Responsible investment, systemic risk and emerging markets

Emerging markets, with their growing populations, their demand for investment in infrastructure and their growing middle classes, are widely seen as important sources of future growth and investment returns.

An important part of the investment narrative is that foreign investment will deliver real benefits to the populations of these countries, with economic growth delivering increased government revenues for social protection and the presence of foreign investors helping improve governance and strengthen institutional capacity.

Yet, the evidence in support of this narrative is not clear-cut. At the project level, investors have found themselves embroiled in controversies around the impacts their investments have had on the natural environment, on the rights of local communities and on workers.

Moreover, in many cases, investors have found themselves wrestling with the challenges presented by opaque ownership structures, less than transparent accounting practices and weak investor protections. In more extreme, but not uncommon, situations investors have to deal with threats such as the expropriation of assets or the removal/rescindment of operating licences, and their employees may have to deal with threats and intimidation or, in more extreme cases, imprisonment and even physical injury.

At the macro-economic level, large inflows of foreign capital have contributed to rising asset prices, economic overheating and strengthening currencies. In fact, there is a growing body of evidence which suggests that significant accelerations in GDP growth (which are often driven by significant levels of foreign investment) are very rarely turned into sustained, higher levels of economic growth over the long term.From a social perspective, distorted power structures that allow elites to easily appropriate the gains from economic growth and the lack of legal protection for the rights of the poor mean that, rather than providing a catalyst for positive change, foreign investment can actually widen the gulf between those who benefit from growing economic prosperity and those who are largely excluded or exploited by the process.

Furthermore, as has been seen in the course of the many of the financial crises over the past 20 years, even if fund inflows do contribute to economic growth, the economic and social consequences of market meltdowns that see investors collectively stampeding for the exit are catastrophic.

So how should investors respond? Clearly, these are systemic rather than stock-specific issues, and so are likely to require a collective response from investors and other stakeholders. Furthermore, they are not just about the institutional checks and balances that investors rely on when investing in developed markets, but also require that attention is paid to, amongst others, institutional and societal structures, to the rule of law and to the rules (in both development and emerging markets) around issues such as solvency and liquidity which can force selling in the event of a crisis.

Unfortunately, the complexity and importance of the issues do not lend themselves to simple solutions. Investor work in this area will need to start with a proper analysis of the role – positive and negative – that foreign investment (and, indeed, wider discussions about trade and investment liberalisation) play in ensuring social, economic and financial stability.

Within this, investors need to understand how higher financial flows may interact with and in fact exacerbate the institutional and governance failings that have historically underpinned low growth rates, or how they can negatively affect the poor.

It will also require that investors consider their own role, the role that needs to be played by other actors (national governments, international development agencies, international financial institutions, etc.) and the role that institutions, rules, and policies can play in ensuring that foreign investment contributes to poverty alleviation and development, and in ensuring that the human and social consequences of financial events (e.g. rapid capital inflows and outflows) are managed effectively.

Clearly, this is a demanding agenda, moving well beyond the scope of current discussions about responsible investment and into the areas of international policy, systemic risk and institutional structures. The actions required to effectively address these issues may look very different to those that are being discussed in the wake of the financial crisis.

For example, it may be necessary to consider whether full trade or investment liberalisation are appropriate for emerging markets, whether there are needs for regular‘human impact assessments’ to assess the human impacts of capital inflows or outflows, or whether stabilisation measures (e.g. limits on the rate of capital inflows or outflows) or social protection measures (e.g. an international bail-out fund to address the human and social consequences of rapid capital outflows) need to be put in place.

Ultimately, and acknowledging that it is often earlier to describe a problem than to develop effective solutions, the central question for investors (and test for responsible investment) is whether their activities make a real and sustained contribution to poverty alleviation and development.

Dr Rory Sullivan is the editor, with Daphne Bilouri, of Issue 48 of the Journal of Corporate Citizenship, focusing on responsible investment in emerging markets. LInk