25th January 2016

In this issue…

• As emerging markets fall out of favor, companies that are open to investors who practice responsible finance could find a patient source of capital
• Part 2 of our annotated version of Breakingviews Predictions 2016 looks at Basel IV and Islamic banks and how oil could return to $80/bbl

FAST FINANCE

Last week, the International Institute of Finance released a report showing total net capital outflows from emerging markets reached $735 billion in 2015, of which $676 billion was from China. With predictions of $448 billion coming in 2016, there is likely to be continued pressure on emerging market asset values and the fact that most of the actual outflows are coming from China will be cold comfort to investors in many emerging markets that will feel the effects of investor pessimism about EM. Investors who can take the long-term view, in part by integrating responsible finance practices like ESG, could be the ultimate beneficiaries of the drop in asset prices.

As Emerging Market current accounts turn to deficit, the need to incorporate responsible finance rises

An opening is coming for responsible finance as the supply of capital tightens across emerging markets in Asia. The $59 trillion in assets owned or managed by the signatories to the Principles for Responsible Investment are turning their eyes towards emerging markets. Companies in emerging markets are becoming more receptive to the additional requirements that comes with this source of responsible finance.

Investors concerned with environmental, social and governance (ESG) issues have had a challenging time expanding into emerging markets because companies have not typically been willing to engage on ESG issues. The years from the beginning of the financial crisis through 2014 were strong growth years for emerging markets at a time when developed markets saw reversal in growth followed by a slow and unsteady recovery .

During the 5 years after the financial crisis, emerging markets attracted significant capital flows. During the financial crisis, negative current account balances in developed markets were accompanied by large capital flows into emerging markets. The effect of this inflow was that it reduced the cost and increased the availability of capital across emerging markets. This reduced pressure on companies to seek out capital based on factors besides just the cost of capital reduced the impetus to consider extra-financial factors.

The trend of strong growth in emerging markets inflows continued after the financial crisis before weakening in recent years as China’s economic growth decelerated and commodity prices fell. As capital flows reverse from emerging markets towards developed markets, there is a greater push among companies in emerging markets (as well as stock exchanges), including those from Asia, to consider ways to become more attractive to the growing share of assets (30.2% of global managed assets integrate some form of ESG) managed responsibly.

There is a particular opportunity within Asia for both traditional responsible finance (e.g. investors who integrate ESG into their analysis), which has been growing rapidly in Singapore, Hong Kong and Thailand, as well as Islamic finance, which accounts for the majority of responsible investment assets in Indonesia, Malaysia and Pakistan. According to the ASrIA Sustainable Investment Review, nearly 40% of all responsible investment assets in Asia are Islamic investment assets.

The opportunity in the future across Asia is based on the recognition that there is a place both with Islamic finance, which accounts for the bulk of the negative/exclusionary investment assets, as well as integration of ESG. These two approaches which together account for over 90% of responsible investment assets, are not in conflict with one another and are in fact complementary. The challenging situation for emerging markets, particularly in Asia, also represent an opportunity to look more closely into how they are more aligned than has been recognized to date.

Join the discussion about the future or responsible finance and how Islamic finance can be integrated within it at the Responsible Finance Summit, organized by the RFI Foundation, co-organized by Middle East Global Advisors and hosted by Bank Negara Malaysia in Kuala Lumpur from 30-31 March 2016

Breakingviews Predictions 2016

Every year, Reuters Breakingviews develops a set of financial market predictions for the year ahead that outline important and sometime unexpected trends for the year to come. With their permission, we have selected some of the most relevant to the MENASEA region which we shared in last week’s Finance Forward as well as this week’s issue.

No sooner had the ink dried on Basel III standards and their implementation begun, had work began on the next set of regulatory standards to build on, or in some cases, to fix Basel III. The shift towards greater reliance on more Tier 1 common equity (CET1) relative to other lower-quality forms of capital was good for Islamic banks and could be strengthened with Basel IV, although that puts it in the firing line of critics who say that will stifle economic growth.

Weakening CET1 requirements could hurt Islamic banks’ ability to deliver competitive returns on equity more challenging unless investors begin to recognize that potentially lower but less risky returns on equity in Islamic banks may deliver a better risk-adjusted return than more volatile equity in conventional banks.

The full implementation of Basel IV may take several years. But the key question is whether European lenders, once it does kick in, will need to maintain their key common equity Tier 1 ratios at the current level of about 12 percent of RWAs. […]Brussels will want a slight uptick in lending to continue. So Basel IV will be in its sights, given Barclays analysts reckon it could knock 2.2 percentage points off lenders’ common equity Tier 1 ratios. European financial services commissioner Jonathan Hill has already commissioned a review of the net effect on economic growth of various post-crisis rule changes. Its conclusion may be that Basel IV should either result in lower capital requirements, or be substantially watered down.

Another Breakingviews prediction that would impact the MENASEA region relates to possible light at the end of the tunnel with regards to the price of oil. Although the drop in crude oil prices during the last 2 years has been relentless, there are still factors which could help return it to higher levels which Breakingviews expects to be “above $80”. It is closer to the $100/barrel target given by Emad Mostaque in a Q&A with Finance Forward in early December that were largely based on underpricing of geopolitical risk, a different catalyst than what Breakingviews sees:

As more high-cost production is either shut down or slowed down, OPEC’s pricing power will come to the fore. The IEA says oil prices will swill around the bottom of the barrel until 2018. If demand for oil rises with a global economic growth spurt – fuelled perhaps by the low cost of energy – the oil price will move up sooner than that. The precise price to be seen at any moment in 2016 is unpredictable. But elemental oil market forces suggest that a barrel of black stuff will revert back towards its 10-year mean above $80.