Emerging markets investing risks

However, it is difficult to measure and its impact on asset prices is underappreciated and poorly understood. Macro-political trends — including more frequently and rapidly transmitted shocks — are increasing the need for incorporating a systematic approach to political risk into emerging market portfolio management. As described above, political risk is a key driver of emerging market returns. However, it is challenging to measure and formally incorporate into the investment process, and its effects on asset prices generally are under-appreciated by investors.

To address this gap, Eurasia has developed a systematic approach to measuring political risk, which forms Pillar 3 of the investment approach described above. In this section we discuss why political risk matters to emerging market asset prices and what factors are driving the increasing influence of political risk, and how Eurasia has implemented a methodical approach to assessing political risk, which is embedded in the Nikko Asset Management investment process.

Why political risk matters — key drivers There is evidence of significant relationships between political risk factors and returns across various asset classes, in areas such as equity index volatility, bond spreads, formed risk premia between spot and forward FX rates, and CDS spreads. Research also shows that political effects are especially important in the emerging markets. In particular, there are five main factors explaining why politics matters so much for asset prices in emerging markets: Institutional capacity to manage shocks.

Political institutions, government strength, and the relationships between societies and their governments place important constraints on the ability of governments to manage adverse internal and external economic shocks. This can take the form of institutional constraints on fiscal and monetary policy responses to economic contractions, emergency legislation and crisis management, and economic reform.

Most fundamentally, politics create uncertainty about future policies, which in turn affects expected levels of economic activity growth and profitability through their impact on investment, taxes, consumer and business confidence, and the price and availability of credit, among other channels. The competitive environment, in turn, directly affects both the value of firms and the volatility of the operating environment — which are both reflected in asset prices.

Politics and policy choices directly impact the ability and willingness of governments and state-owned enterprises to pay debt. Market structure can amplify political shocks. Unanticipated political shifts can cause large and very fast shifts in desired portfolio balances, resulting in large price adjustments. Being able to adjust early to political signals can significantly help investors in emerging markets manage their downside risk. How to measure political risk While politics is clearly a major contributor to tail risk in emerging markets portfolios, the challenge is in defining and quantifying how these political forces interact with the market to gain insight into their effect on returns.

In modelling the effects of political risk, the first key challenge is definition. Often, political risk means different things in different contexts. The second major challenge is developing a systematic method for measuring the political risk. Eurasia Group defines political risk along four main parameters: political stability, social stability, security in terms of internal and external threats , and economic stability both short and long-term.

These aspects are discussed in more depth below. Measuring variables such as political risk is methodically difficult. No direct metrics of political risk exist. Because there are few tools for measuring political risk, or estimating how it is priced across countries and asset classes, investors tend to fall back on ad hoc measures and generally purely qualitative approaches. As outlined in the description of Pillar Three, to overcome this gap Eurasia Group has developed a systematic methodology for measuring political risk and using it as a signal for top-down country allocation decisions across asset classes.

Three important parts of this framework are: Country scores that capture current levels of political stability the Global Political Risk Index ; Formal assessments of the future outlook of political stability and its impact on the business environment political trajectories ; Asset pricing models that estimate the interaction between political risk and market prices.

The regime is the set of rules that establish the institutions of the state, define the powers of those institutions, and condition interactions between the state and society. The government controls the executive institution of the regime.

The GPRI assigns quantitative scores to countries, expressed on a scale of 1—, with higher numbers corresponding to lower levels of risk. Based on these scores, the GPRI also produces ordinal rankings of the countries. Each of these categories contributes to the degree of state stability that a country has, as each can influence the legitimacy of the current regime and government. The Government score captures state stability by measuring the strength and durability of the regime and the government through factors including the cohesiveness of the government and the opposition, the degree to which the government has popular support, and the strength and transparency of government institutions.

The Society score captures the presence and intensity of, and the potential for, social conflict that creates risks to state stability. The Security score captures state stability as influenced by internal and external security risks, including factors such as military spending, terrorism, domestic and inter-state armed conflict, and security alliances. Short-term factors include economic performance and government finances, while long-term factors take in the structure of the economy and the environment for the private sector.

The qualitative inputs are translated into a raw score. Eurasia Group has applied these political risk variables in empirical work using a time series of 22 emerging market equity returns and bond spreads since Returns and spreads first are regressed against a set of macro and market fundamental variables; the time series of political stability is then introduced into the regressions to see how it improves the ability to explain the variation in returns and bond spreads. Key findings of this work include: For equity markets, incorporating a political risk measure meaningfully improves our ability to explain differences in market returns between countries compared to a model of equity market fundamentals alone.

Measures of political risk are generally uncorrelated with equity market fundamentals, suggesting that political risk provides independent leverage in explaining why equity returns vary across countries. We find similar results with emerging market bond spreads: incorporating a formal measure of political risk meaningfully improves our ability to explain differences in bond spreads — both between countries and within countries over time — compared to macro and credit fundamentals alone.

The growing need for a systematic approach on political risk While macro-political conflicts continue to dominate the headlines Russia-Ukraine, ISIS, Syria, Iraq and have added a general degree of uncertainty and volatility to markets, in general, they have been viewed as local, contained conflicts. We forecast that the frequency and intensity of macro-political crises are likely to increase given the current structural shifts in the international balance of political and economic power.

The United States is less willing and able to provide global leadership, but no alternatives have yet emerged to take the place of the US. Traditional American allies are distracted by domestic issues and less aligned. Emerging market countries have become powerful enough to block global initiatives, but not so powerful or coordinated that they can offer their own alternatives. A growing China, a declining Russia, and many emerging markets with competing priorities and widely varying political systems are leading to more major powers with more divergent interests.

The effects from heightened political risk spilling over into emerging markets will require investors to take a more systematic consideration of the transmission of political risk. As Fig. Because this political risk is contributing even more heavily to market prices, the need to incorporate a systematic approach to measuring political signals into emerging market portfolio management has increased. Diversification benefits between asset classes within emerging market countries also decline markedly during times of crises, as political risk tends to drive correlation of all assets higher.

The linkage between political analysis and portfolio management As noted in the first section, the growth of local currency bonds and other asset classes within emerging markets now provides the investor with multiple sources of excess returns. The higher volatility of this broader range of emerging market assets has been seen as providing an opportunity to generate better risk-adjusted returns. A number of emerging market multi-asset funds launched post the crisis. Today, this risk has largely disappeared.

Stronger international law and the symbiotic nature of growth in emerging and developed economies reduced asset seizures to nearly zero during the s. The Changing Face of Risk in Emerging Markets Overt seizures of foreign assets by host countries in emerging markets essentially evaporated by However, other political risks to those assets for example, from potential regulatory action have risen dramatically since then. Source: Seizure data left side from M.

Other recent data are consistent with the finding that policy risk has increased greatly. And a survey by the Multilateral Investment Guarantee Agency and the Economist Intelligence Unit found that multinational enterprises considered breach of contract, restrictions on the transfer and convertibility of profits, civil disturbance, government failure to honor guarantees, and regulatory restrictions all to be more significant risks than the potential seizure of assets.

Unfortunately, the traditional financial and contractual mechanisms that firms use to assess and mitigate business risks have limited value. In this article, we explore the experiences of multinational investors as they confront these issues in a variety of industries and countries, and we offer best-practice guidelines for assessing the political landscape and for modeling political decision making.

As with the management of any risk or uncertainty, political mastery can become a source of competitive advantage in addition to a means of avoiding losses. Political mastery can become a source of competitive advantage and a means of avoiding losses.

These approaches, however, offer little protection against policy risk. For starters, legal contracts are useful only if they are enforced, and shifting laws and regulations can render them void. In the s many Southeast Asian governments wooing private power investors offered contracts that insulated the investors from risks related to lower-than-expected demand, fuel supplies, exchange rates, currency conversions, regulations, and political force majeure.

Political officials had to choose between honoring the contracts, at the risk of compromising their own popular support, and renegotiating them in order to maintain that support. In the end, many career-minded public officials in Southeast Asia chose to renegotiate or cancel scores of contracts.

Even when contracts can be legally enforced, experience shows that inventive politicians can circumvent them, through a wide variety of means other than changing laws. For example, in , when U. My reasoning is that if you back the right assured, you can usually keep problems from occurring in the first place—and if they do happen, you have an excellent chance of mitigating your loss.

Financial hedges have limited value for similar reasons. Instruments for hedging against risks in specific emerging markets—such as exchange-rate, market, and credit risks—are ubiquitous because multiple parties are willing to participate. The project- and firm-specific nature of policy risk, however, renders conventional hedging strategies infeasible.

Some of the more-inventive instruments are based on the average risk premium associated with existing companies in a given country—but they give false comfort. Because the baseline risk premiums are those of firms that are actively participating in a given market and that often have their risk-mitigation strategies in place , new entrants are likely to face far greater exposure.

In fact, foreign investors who focus on constructing financial hedges at the expense of developing their own risk-mitigation strategies may increase their exposure. It is therefore not surprising that, despite the ability to calculate residual risk premiums, no financial institutions have used such premiums to price an instrument that pays out money when a policy risk is realized. The New Risk-Management Playbook Given the difficulty of constructing hedges against policy risk through contracts, insurance, or financial risk-management tools, foreign investors must accept the responsibility for directly managing the risk themselves.

For many companies, that means rewriting the playbook. Instead of looking for immediate ways to improve operations, managers have to move beyond the quick cost-benefit analyses that they usually undertake and think more about how they can frame and shape public debate. And they must learn how to apply political pressure, either individually or as part of a coalition.

Investing in goodwill. In the developed world, managers spend a great deal of time and energy on improving efficiency. When companies move into less developed markets, they often expect huge, instant efficiency gains from exploiting the technologies, business models, and practices that they have managed to hone in their home markets.

Unfortunately, the political costs of such practices may outweigh those gains. Consider the Christmas blackout in large parts of Brazil, including Rio de Janeiro. The then recently privatized electric utility Light in which AES held a A smarter approach was used by Italian state-owned oil company Eni. Framing the debate. When companies enter new countries, they often engage in extensive PR campaigns that amount to little more than advertisements for the brand and specific commercial ventures.

Instead, firms need to master the art of political spin. New entrants garner support for policies that favor them over incumbents by citing the abuse of monopoly power. Instead of engaging in PR campaigns that amount to little more than advertisements for the brand, companies need to master the art of political spin. This type of debate played out in the South Korean wireless market. The network of relationships in a society greatly influences policy outcomes, especially in countries with weak legal systems.

Once again, Eni has shown the way, this time in Kazakhstan. The company favors Kazakh over non-Kazakh suppliers, and it conducts knowledge-transfer, training, and development seminars for them. For the vast majority of organizations—which do not possess enough leverage to influence the full range of relevant actors on their own—a crucial component of an effective strategy is to assemble a coalition of interests. The major Korean carriers wanted to shift to the globally favored WCDMA standard for the newest generation of cellular service, but domestic champion Samsung had developed a global leadership position in the competing CDMA technology.

Observers in central Europe have noted the lobbying success of the German and French governments on behalf of national champions in countries seeking EU membership. Taking these pages out of the political playbook requires building the sorts of capabilities in intelligence gathering and analysis that are familiar to politicians, spies, and journalists.

Managers must begin by understanding the attitudes, opinions, and positions of relevant actors toward their firm, the industry in which the firm operates, and any specific actions that the firm might take to influence outcomes on the playing field. Tapping the Right Flow of Data Traditionally, managers who have undertaken political analyses in a host country have directly consulted employees, local business partners, and supply chain partners.

The information-gathering process varies in intensity and structure, ranging from surveying radio and newspaper stories to conversing with locals to using computerized contact-management systems. Some firms rely almost exclusively on informal chats, whereas others favor more-formal Delphi iterative expert survey methods. Ratings are incorporated, in the form of country risk premiums, into the discount rates used to evaluate investment opportunities. This approach appears to have the formal rigor of financial risk management, but it is actually inadequate.

To begin with, such ratings usually fail to account for the fact that the levels of policy risk vary among different investors in a country, some of whom may adapt their business practices to local norms and lobby key policy makers better than others do. Also, policy-risk exposure is to some extent contingent on the relative importance of the proposed investment to the two parties how easy is it for the firm to walk away, and how badly does the local government want the deal?

Finally, country risk ratings are usually retrospective, reflecting past policy outcomes. To assess the correlation with current policy risk, an analyst needs to determine how similar the past and present policy-shaping factors actually are.

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During and right after the global financial crisis , emerging markets fell sharply but then gained it all back just as quickly. On and on the story goes. And that was after record-breaking highs just two weeks prior. This Chinese company purportedly ended with 4, coffee outlets in China, a number larger than Starbucks.

There truly are some fantastic opportunities. And though you can never eliminate risk in the stock market, you can limit it. What is your opinion on investing in emerging markets? Is the reward worth the risk? Share your thoughts in the comments below. Emerging markets are a unique investment opportunity because they offer equal parts of risk and reward. While there are huge gains awaiting investors that can identify the right emerging market investment at the right time, the risks involved are sometimes not well understood.

Key Takeaways Emerging markets have remained a popular investment area since their introduction in the early s. While there are huge gains awaiting investors that can identify the right emerging market investment at the right time, the risks involved are sometimes understated.

The process of emerging into a developed economy isn't always an upward trajectory and when countries face political upheaval or natural disasters that seriously and suddenly stymie their economic growth, it can cost enthusiastic investors a lot. When basic caution is exercised, the rewards of investing in an emerging market can outweigh the risks; the biggest growth and the highest-returning stocks are going to be found in the fastest-growing economies. What Are Emerging Markets? Emerging markets describe economies that exist between the stages of developing and developed.

The emerging-market phase occurs when economies see their most rapid growth, as well as their greatest volatility. When identifying emerging markets, investors and economists are looking for countries where there is very little political or social unrest and consistent economic growth. Risks of Investing in Emerging Markets Investing too late in an emerging market is the biggest risk of this type of investment. China is a good example of an economy that was previously considered an emerging market.

However, by the time that the majority of people became aware of the growth of the Chinese economy, it was already well on its way to becoming an economic powerhouse. At the height of an emerging market's popularity, investing can be very costly. In addition, the growth of emerging markets isn't steady and they can be very volatile, so the timing of an investment is very important. The process of emerging into a developed economy isn't always an upward trajectory.

Countries can face political upheaval or natural disasters that can seriously and suddenly stymie their economic growth.

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