sharing in governance of extractive industries

Governance Drives Returns! Especially in Commodity Dependent Countries

by Ole Hagen Jørgensen is Director of Research at Global Evolution Fondsmæglerselskab in Denmark

This is the 7th and last blog from the How is industry adjusting to persistently lower commodity prices? What does it mean for good governance prospects?  GOXI mini-series


Do lower commodity prices cause governance risks in resource dependent countries? In times where low commodity prices put pressure or relief across natural resource dependent countries, their capacity and willingness to reform is bluntly revealed. In such an environment, investors can generate substantial returns by picking the right countries to invest in—with this ability being directly dependent on monitoring of governance and political risk as an ESG-overlay to active asset management. Global Evolution, a Danish emerging market asset manager, systematically integrates political risk into valuation models for government bonds; and finds that it enables them to generate superior returns in emerging markets since their research reveals strong signals for over- and undervaluation of government bonds based on changes in governance and, more broadly, ESG factors.

Research by Global Evolution (www.GlobalEvolution.com) reveals that emerging market countries that improve governance levels over time generate returns that are significantly and systematically higher than those countries with deteriorating governance levels (figure 1); and especially in resource dependent countries, as Global Evolution econometric research illustrates (Table 1, regression 8 shows that resource abundant countries are associated with higher returns). Consequently, there is a strong business case for considering governance and ESG dynamics as an integrated part of an investor’s investment process because governance, and ESG dynamics more broadly, is highly correlated with sovereign spreads and returns in frontier and emerging markets—consequently bridging governance with returns in resource dependent countries! The main message is that superior returns in the Global Evolution Frontier Fund come from resource dependent countries with improving governance.

Figure 1. ESG and Governance drives frontier market returns; especially in resource dependent countries…

Source: Global Evolution Frontier Fund; Global Evolution proprietary ESG ratings based on data from the World Bank and Verisk/Maplecroft.

A timely and novel finding by Global Evolution’s research is that resource dependent emerging market countries have a real chance of offering high returns to investors if they improve on governance. This basically means that countries that improve governance levels will generate superior returns to investors in government bonds; especially, when these countries have lots of natural resources or commodities. However, if governance levels deteriorate then returns in resource dependent countries would be relatively poorer.

Table 1. Resource dependent countries generate returns; especially when they also improve governance from low levels…


Note: The numbers in brackets are t-values and stars (*, **, ***) indicates that the estimate is significant at the 10%, 5%, and 1% levels. The dependent variable is total fund returns from July 2, 2014. Initial income is GDP level in 2014; ESG level comprises a weighted rating across environmental, social, and governance ratings in 2014; ESG change is the change in the ESG rating from 2013 to 2014; Inflation is CPI inflation per July 2, 2014; resource abundance is the log of natural resources as a share of GDP; the interaction term is the multiple of natural resources as a share of GDP and governance (as encapsulated in the G rating in the aggregate ESG rating); manufacturing is the log on manufacturing as a share of GDP; the interaction term is the multiple of manufacturing as a share of GDP and governance (as encapsulated in the G rating in the aggregate ESG rating). Countries in the sample include: Angola, Argentina, Armenia, Bangladesh, Belize, Burundi, Costa Rica, Dom. Rep., Ecuador, Egypt, Gabon, Gambia, Georgia, Ghana, Guinea, Honduras, Iraq, Ivory Coast, Kenya, Kyrgyzstan, Macedonia, Malawi, Mongolia, Mozambique, Nicaragua, Nigeria, Pakistan, Rep. Congo, Rwanda, Senegal, Serbia, Sierra Leone, Sri Lanka, Tajikistan, Tanzania, Uganda, Uruguay, Venezuela, Vietnam, and Zambia. The fund contains different-sized positions across hard and locally denominated currency bonds.

Source: Global Evolution Frontier Fund; Global Evolution proprietary ESG ratings based on data from the World Bank and Verisk/Maplecroft; macro-data are from Haver Analytics.

Therefore, there is a “governance premium” in resource dependent countries that is especially prevalent under low commodity prices: Investors will achieve higher returns and countries’ governments will experience lower borrowing costs due to lower sovereign risk and, thus, lower costs of financing. Consequently, countries with an large-scale extractive-industries sector will see lower costs and larger fiscal space that can alleviate budgetary pressure or leave financial room for growth-enhancing investments; but only if they improve on governance and ESG factors. And this is the key issue; countries tend to suffer from the “natural resource curse” where higher resource wealth tends to translate into higher corruption and lower governance levels. As figure 2 illustrates, econometric research by Global Evolution indicates that 10% higher resource abundance is reflected in 1% worse governance across emerging market countries (a correlation that is statistically significant).

Against this backdrop, there is an important perspective in which this research should be viewed; a perspective that is crucial to investors and capital flows more generally: when oil and commodity prices have dropped by as much as we have seen since June 2014 (WTI oil from $105 to $30 per barrel), then royalties generated for government budgets are severely cut, leaving the government sometimes in desperate need for financing to fill this revenue gap. Governments can basically react in three ways depending on their royalties-dependence:

  • if royalties-dependence is low, then there is no real pressure to make reforms or fight corruption because the effect on the budget from low commodity prices is low.
  • if royalties-dependence is average, then there is some but not much pressure to make reforms because the effect on the budget from low commodity prices is felt but not constraining. This group of countries will muddle through with no real changes and prospects for superior returns to investors and governance premiums for the society.
  • if royalties-dependence is high, then there is either a strong incentive to make sustainable reforms; or a strong incentive of rent seeking and corruption because the effect on the budget from low commodity prices is high and constraining government operations, and can potentially lead to social uprising and societal destabilization.

In Ghana, for example, we have recently seen massive fiscal improvements on something as politically sensitive as the wage bill for public employees; a case that supports the “reform incentive hypothesis” above. On the other hand, Venezuela is seeing worse and worse economic conditions and no reform-progress which will likely lead to increased social unrest. These examples are clear cases of the two-way street for governance that governments face when commodity prices exert massive budgetary pressure.

Consequently, highly resource-dependent countries are crucial for investors to carefully watch since it can really go either way: either the reform program will be greatly improved, or rent seeking and corruption will emanate. Making the right investment decision for such countries must be based on solid monitoring and valuation modeling; integrating governance and ESG dynamics in a systematic way as pioneered by Global Evolution.

With these insights in mind, the question whether investors are forced to choose between attractive returns and investing with sustainability in mind, the answer is no! This is because the research by Global Evolution clearly reveals that governance and ESG improvements significantly drive returns in the emerging market sovereign bonds space; especially for resource dependent countries. And, these findings are amplified through the incentives of government officials when oil and commodity prices are dropping by as much as we have seen since the middle of 2014.

An additional finding by Global Evolution shows that both returns and volatility increase when governance and ESG dynamics improve, but the effect is significantly larger for returns than for volatility. Consequently, ESG improvements significantly enhance risk-adjusted returns in frontier markets—providing investors with higher risk-adjusted returns when they take governance and ESG dynamics into account in their investment process. Again, these dynamics become increasingly important the more resource dependent a country is given the slump in commodity prices.

Global Evolution estimates and assigns proprietary governance and ESG ratings to countries in order to systematically monitor such dynamics. Based on governance and ESG dynamics, their quantitative Valuation and Rating Model (VRM) has the power to estimate signals for over/undervaluation for dollar-denominated sovereign bonds. In addition, the model estimates proprietary credit ratings across countries which have been “ESG-adjusted” because it adds value in terms of the models forecasting power of future spreads. Their “ESG overlay” generates valuable extra-financial information for the investment process; and for an investor who is heavily exposed to resource dependent emerging markets, such an ESG-overlay to the valuation model is crucial to outperform.

In summary, countries with an extractive-industries sector tend to experience more pressure to make reforms during low or falling commodity prices while they are under budgetary pressure. Intuitively, there is a powerful channel through governance and ESG factors depending on how resource dependent the country is, and this is confirmed through the empirical research by Global Evolution (for their research on the implications for returns, spreads, and credit ratings of changes in ESG indicators in emerging markets, see http://www.globalevolution.com/artikel/bridging-esg-with-returns-in-frontier-markets.aspx. As a consequence, there is a “governance premium” in resource dependent countries that is especially prevalent under low commodity prices.

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