Jan Dehn, head of Research at Ashmore discusses current geopolitical issues and the implications for Emerging Markets investors.
The transformation of finance, economic policy and global politics that was sparked by the economic crisis in developed countries in 2008/2009 is far from over, in our view. Global politics is becoming more confrontational and investors in Emerging Markets need to pay particular attention, because the direction of travel being mapped out largely by developed countries is serving their own self-interest.
The widespread perception of immorality at the heart of the financial sector presented an opportunity that was not lost on a political establishment desperate to win back to the state some of the many powers ceded to the market over the past few decades. The result was the most draconian overhaul of the global regulatory system since the Great Depression. But, needless to say, the overhaul was not done without a keen eye on the potential political benefits. Thus, rather than fixing the flawed fiscal and monetary policies that had contributed the most to the crisis, regulators now turned their guns on entirely innocent bystanders, namely Emerging Markets.
The new regulatory system dramatically increased the risk weightings for bonds issued by countries with a lot of poor people, while keeping them at zero in countries with a lot of rich people. The result was a powerful first wave of financial repression without which the descent into full-on Keynesian policies and big government in Western economies would simply not have been possible. Central banks in both Developed and Emerging Markets also helped a great deal by pushing interest rates to all-time lows and buying or promising to buy lots of bonds in developed countries in exchange for freshly minted currency.
Indeed, the only area where governments had more or less managed to keep pace with the private sector over the past few decades was in the area of debt accumulation. Despite generally smaller governments, states had nevertheless managed to accumulate unprecedented amounts of debt largely due to unsustainable tax cuts, military adventures abroad and the desire to minimise voters’ exposure to income volatility by wrapping them up in the cotton wool of benefits. This is why the zero risk rating for developed market debt was so fortuitous; as everyone knows when debt is risk free there is no limit to how much can be issued.
Macroeconomic policy also changed beyond all recognition. Financial asset price inflation (aka bubbles) hitherto considered a risk to be avoided became – literally – the central pillar of monetary policy across the Western world. The associated risk of inflation, so long seen as a foe, was quickly dismissed as insignificant. Meanwhile, the economic case is for higher inflation is slowly being made and it should not be a tough sell: inflation is wonderful in indebted countries because it reduces real rates, erodes the real debt stock and weakens currencies to enable countries to export at the expense of other countries, while they deal with sluggish growth at home due to deleveraging challenges.
As for the once-touted economic evils of inflation, such as its deterrent effect on investment those are easy to dismiss: There is no investment in the first place. The political benefits of inflation are also obvious. Inflation hurts future generations by robbing them of savings, while the currency weakness that accompanies inflation will pass the cost of adjustment onto mainly Emerging Market central banks as holders of 80% of the world’s FX reserves.
In addition the vilification of banks, financial repression via the regulatory system and beggar-thy-neighbour macroeconomic policies, there was also a huge change in conventional politics. Wanting to divert attention away from their impotence in the face of sluggish growth and enormous income inequality at home, politicians in developed countries have increasingly turned to foreign policy.
The West is now making great strides forward in the realm of aggressive foreign policy, but it took them some time to catch on. At the beginning, just after 2008/2009, the West was actually forced by economic necessity to abandon some of its less strategically important partnerships with dictators in North Africa, thus spawning the Arab Spring. Soon the unrest spread from North Africa to the very heart of the Middle East, Syria.
There is no doubt that the humiliation of the West in Syria emboldened Russia’s President Putin, al-Assad’s backer. Not long afterwards Putin decided to grab Crimea, prompted by the fall of his ally in Kiev, Victor Yanukovich. Finally, the West woke up to the fact that it needs to be far more aggressive in order to secure those all-important foreign policy victories to keep the home fires burning.
Soon Putin was painted as a rogue leader with Hitler-like lebensraum ambitions. Russia’s perspective, understandably, is somewhat different. Moscow has viewed the West as a threat dating all the way back to Napoleon. Maybe they have a point. At no time in history has the military might of the West been so unrivalled. The West regularly deploys its forces in military adventures all over the globe, sometimes without prior UN approval, sometimes after lying to the UN. Russia, feeling beset on all sides, saw its national interest fundamentally threatened by the potential loss of its strategically essential Black Sea port of Sebastopol after Yanukovich’s fall.
This time the West was ready. The annexation of Crimea drew immediate and fierce Western condemnation and recrimination. Diplomatic necessity then triggered mutual rounds of sanctions culminating in a proper old-fashioned Cold War style localised ‘hot war’ in Eastern Ukraine. By now, it should be clear that global politics really has changed. The flash points are likely to be the familiar ones from the Cold War of old, namely the Middle East, the Russian periphery and in the far East as China increasingly challenges Japan (and therefore the West) for dominance there. In short, global politics has come full circle.
From global political excess during the Cold War through the near-extinction of international politics in an orgy of economic excess during the Greenspan Bubble, we are now back once more to a miniature version of the Cold War. ‘Miniature’ because no country today can muster the economic resources required to restore the global political hegemony of the Superpowers of old. But nevertheless a marginal negative for those unfortunate Emerging Markets, which, like Ukraine, find themselves caught in these new geopolitical forces. The good news is that the majority of Emerging Markets countries are unlikely to become pawns in this game; controlling more than 50% of global GDP with vastly better macroeconomic fundamentals than developed countries they are simply too strong to be dominated.
But the rise of aggressive self-serving foreign policy in the West should make Emerging Market issuers and investors sit up and pay attention. Where will the West strike next? One area that has so far been relatively free from political interference is law. But that may be about to change. Emerging Markets countries still rely heavily on New York and English Law for issuance of bonds (though mainly for foreign currency denominated paper, which is about 14% of total EM debt). Should EM issuers and investors worry that New York and English Law become instruments of foreign policy?
The answer is yes. A new and nasty development in the politicisation of finance aimed, it seems, at Emerging Markets may soon be upon us. Debt sanctions have not yet been adopted into English or New York Law, but the idea is gaining influence and finding willing backers in the context of the Russia-Ukraine conflict. The central idea of debt sanctions is to deny enforcement of contracts for political reasons, including contracts governing bonds. Debt sanctions are being pushed in connection with USD 3bn of financing under English Law extended to Ukraine by Russia in the dying days of the Yanukovich regime. Debt sanctions would annul Russia’s remedy – i.e. Russia’s right to seek redress in English courts in the event of non-repayment by Ukraine. While proponents of debt sanctions argue that such measures should only be applied in a limited and narrowly targeted manner (with sunset clauses), it is our view that debt sanctions could quickly become a widely used instrument of foreign policy, of course, each time only applied in a limited and targeted way.