Rethinking risk in emerging markets

By Chris Vellacott

Middle-class anger at not seeing enough of the fruits of economic growth is growing in developing economies, and that anger is forcing the world’s biggest investors to rethink how they rank emerging markets.

Political risk has always been a fact of life for investors focused on the developing world, but many money managers are now assessing which countries have institutions and governments robust enough to stop the kind of anger boiling over into the chaos seen after the Arab Spring uprisings.

The emergence of what one investor called ‘the Facebook Middle Class’ – aspirational but frustrated as elites soak up the gains from economic growth – is creating a potentially explosive environment in key economies such as Brazil and China, they say.

"This middle class is waking up to the fact that the government does not offer you the schools, the roads, healthcare system, the housing that the middle class around the world gets," said Jorge Mariscal, UBS Wealth Management’s chief investment officer of emerging markets. "It is this phenomenon that is creating enormous amounts of resentment."

The insurance market is showing clear signs that companies with international operations are becoming more and more anxious about social discontent in particular.

Insurers are seeing a spike in demand from companies looking for policies to cover "soft" political risks – such as heavy-handed policy responses to civil disorder that damage business prospects – as opposed to hard political risks like war, said Andrew van den Born, the executive director in the political and trade credit risk practice at insurance broker Willis.

"We’re seeing growth in soft risks – income disparity, poverty, food prices," van den Born. "There’s been an upward trajectory in demand for this product since the Arab Spring."

Credit insurer Coface, which covers companies against default by their clients, has placed its ratings of Turkey and Venezuela on ‘negative watch’ reflecting "political fragility". Both have seen civil unrest.

Global managers of stocks and bonds are also growing more aware of the roots and results of such social tension. They see the extent to which it depresses economic growth over time and undercuts long-term returns.

Rapid growth in the developing world has drawn millions out of poverty and created a new middle class, but inequality has simultaneously increased in countries such as China and India, the Organisation for Economic Cooperation and Development said in a report published earlier in July.

The resulting social tensions threaten to "hamper growth and lead to instability," the OECD said.

Global managers of stocks and bonds are also growing more aware of the roots and results of such social tension

Investors also note that qualitative factors such as institutional or government stability must be taken into account. Quantitative measures of inequality are not enough in isolation.

The most closely watched measure of equality used by economists – the Gini Coefficient used by bodies such as the World Bank and OECD – show income inequality is wider in Nigeria than in France, for example. But it also shows Belarus and Japan have among the most even distributions of income in the world, although they offer very different investment prospects.

The world’s biggest asset manager, Blackrock, produces a Sovereign Credit Risk Index for investors, 30 per cent of which is made up of the category ‘willingness to pay’ – an assessment of a government’s effectiveness and stability – alongside conventional quantitative measures.

Alastair Newton, a senior political analyst at Nomura, identifies civil unrest seen over the past year in a long list of countries, including Brazil, Chile, Egypt, Thailand and Turkey as "a quasi-systemic threat," and places it high on a list of "issues which keep me awake at night".

Not all investors are so gloomy. Some argue that this middle-class agitation in Turkey, Brazil or Chile should be seen as growing pains associated with a process that is overwhelmingly positive.

Masha Gordon, London-based Head of Emerging Market Equities at Pimco, argues investors should also be heartened by events in India, where the election in May of a reform-minded government, has shows the new middle classes can spur change for the better.

Source Reuters