ESG criteria, i.e. information on the environment, society and governance, provide valuable additional information, particularly for investments in emerging markets. This avoids risks and generates higher returns. At the same time, ESG investments provide emerging countries with incentives for more sustainable development and thus contribute to greater prosperity over the long term.
Anyone interested in successfully investing in emerging markets both sustainably and long-term should take a close look at ESG criteria alongside the traditional analyses.
The economic consequences of the COVID-19 pandemic are affecting many emerging markets from several directions:
- major sources of income such as tourism and exports have been weakened
- indebted governments lack the funds for stimulus packages
This is giving rise to a deep economic recession in which investors must be particularly selective. Particular attention should also be paid to economic weaknesses typical of emerging economies. The consideration of ESG factors, i.e. aspects relating to the environment, society and governance, can be a useful complement to the traditional macroeconomic analysis. Such a view, in addition to economic variables and political risks, provides investors with important clues about a country's longer-term stability.
Long-term performance only with sustainability
ESG factors can be broken down into three areas:
- Social responsibility area: educational standards, the quality of the health system and income inequality play a role here; improvements in these areas often lead to better living conditions and thus boost growth in the long term.
- Governance area: when a government is trustworthy and stable, with the necessary institutions and a sound, properly supervised financial system, it is often particularly business-friendly; arbitrary actions and government defaults are then less likely.
- Environmental area: here too, there are potential risks in emerging markets; the exploitation of resources boosts the economy in the short term but this is outweighed over the long term by the damage that has been inflicted.
The inclusion of ESG aspects does not only serve as a supplement to a country's risk assessment. It also is suitable as the basis for a long-term, financially sustainable investment approach.
The significance of ESG factors in emerging markets
The greatest risks – but also the biggest opportunities – can be found in the ESG area in emerging markets in particular. For example, investors can make a country’s borrowing capacity and the associated costs dependent on ESG ratings. In this way they motivate emerging markets to act in a more sustainable manner. Since the last financial crisis, there has indeed been a trend towards including ESG factors into investments in these countries. In recent years this has even turned into something of a boom: in the Asia-Pacific region, ESG assets are expected to rise from USD 2 trillion in 2018 to USD 11.1 trillion in 2020*.
The ESG models that allow not only a comparison between countries but also take account of a country’s development appear particularly promising. This is because they also contain important information: in Turkey, for instance, governance ratings have deteriorated over the past six years. In Sri Lanka, on the other hand, the ESG rating has trended upward, making the country more attractive for investments.
How ESG criteria lead to higher returns
Sustainability is not the only reason why it makes sense to consider investments in terms of ESG criteria. Past experience shows that emerging markets with positive ESG developments generate better returns, both in general and in risk-adjusted terms. Conversely, if countries have poor ESG ratings the credit risks are also usually greater. These include political and social unrest as well as environmental disasters. So if investors refrain from investing in countries with poor ESG ratings, they avoid this type of risk that cannot necessarily be predicted by a traditional analysis model.
In the current COVID-19 pandemic too there are signs that ESG investments generate higher returns in times of crisis than other investments: ESG investments in government bonds from emerging markets outperformed the market as a whole in the first quarter of 2020 by more than 1.7%. Ultimately, therefore, long-term, sustainable investments in emerging markets benefit everyone.
* Source: J.P. Morgan, EM as an Asset Class in the Post-pandemic World, 11.9.2020
Published for the first time in Investrends.ch
Authors: Rishabh Tiwari, Portfolio Manager Fixed Income Emerging Markets
& Josipa Markovic, Economist Emerging Markets, Swiss Life Asset Managers