Emerging markets political risk

Emerging market political risk is being sparked by weak economic performance and pressure on financial systems, explains Maarten-Jan Bakkum at ING Investment Management.

With many eyes turned towards Ukraine in the middle of March, the dangers of political risk to emerging markets investors continued to grow elsewhere, according to a warning note from Maarten-Jan Bakkum, emerging markets
strategist at ING Investment Management.

Key markets cited include Venezuela, Thailand, Nigeria and Turkey, while Bakkum sees growing macro imbalances in South Africa, Turkey, Brazil and Indonesia. China is undergoing continued stress of its financial system, which together with the negatives seen in the
above markets outweighs the few bright spots such as Mexico’s construction sectors and India’s external accounts.

“We believe that cheaper currencies will not be enough to correct imbalances and improve growth prospects. Policy makers will have to come up with the necessary supply-side reforms. After many years of credit-driven and China-driven growth, new domestic growth engines are required now,” Bakkum added.

The issue of political risk has come to the fore because of a change in the environment around emerging markets investments. Foreign capital is harder to come by, and demand from China has eased. These types of factors have contributed to slower growth in markets that were previously being fuelled by domestic demand that rested on access to cheaper credit.

However, this type of approach contributed to levels of imbalances in economies that have enabled situations to deteriorate rapidly. For example, Bakkum says that “the situation in Ukraine was able to get out of hand as quickly as it did due to the dramatic state of the economy after years of bad policies and rampant corruption.

“We cannot look at Venezuela, Thailand, Nigeria and Argentina in a different way. The risk of an escalation of events in these countries is substantial.”
What investors will note, is that the above list accounts for a notable share of emerging market debt indices, Bakkum continues.

And the timing of these challenges is poor. Emerging markets arguably need more reform to help create economic growth, but policy is hard to implement when it is struggling with unrest. “In this environment, investors should not be in a hurry to move back to emerging markets,” Bakkum says.

The strategist picks out Turkey as particularly vulnerable to the current challenges, and he says that it represents many emerging markets “in a nutshell”, because it highlights five key factors behind the decline in emerging markets as a sector.

Firstly, Turkey’s economic growth was previously boosted by growth in credit, which resulted in a sharply rising debt/GDP ratio. Capital inflows sustained the credit growth, but also resulted in a growing current account deficit. The fourth key challenge is that Turkey has suffered from poor policy response to danger such as not meeting its inflation target.

This in turn is linked to the political risk that comes with a country that has seen the same ruling party in power for over a decade. Bakkum describes it as leading to a “concentration of power” that has undermined key institutions in the country, such as the judiciary and Parliament, which in turn means that protests are more likely to take the form of street protests rather than Parliamentary opposition.

Taken together, the factors affecting the economic environment in Turkey point to a recession. This could bring credit growth down, leading to a deleveraging process. The problem of forecasting a soft landing is that it is not possible to know the outcome on corporates in the country, many of which owe debts in foreign currency

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