diverts resources away from productive investments. Along with transparent policymaking and sustainable growth comes a greater likelihood of debt repayment.

An ESGP framework is a useful tool for investing in emerging markets as it can explain differences in sovereign credit spreads, even after controlling for macroeconomic variables. It appears then that ESGP factors offer additional information to explain sovereign risk. Differences between market sovereign spreads and what an ESGP score would imply can inform investors of potential richness of cheapness of sovereign bonds.

An ESGP measure can also form the basis to design an emerging markets portfolio in line with investors' specific concerns and restrictions. For instance, it is recognized that institutional failings and the prevalence of corruption are often factors that lead to stunted development and lower social outcomes. This could be a reason to exclude from the investment universe those countries below a certain threshold on governance and political dimensions.

A back-testing exercise suggests that an emerging markets debt portfolio designed with a focus on ESGP would help mitigate risk, thanks to the enhanced average quality of issuers from an ESGP perspective, without compromising performance.

Challenges that emerging countries aim to overcome can also be highlighted by an ESGP framework. Over time, some countries saw changes in their institutional setup that aided their development, while others fell further down due to the lack of or inappropriate reform. Two cases in point are Romania and Venezuela.

Romania is one of the few countries that improved across all four dimensions since the global financial crisis, showing clear progress in economic reform and in the fight against corruption. European accession brought greater transparency and accountability of the public sector, therefore improving Romania's corruption score over the past few years. The business environment in Romania experienced several regulatory reforms, which eased the process of starting a business and the reorganization of insolvent firms, strengthened contract enforcement and reduced corporate taxes. These achievements have been gradually priced in by markets as Romanian sovereign bonds outperformed the wider market over the past five years. Credit rating agencies might not have fully caught up with these improvements yet since they have only awarded Romania a one notch upgrade over that time period.

On the other hand, Venezuela suffers from economic and political challenges that have been slowing its development for a long time. Venezuela's ESGP metrics have been trending downward since 2005. Of the 80 countries in the emerging markets universe, Venezuela stands second to last on the perception of corruption score. Investment in the private sector is limited due to the difficulty of doing business and opaque governing institutions. State fragility is also a concern, weakening investor sentiment. While the collapse in oil prices pushed sovereign credit spreads much wider, the continued erosion of institutional quality reflected in ESGP measures has long impacted Venezuela's creditworthiness.

Taking into account ESGP factors can help investors assess sovereign creditworthiness in a more holistic manner. This is especially true within the emerging markets debt universe, where ESGP indicators can vary significantly from country to country, and where their impact on growth and sustainability is often greater. As the examples of Romania and Venezuela underline, improving or deteriorating ESGP factors appear to correlate with sovereign spreads. Importantly, ESGP considerations appear to be useful in portfolio construction and mitigating risk without surrendering the associated performance.

Nicolas Jaquier is an economist of emerging markets debt at Standard Life Investments.