The Importance of Governance in Emerging Markets

A timely reminder that quality matters, and diversification is key in emerging market debt; and for sovereigns that means the quality of their governance structures as well as their economic performance.

The extreme volatility experienced in Brazil in recent weeks is a timely reminder of the significant idiosyncratic risks present in emerging market debt (EMD). Sell-offs of this nature, that occur across all sectors of the market; equity, currency, local rates, spreads are generally caused by the rapid loss of investor confidence in that country. Once lost, risk premia ratchet higher across the board, and can take a long time to recover, as investors nurse losses and scepticism and doubts prevail.

For context, when the news of the new allegations broke, Brazilian equities were limit down -10%, the currency weakened over 8%, and local bond yields rose by approx. 200bp. This significant repricing of Brazilian assets was, as we know, driven by allegations of another corruption scandal involving political and business leaders. The reverberations from the original “Operation Carwash”, established in 2014 to investigate money laundering and bribes, continue to be felt as Brazil seeks to flush the dirt from the system. This brings to light how easily confidence can be lost when a country already has fundamental weaknesses surrounding its governance structures and business culture. For this reason, at State Street Global Advisors (SSGA), we evaluate local EMD from the quality angle, which includes a Governance indicator as part of our quality tilted approach to EMD local currency exposure.

Brazil, which scores very poorly in our quality tilted approach, has been one of our largest underweights at approx. -2% for this very reason. This position contrasts strongly with most active investors in this space. Data from eVestment* suggests that almost 75% of active EMD investors were overweight Brazil recently, with a third of this investor universe holding an overweight exposures of 3% or more versus benchmark. It is clear therefore that EMD investors chose to ignore Brazil’s fundamental governance weaknesses and latched on to the momentum trade which blew up so spectacularly. For countries’ with good and improving fundamentals that also score well on governance like Indonesia, the strategy has been overweight and this can mitigate the impact when episodes like this happen. It is important to appreciate that this was not an isolated episode in local EMD either; we have seen events of similar breadth and magnitude in Turkey, South Africa and Russia in recent times. It should not be surprising, that each of these countries scores quite poorly on our governance factor.

So in local currency emerging markets, which are characterised by high idiosyncratic risk, the prudent investor should seek to maximise diversification, and not rely on concentrated positions that are based on momentum or high expectations of policy success.

For the above reasons we continue to see strong interest in our EMD strategies that employ either an indexed or quality tilted approach.

David Furey – fixed income portfolio strategist – State Street Global Advisors