The United Nations Development Programme (UNDP), which focuses on the world’s least developed countries, will be consulting with the international finance sector in the coming weeks on ESG, impact and SDG finance.
The UN is keen that private finance helps to achieve its 17 Sustainable Development Goals (SDGs), but with emerging markets suffering the largest ever recorded outflow of finance as a result of the current downturn, this agenda is under pressure.
Washington-based finance trade body the Institute of International Finance (IIF) has been tracking emerging market outflows since the COVID-19 crisis and oil price instability rocked financial markets. Such outflows are not unusual during times of economic stress, but Jonathan Fortun, a macroeconomist at the IIF, says that the current levels are unprecedented.
“Since 2008 you have seen a lot of liquidity in the markets because of QE, and this has been pushing out money from developed markets into emerging markets as it is seeking yield,” he explains, adding that a commodities “supercycle” had been also driving growth in many emerging market countries.
“We’ve had 5-10 years that have been really good for emerging markets. They had been enjoying a lot of success and income, which had allowed countries to develop and lift a lot of people out of poverty. What has happened in the last weeks has been unprecedented because all this build up has suddenly gone.”
Fortun says the outflows in the first three weeks of the current period of economic turmoil were equivalent to the inflows in all of 2019. IIF’s latest research puts the overall figure at $100bn outflow, across equity and – unusually – debt.
Fortun adds: “There is also a destruction of capital”. While, with previous financial crises, investors may have moved positions between emerging market countries, this time investors are exiting the region completely.
More advanced emerging regions – those most likely to attract international capital – like Asia and Latin America are suffering the biggest hit. Only China has seen some inflows, according to the IIF data.
Emre Tiftik, Director of Sustainability Research at IIF, notes that these countries are already relatively developed, with relatively low sustainable development targets compared to other low-income countries.
“This is the area we really need to focus on,” he says. “How are African countries affected by this crisis? Do they have adequate buffers to mitigate the risks? Are they going to be able to attract capital or additional flows to devote to sustainable development goals like infrastructure investment?”
Just before the crisis hit, the IIF had written a paper on SDG finance in the least developed countries, and one of the conclusions, Tiftik explains, is that there was an overreliance on debt, and not enough focus on equity instruments.
“A low interest rate environment has encouraged all of these countries to issue bonds and they forget to utilise stock markets. Whenever you talk about the stock market, it’s a long-term investment – it has no debt obligation. It’s like a partnership when you buy a stock. So SDG investment requires robust stock market development.”
Tiftik suggests countries could address this problem in their responses to the current crisis.
“Everybody is announcing aggressive stimulus packages. There should be an ESG component in those packages, like an incentive for investors, lenders and borrowers to focus on some of these key issues.”
He also says the development finance community “could play a much more important role in encouraging the private sector to come into these countries”.
“They have to take much more risk. They have been talking about blended finance [using development finance to attract private capital] and it sounds very fancy. but it’s not easy to do. There are so many challenges, so many bureaucratic issues. We need to find more practical solutions, like establishing capital markets in these countries.”
Robust local capital markets
Nick O’Donohoe, Chief Executive of the UK development institution CDC, agrees that countries need to develop their domestic finance markets. “The brutal reality is that every time a shock happens in the system, the natural reaction of people who are risk takers is to try and reduce that risk. And the easiest way to reduce risk is to move away from those places and markets and sectors that you understand less well, and to move money closer to home.”
CDC has a significant portfolio invested almost exclusively in Africa and South Asia. It is currently working on emergency funding for companies in its portfolio, rebooting a risk-sharing partnership for loans that it first set up with Standard Chartered Bank during the Ebola crisis; and looking at who in its loan book might need moratoriums. It is also working closely with portfolio companies that have products that could help tackle coronavirus.
But O’Donohoe feels that, in the longer term, the only way to solve the issue of emerging market outflows during economic crises is to build robust local capital markets.
“As long as we live in a world where countries don’t have significant domestic capital flows of their own – to the extent that it is not all sucked up through government borrowing – and there are well developed equity markets, we are going to see outflows every time you have a crisis in financial markets. I certainly wasn’t surprised by the outflows figures.”
The International Organisation of Securities Commissions (IOSCO) has a Sustainable Finance in Emerging Markets working group that has been working on this challenge. Last year, its co-chair Marcos Ayerra, Chairman of the Securities and Exchange Commission of Argentina, spoke to RI about his efforts to build domestic finance in the country.
Kurt Morriesen, Head of Europe for Sustainable Finance & Impact Investing at the UNDP SDG Innovative Finance, says that the UN’s Integrated National Finance Framework is helping decrease financial risks for emerging markets by building sustainable equity markets and fostering good corporate governance, which should provide comfort to foreign investors and build domestic markets.
He says the UNDP also plans to consult with the sector on SDG finance, ESG and impact soon, and to launch the UNDP Sustainable Investor Network. “It will bring together international organisations, investment communities and business leaders to coordinate SDG strategies and prepare the investment industry for a post-pandemic world,” he explains. “We’re planning a launch programme to assess the socio-economic recovery post-COVID and its impact on the responsible investment industry.”
Regional solutions with international support
Respected sustainable finance and corporate governance expert Herman Mulder welcomes the move. Former Director-General of Group Risk at major Dutch bank ABN AMRO during the 2000s, Mulder is best known for initiating the Equator Principles, and says the international community needs to refocus on the SDGs.
“At a very high level, I’m hopeful that the SDGs will be reconfirmed by the G20 as the only mechanism we still have in place that’s agreed by all 195 countries. It is only becoming more relevant and important to unite around global universal agendas. The question is whether it will happen. You can see everywhere, it’s now self-interest, legitimately.”
Mulder, who has worked with the Dutch finance sector to coordinate on SDG finance, says institutions like the World Bank and UN have a critical role, as do bodies in the emerging markets like the African Development Bank and the Chinese state – one of the largest creditors to many emerging countries. “With support from the international community, we have to find regional solutions rather than having a globalised approach,” he says.
He is also working with the Dutch Government to develop another potential solution: that bodies offering investors political risk insurance and credit enhancement guarantees, such as the IFC Multilateral Investment Guarantee Agency, could extend their services to cover the achievement of the SDGs – paying investors a premium if agreed impact targets are met.
With emerging markets posing potentially higher financial risks than before the crisis, Mulder warns the asset class is likely to fall even further out of the mandates of the world’s big pension funds and investment trusts, which were already underexposed.
Första AP-fonden (AP1), the SEK366bn (€34.9bn) Swedish state fund is unusual in having €4.5bn allocated to emerging markets – about 13% of its AUM. Frontier markets is much lower, at €150m.
Majdi Chammas, the fund’s Head of External Management, says it has maintained its exposure to emerging markets despite the crisis. But, he adds, one-third of its portfolio is passive, although it is steadily moving away from this in order to better manage risk.
“Going forward, you will have to be more selective on what companies to own,” he tells RI. “For financial reasons you will have to make a good assessment on what company will survive because there is a liquidity squeeze. And you will need to take a more forward-looking view on which companies are going to benefit more in this crisis and which are not going to make it.”
Mathieu Negre, Global Head of Emerging Markets at Swiss asset manager UBP, says his team has a close relationship with the firm's impact investment unit, using the same methodology and research to create products and measure impact.
He says UBP has maintained its exposure to emerging markets because “we are correctly positioned”.
But he does worry that the positive societal impact of the portfolio will be under pressure.
“Economic slowdowns set you back a couple of years as you lose output. And with the SDGs added, you lose progress on, for example, financial inclusion or getting people out of poverty because of the GDP contraction we will likely see in these countries.”
Long-term thinking is crucial to realising the SDGs, he adds. “It’s difficult to invest in a company with an intent to have a real impact without it.”
“If institutional investors included emerging markets in their asset allocation in a strategic manner, it would mean capital flows in that country would be unlikely to leave entirely, and that would dampen volatility.
“Coupled with a pool of capital that invests in emerging markets for reasons beyond financial profitability, there is a higher probability they will think of the consequences of taking out their money.
“That’s a key thing we need to see. A real commitment to the long term.”