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The creditworthiness of an emerging market country is dependent on many factors. Typically, investors focus on a range of macroeconomic variables, such as fiscal deficits, debt levels, or the stock of foreign exchange reserves.
Why ESG for emerging markets?
The creditworthiness of an emerging market country is
dependent on many factors. Typically, investors focus on a
range of macroeconomic variables, such as fiscal deficits,
debt levels, or the stock of foreign exchange reserves.
Healthy macroeconomic indicators are a necessary
condition for sound economic development. However, they
are not sufficient without further consideration of a country’s
performance on longer term issues related to environmental
standards, social outcomes and the governance of state
institutions. ESG factors are drivers of economic
development which will play a key role in determining a
country’s ability to repay its debt.
The materiality of ESG factors for sovereign bonds has been
documented in our previous research.2 We think that ESG
considerations are potentially even more relevant when
focusing on emerging markets (EM). Differences in levels of socio-economic achievement, the degree of political
stability or the respect for the rule of law vary significantly
between countries. The emerging market debt (EMD) asset
class has grown and become significantly more diversified in
recent years, as countries from all regions issue bonds for the
first time. Most of the growth over the past decade has
come from frontier economies where ESG practices can
often be lax.
This is why we developed an in-house propriety ESG
framework, which aims to capture these differences. It helps
identify long-term factors and dynamics that might not be
fully reflected into sovereign bond spreads. We believe that
integrating ESG factors in the investment decision making
process will help investors mitigate certain risks and improve
the quality of their portfolios.
Our proprietary ESG framework covers over 90 investable
EM countries. The first step in building this framework is to
select the indicators that are most relevant. The selection
is driven by three main considerations: how well an
indicator captures a certain dimension; the breadth of
country coverage and credibility of the source; and how
much control the government has over implementing
policies that can directly affect the outcome. In total, 18
indicators are selected from various third-party sources
(see Chart A/). We deliberately aim to keep the number of
indicators relatively low, in order to make the framework
usable. It also makes it easier to identify areas of weakness
on which to engage with sovereigns.
Environmental sustainability is a key long-term
determinant of an economy’s development. In addition
to a broad indicator of countries’ environmental policy
goals, we also include direct measures of air quality,
natural resources depletion and stress on water sources.
Social indicators are often an outcome of state
development policies. Among the wealth of social
indicators available, we have focused on five topics
that have a large potential for achieving long-term
development and where government policies can
have a direct impact: gender and income inequalities,
educational attainment, the quality of healthcare,
access to basic finance and personal security.
Governance indicators assess a number of dimensions,
all particularly relevant for investors in sovereign bonds.
For instance, we examine the strength of the rule of law,
transparency of public accounts, level of corruption of
public bodies and stability of the political framework.
In addition, we look at the existence of checks and
balances on state institutions, such as a free press,
established political rights and civil liberties. Transparent
policy-making and sustainable growth are frequently
associated with a greater likelihood of debt repayment.
For each one of our 18 indicators, Z-scores are calculated,
which indicate where each country stands compared to the
average on that dimension. The Z-scores are then averaged
for each of the three pillars, providing a score for each pillar.
Finally, the overall ESG score is computed as a weighted
average of each pillar’s score. The environmental pillar is
given a weight of 20%, the social pillar 30% and governance
50%. We believe that governance factors have the greatest
potential impact on a country’s ability to implement robust
environmental standards and achieve favourable social
outcomes. Lastly, our ESG scores are normalised on a scale
from 0 to 10.
A/ Indicator selections
Source: Allianz Global Investors
and sustainable growth are
frequently associated with
a greater likelihood of debt
Integration of ESG in EMD investment process
The ESG framework is an integral part of the investment
process for EM debt as it can help account for differences in
sovereign creditworthiness. Deterioration in a country’s ESG
score can be expected to be accompanied by wider credit
spreads on its bonds. The close link between ESG factors
and credit spreads is visible in the significant correlation
between the two metrics3 (see Chart B/). Of course the
relation is far from perfect, so that deviations of credit
spreads from those implied by a simple regression model
can be used as an indication of possible richness or
cheapness of sovereign credits on an ESG basis.
Due to the limitations of ESG data which are often lagged
and slow moving, we find it necessary to complement the
analysis with an assessment of whether a country is on an
improving or deteriorating ESG trend. This is done as part
of our regular internal research process. Complementing
the hard data with a forward-looking assessment allows
us to reflect more recent changes in policies that might
potentially influence ESG quality. For example, the recent
weakening of the rule of law in Poland has not yet been
fully reflected in the country’s still high ESG score.
Combining the quantitative and the qualitative outputs of
the framework generates interesting signals. In particular,
countries that flag as cheap on the regression model and
are on a positive direction of travel should be of interest as
it suggests that ESG factors might not be fully priced in.
B/ ESG scores correlate with sovereign bond spreads
Source: AllianzGI, Bloomberg, Data as of October 2019
The ESG framework is an integral part
of the investment process for EM debt
as it can help account for differences in
Sustainable and responsible investing (SRI) strategies
The ESG framework can be used to build exclusion lists, in
order to answer investors’ potential concerns on various
ESG- related issues, and improve the profile of an EMD
portfolio. Filters can be set up for country selection based
on the overall ESG score, or based on different weighting for
E, S or G. This will enable portfolios to be managed against
SRI or ESG benchmarks (such as the JPM ESG Suite of
indexes), or tailored solutions to meet client requirements
One such approach could be to exclude countries falling
below the 10th percentile on each of the three pillars. The
idea is to insulate portfolios from the worst offenders on
each ESG dimension, making sure that a country performing particularly badly on any single pillar is still picked up by
the filter even if it performs better on the other two pillars.
For instance, it ensures that Venezuela is excluded due to
significant deficiencies on the governance front, even if it
scores above average on the environment pillar.
Besides potentially avoiding outright sovereign defaults,
utilising the framework for exclusion strategies, can also
help limit exposure to countries where ESG factors are
gradually deteriorating, which might eventually lead to
underperformance. The trend in Turkey over the past few
years has been a good example of how value can be added
by an early consideration of ESG factors (see Chart C/).
C/ Output from ESG Framework (selected countries)
Source: Allianz Global Investors, Data as of November 2019
Case study – Turkey
In 2018, Turkey was buffeted by a severe shock as tighter
global liquidity conditions and rising geopolitical tensions with
the US combined with a build-up of economic vulnerabilities
(high inflation, large external imbalances, FX mismatches and
rapid increase in corporate debt leverage) to trigger a currency
crisis. However, the deterioration in Turkey’s social and
governance factors was already evident for a number of years,
which eventually made the country significantly less well
equipped to deal with the economic crisis.
Social tensions came to the forefront in 2013, when the
government cracked down violently on protesters against
an urban development plan. Protests were also fuelled by
concerns over freedom of the press and limits on social
media activity. Social divisions intensified after the ceasefire
with Kurdish rebel groups fell apart in 2015 and the
insurgency erupted again. Kurdish members of Parliament
have been arrested and the Turkish military became
involved in the border region in Syria to contain the advance
of Kurdish fighters there.
Over the last few years, President Recep Tayyip Erdogan
(RTE) worked to concentrate power at the expense of
independent institutions. His constant attacks against the
central bank kept it from implementing an adequate
monetary policy. Independent media have all been taken
over by the state and many journalists have been jailed.
Following accusations of corruption against his government, and his family entourage, RTE cracked down on members
of the Gulen organisation in the judiciary, military and
education systems. The rise in fragmentation erupted with
an attempted military coup in July 2016. While the failed
coup was testament to Turkey’s social divisions, the backlash
proved to have a more lasting effect. RTE purged thousands
of suspected Gulen followers from official institutions, and
moved to consolidate power the following year, by
transitioning to an executive presidency system which
greatly weakened the powers of Parliament.
Issues related to social cohesion and governance are now
leading to a large brain drain out of Turkey, accentuated
by the purge of government bodies following the failed
coup. For a long time, many investors judged that mounting
concerns on social and governance issues did not have
a significant bearing on the broader macroeconomic
framework. However, this perception proved wrong as the
gradual trend of weakened institutions and concentration
of power in RTE’s hands culminated in the replacement of
respected economic policy-makers with the president’s son-
in-law at the finance ministry. As a result, Turkey has
become much less resilient than in the past. The capacity
to implement a package of needed economic adjustment
measures is now weakened. Since the failed coup attempt,
the performance of Turkish government bonds has been
significantly weaker than that of the other emerging
markets (see Chart D/).
D/ Sovereign hard-currency bond performance (Jan 2013 = 100)
Source: JP Morgan. Past performance is not a reliable indicator of future results.
Emerging market debt is an increasingly diverse asset class.
In this respect, active asset management is key and it should
be coupled with a robust, integrated ESG investment
process. With this in mind, we have developed a proprietary
framework to integrate our assessment of ESG factors into
the more traditional analysis of macroeconomic drivers in
emerging economies. ESG integration will help investors
improve the quality of their portfolios and mitigate certain
risks. In addition, investors will need to start engaging with
sovereign issuers on the more qualitative aspects of risk,
including ESG factors.
1) Allianz Global Investors : Financial materiality of ESG risk factors for sovereign bond portfolios by
Dr. Steffen Hörter, Global Head of ESG Strategy, Allianz Global Investors
2) The correlation between the ESG score and the logarithm of credit spreads is -0.6. We take the logarithm
of credit spreads since the relation between spreads and credit quality indicators (credit ratings, macroeconomic
variables or ESG score) is closer to an exponential fit rather than a linear one. The relation between the two
variables remains even when other factors, such as credit rating and macroeconomic indicators, are controlled for.
The underperformance of momentum-driven
investment strategies in the recent past
has caused some investors to wonder: Is
momentum dead as a risk factor? Kai Trinkies,
Team Lead Conusltant Relations, likes to
discuss this issue with Thomas Zimmerer,
Global Co-Head of Multi Asset at Allianz
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