Beyond Russia: The sovereign ESG elephants in the room

Political Risk Outlook 2022

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In a rocky year for markets, emerging and frontier market sovereign debt investors have it tougher than usual. After two years of pandemic subsidies, inflationary food and energy supply chain shocks are threatening political and fiscal turmoil, while rate hikes in Washington, and soon Brussels, are weakening the macro investment case. Given the external environment, fund managers may be tempted to put ESG on the backburner. Here’s why they shouldn’t.

On the ethical front, the invasion of Ukraine by Russia has raised questions over emerging and frontier market (EM/FM) government bondholders’ balancing act on ESG. Our latest Sovereign ESG Ratings confirm the suspicion that if Russia is now unacceptable, several other portfolio stalwarts should also merit fresh scrutiny. Along with China, these include Turkey, Egypt, Saudi Arabia, and Indonesia.

In line with our recent research into ESG in government debt, countries’ sustainability profiles are going to matter for credit risk in this bleak new global landscape.

For government bondholders, the problem extends far beyond their Russia exposure. Our analytics identify several cases where unravelling ESG – notably governance and social risks – could plausibly deepen credit risks; as well as a handful, including Poland and Romania, where positive ESG momentum will be supportive of value.

Time to put up or shut up on ethics

Russia’s invasion of Ukraine has left ESG investors in an awkward position. Most obviously, investors’ willingness to step away from Russia, where their hand was forced by sanctions anyway, contrasts with their ongoing involvement in China. China’s complex E, S and G situation is first and foremost problematic for Western corporates, but sovereign bonds and state-backed entities have also been a source of (scarce) high yield in recent years.

Russia and China are not the only problem in town though. It’s not hard to imagine one of the many autocrats of the heavily traded markets sitting in sovereign portfolios doing something comparably bad to some of the worst excesses we’ve witnessed from Moscow and Beijing. Hypotheticals aside, our Sovereign ESG Ratings show that 15 hard currency issuers already perform worse than Russia on ESG, as shown in Figure 1. Two have also issued more hard currency debt than Moscow and are consequently often more heavily weighted in portfolios than Russia was before the invasion: Turkey and Egypt.

Human and labour rights violations and governance are Ankara and Cairo’s standout weaknesses. Turkey has a governance score of 1/100 – the worst of any investable market except Ethiopia. Alongside persistent political risks, the country’s institutional environment has unravelled as corruption has spread and democratic governance and judicial independence have weakened. Egypt, meanwhile, currently scores just 4/100, after tipping into the weakest performance range for institutional strength in late 2019, again because of eroding democracy and judicial independence.

Moreover, two other countries – Saudi Arabia and Indonesia – also stand out as heavily traded markets with ESG profiles that are slightly better than those of Russia overall but still problematic for any fund manager claiming their profits are principled.

On some measures, Saudi Arabia looks a solid bet. Its Governance score, a key indicator of stability, has improved significantly from 3/100 at its nadir in 2018-Q4 to 42/100 today. And as Figure 1 also shows, its spreads are unusually low, as markets have seen it boosted by macro tailwinds, especially oil prices. So what’s not to like? From a normative perspective, plenty. The Governance improvements, while significant, have come at the expense of civil rights and freedoms, repression of dissent and crime, and tighter controls on sources of instability. The country remains in the weakest possible clusters in the Institutional Strength and Human Rights dimensions of our Sovereign ESG Ratings.

For all the talk of ethics, this hasn’t yet translated into any ‘walk’. Beyond Russia, there has been little significant change in EM portfolios’ holdings in countries that have highly questionable ESG profiles. But the war is piling more pressure onto managers who have so far been just about able to navigate between autocratic issuers and a new cadre of ESG-aligned clients and other stakeholders.

Geopolitical shifts suggest that the claim that all EMs in a portfolio can be gradually prodded into alignment with the values of ESG investors no longer holds. And this, taken in combination with new regulations in Europe (and soon in the US) demanding that funds do ‘what they say on the tin’, means that something’s got to give, sooner or later.

ESG headwinds to hit selected markets hard

Amid these emerging ethical pressures, some managers are opting to stick to their ESG integration guns by only paying attention to ESG when it affects downside risks or upside opportunities, not for its own sake.

But ultimately, they are going to end up having to review their exposure to many of the same countries anyway given that ESG factors are set to be material to market action in some key countries this year.

It’s true that some governments, notably Riyadh and other Gulf hydrocarbon exporters, are for now relatively immune to investors’ ESG-related qualms thanks to robust oil prices. For others, conversely, notably Sri Lanka, Lebanon, Ukraine and Belarus, extreme outcomes are already more than baked into the price.

It’s also not all bad news: strong ESG momentum in a few small markets such as Poland could be an additional fillip to value. But in many other cases, weak ESG fundamentals will make it much harder for governments to withstand 2022’s macro storm, both augmenting the grievances of discontented citizens and undermining officials’ ability to manage that same discontent effectively.

Take Turkey, for example. Ankara’s extraordinarily heterodox approach to monetary policy, which has made the country more vulnerable than most to the latest macro pressures, is impossible to understand without factoring in the country’s institutional decline. And those same governance failings have now turbo-charged the political risk environment. Political, economic and social tensions are already running high ahead of the expected 2023 election, which the increasingly unpopular Erdoğan, now in power two decades, is looking to manipulate to the ruling AKP’s advantage. The country is already trading cheaply, as Figure 1 shows, but arguably not cheaply enough to reflect these storm clouds on the horizon.

Similarly, while Egypt’s spreads already factor in much of the elevated risks, this key wheat importer is, counterintuitively, likely to be more fragile to unrest because of its exceptionally repressive governance profile under Al-Sisi. As shown in Figure 2, it is also part of a broader picture across MENA of markets that are persistently poor, or deteriorating, on ESG; and along with Tunisia it is on our civil unrest watchlist this year thanks to surging food and energy prices.

The confluence of weak ESG trends and intense macro pressures is likely to play out in selected markets elsewhere too, including Indonesia and the Philippines.

But watch out for Peru in particular, where the copper-tinted conventional wisdom that this liberal mining economy is largely insulated from volatile domestic politics is looking outdated. Peru’s sovereign ESG score, already below the regional average, reflects this – dropping a full ten points in the year to 2022-Q2, the largest such decline among all USD issuers apart from Ghana, with sharp falls across G and E that will feed into an already-weaker S moving forward. This deterioration is playing out on the ground in a swelling wave of social protests targeting mining, agriculture and other key sectors, a situation that was simmering well before the pandemic. The result is that miners and other corporates are leaving investment plans on hold despite record high global metals prices.

What bondholders may not yet have fully appreciated is that the current political and broader ESG instability in this Andean country may not be resolved even with an early election. They are, therefore, at some risk of a shock. In our view, spreads are not yet fully reflective of that despite running above the country’s long-run norm, as shown in Figure 1.


Going well beyond political stability and governance, our new Sovereign ESG Ratings are capturing a swathe of cross-cutting social and environmental factors that either affect or provide early insight into emerging political risk – and ultimately credit risk itself.

Tapping into data such as this, investors (and policymakers) can start looking ‘beneath the hood’ to make connections that might not otherwise be apparent. And, in the costly and complex post-pandemic and pre-net zero era, it’s better to identify both where and how the next crisis will emerge, than to wait and react to events that are beyond their control.

James Lockhart Smith

VP, Head of Sustainable Finance

Eileen Gavin

Principal Analyst, Markets & Americas

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