All eyes this week were on the Eurozone as Greece teeters on the brink of Euro exit. The ripples spread across the world…and across the Mediterranean with effects on North Africa, the Levant and Turkey, as described in our first feature article. In other MENASEA news, Malaysia’s Prime Minister was hit with a report from the Wall Street Journal alleging deposits totaling $700 million were transferred to his bank account from 1MDB, a fund chaired by PM Najib that was dramatically expanded during his tenure as prime minister. In response, the Ringgit fell below the psychologically important RM3.80 per dollar, the level it was pegged in September 1998 in the midst of the Asian Financial Crisis.
The ‘Grexit’ effect – MENA edition
The current EU zone landscape
A Greek exit from the euro zone, or Grexit could mean Greece returning to the drachma – implying a shift away from ever closer integration without precedent in Europe. The risks from a Grexit range from higher near-term volatility to a major ‘black swan’ event if the Greek exit triggers contagion in other peripheral countries. Despite having moved most of the direct Greek exposure off bank balance sheets and to official institutions (including the ECB, the IMF and national governments through the European Stability Mechanism), risk from contagion to Portugal, Spain and (especially) Italy keeps policymakers awake at night. The risk of contagion so far has been off the table since ECB chair Mario Draghi pledged to do “whatever it takes” to save the Euro in 2012.
Peripheral 3Y Bond Yields – This time is different
Italy (green) and Spain (white) (above) and Portugal bond yields not spiking as they did in previous crises
Source: Thomson Reuters EIKON
Short-term volatility and uncertainty in global financial markets reflects headline risk about Greece, as well as reactions to other global events including the Chinese market crash and the nuclear talks between Iran and the P5+1. At this point, it appears that the political will for the European project remains strong notwithstanding what happens with Greece and so Draghi’s pledge should continue to limit contagion than in prior Greece crisis prior to 2012. The rhetoric that larger-debt ridden countries such as Italy and Spain would rally against anti-austerity measures being imposed on them following a ‘No’ vote by the Greeks is unlikely to take shape. Greece’s impasse will in fact serve as cautionary tale.
The probable fallout in nearby MENA countries
The short-term outlook is for volatility. However, since Greece makes up less than 2% of Eurozone GDP, the fallout on the MENA region will be felt economically mostly by countries nearby, for which Europe is a large export market. This mostly means Turkey, the Maghreb countries and Egypt where the European market represents 33%, 46% and 21% of total exports, respectively in 2013. Going further into the trade data, peripheral European countries represent 17%, 32% and 16% of total exports for Turkey, the Maghreb countries and Egypt. More distant countries, even Lebanon and Jordan, are much less exposed with just 7% and 3% of their exports going to Europe, respectively.
In the short-term, the economic uncertainty will limit risk taking as funds shift towards US dollars or Swiss Francs in a flight to safety. An additional effect from the flight to quality would be reduced risk appetite, including for foreign direct investment. This could depress economic activity of the MENA oil importing countries such as Morocco, Egypt and Libya where European Foreign Direct Investment (FDI) is a main component of the gross FDI.
The long-term picture from a Greek exit, if it materializes, would be a stronger Euro (Germany’s weight would rise slightly with Greece’s exit and the bias would be towards more German hard money central bank policies). Most of the countries identified above either have floating exchange rates or managed exchange rates linked to several currencies (except Jordan which pegs to the dollar). A strengthening Euro should help their exporters (most of the countries above are oil importers) through their devaluation. Provided the devaluation is moderate, it will provide a benefit greater than the risk of rising inflation.
Building roads to sovereign wealth – combining EM and ESG
Among sovereign wealth funds, the shift towards incorporating ESG is relatively new, but there are significant challenges for asset managers trying to offer appropriate products. Within the sovereign fund universe, leaders such as Norway’s Government Pension Fund Global, which recently heightened its focus on climate change by announcing a full divestment from coal, are blazing a trail deep into the responsible investing wilderness.
Managing costs mean asset managers need an ‘edge’
The challenges for asset managers to take advantage of the shift towards ESG comes in response to pressures on the cost side, the tendency for many SWFs to move management in-house for some asset classes and a growing preference for alternative asset classes, notably emerging market infrastructure. SWFs will have to find a way to capitalize on these shifts with their ESG offering and can supplement their offering with Shariah compliant options for SWFs in Muslim majority countries.
On the final point, offering Shariah compliant options alongside the asset classes highlighted below will maximize their ability to attract SWF assets. Islamic finance has been a particularly challenging area for SWFs in Muslim majority countries because the Islamic fund sector offers few choices of asset managers with a long enough track record and enough capacity to take on the size of assets a SWF will bring.
Connecting Western ESG Funds to SWF assets
As sovereign funds reevaluate their overall cost structures, the easy answer for asset managers is to offer lower cost models like passive investments (tracking index) but in ESG, this loses much of the value-add that ESG delivers. It has “the limitation of lacking the potential for either financial outperformance, or, as a practical matter, direct engagement with portfolio companies”. The more ESG develops from being a bare minimum risk mitigation tool to being an essential part of meeting beneficiaries’ expectations, the more the beneficiaries will expect engagement.
If asset managers are not as able to secure mandates for the main asset classes and cannot replace their actively managed offering with a passive ESG one, they will have to move into more specialized asset classes where the value from external managers and the scale economies that the fund manager can get that the fund cannot are more significant.
What this means for alternative asset managers with an emerging market specialization
Private funds have lagged in adopting ESG but the private equity sector and infrastructure are some where fund managers are really taking notice and beginning to sign on to initiatives like UNPRI. UNPRI has also just released a public consultation on the responsible investing diligence questionnaire for limited partners. While at an early stage, the growth in these ESG alternatives is well timed in that it coincides with a shift by SWFs away from global bonds and into more alternatives, particularly private equity and infrastructure and in particular emerging market infrastructure.
McKinsey estimated that $57tn will need to be spent on infrastructure between 2013 and 2030 and other sources suggest the shortfall is $1tn per year (with $200-$300 billion more per year for ‘clean’ infrastructure). The popularity of infrastructure with SWFs is based both on their unique position for the large deal sizes and their long time frame for investments (despite a drop in oil prices, 42% of SWFs in a INVESCO survey reported their funding would increase in the current year compared to only 33% who said it would decrease). Of all SWFs, only 9% invest in EM equities or fixed income while 17% invest in EM infrastructure, making it a key asset class for EM-focused ESG funds to target to attract SWF assets.
For asset managers that want to go the extra mile to provide a Shariah compliant alternative asset for SWFs in Muslim-majority countries, there is a significant opportunity for Islamic infrastructure finance. Even without the Shariah compliant angle, the emerging market infrastructure opportunity is a significant one for asset managers and one where ESG can provide more benefit to the population served, to the beneficiaries and to the asset managers.
Find out more information about responsible investing, ESG analysis and Islamic finance with the leaders from the industry and from significant emerging markets at the Inaugural Global Ethical Finance Forum to be held from 1-2 September 2015 in Edinburgh, Scotland.