Sustainability factors — particularly climate risk, education and sociopolitical stability — influence the way investors price sovereign credit, says Lazaro Tiant, sustainable investment analyst at Schroders.
This makes the integration of sustainability analysis into sovereign investing an essential consideration, he writes in a note published Feb 19.
Climate risk: vulnerability, readiness, and emissions
The physical risks associated with climate change have a direct impact on agricultural activities, food availability and pricing, which could potentially escalate inflation risks and adversely affect countries reliant on imports.
Similarly, countries exposed to extreme heat and flooding can suffer significant economic damage. This is not a new or novel consideration for investors, says Tiant, but one that requires detailed attention as countries evolve climate agendas and implement policies to enable solutions.
“Since the 1970s, there have been US$4.3 trillion in economic losses from climate change, US$1.7 trillion of which occurred in the US,” writes Tiant, who is based in New York. “However, when considering economy size, the effects are disproportionate.”
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According to the World Meteorological Organisation, developed countries experienced economic losses equivalent to less than 0.1% of GDP in more than 80% of disasters, with no losses greater than 3.5% of GDP.
In contrast, in the least developed countries, losses equated to more than 5% of GDP, including disasters causing losses up to nearly 30%.
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Transition risks and opportunities manifest through a country’s climate policy agenda and can include scaling up or rolling back climate efforts, says Tiant. “Technological advancements, the availability of natural resources or the development of transition-focused services provide the rationale for capital deployment in this area.”
Through strategic policymaking, governments can stimulate economic growth while counteracting the potential GDP losses, says Tiant.
Sustainable sovereign investors must pay attention to how these issues affect borrowing costs, whether through lower GDP, changes in fiscal or monetary policy or structurally altered inflation expectations, he adds. “Policy changes such as the Inflation Reduction Act (IRA), the EU’s Critical Raw Minerals act or China’s decarbonisation plan are increasing in scale and potency, with potentially profound economic consequences.”
As it relates to carbon emissions, governments may consider policy which implements pricing mechanisms to reflect a country’s performance, writes Tiant. High-emitting economic activity faces penalisation, which will affect sovereign debt valuations.
However, given the lack of global carbon policies, considerations such as a country’s share of global emissions are less material in sovereign debt valuation compared to its approach to transitioning and demonstrating ‘climate readiness’.
Investors who proactively assess and understand the value of national initiatives stand to gain insights into possible shifts in yields, he adds, along with the liquidity profile of countries making genuine progress.
“Countries that are making significant progress in their transition or adaptation efforts should contribute to the reduction of any risks associated with their yield rates.”
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Demographics: education, innovation and brain drain
Demographics also play a role, with pressures on long-term debt trajectories stemming from rising age dependency ratios and persistent income inequalities, says Tiant. Education, a value-creating investment in human capital, can offset such inequalities and strengthen fiscal sustainability, as long as the impact of brain drain is minimised.
The Global Innovation Index (GII) provides insights into a country's innovation performance and potential growth driven by the knowledge economy. This provides a comprehensive view of a country's innovation capabilities and efficiency.
Switzerland, Sweden, the UK and South Korea excel in converting innovation inputs into tangible economic outputs. For example, Sweden ranks 4th in input and 2nd in output; South Korea ranks 16th in input and 4th in output.
The US, on the other hand, ranks 2nd in input, but only 5th in output, highlighting that there are inefficiencies in the diffusion and/or adoption of domestic innovation.
However, talent mobility and migration — or brain drain — can have significant impacts on a country's domestic capabilities and future growth, Tiant notes.
Countries such as Sweden, Denmark, Australia, and Canada have historically kept talent at home and continue to do so. Net exporters of talent over 10 years include the US and Japan.
According to Schroders, countries that have experienced lower brain drain over the past decade saw an average economic growth of 2.4% compared to 1.4% for the countries that were net exporters, such as the US, Japan, Portugal, UK, South Africa, France and Austria.
“It is also worth highlighting that the set of countries with historically lower displacements — [such as] Denmark, Canada, Australia and Germany — are not only experiencing more growth on average, but are also seeing that mirrored with lower funding costs,” writes Tiant.
Socio-political stability
Lastly, socio-political stability can affect political risk premia by reinforcing or undermining institutional strength, says Tiant.
Conflicts or wars can put a significant financial burden on a country, mainly due to escalated military spending, which might lead to increased borrowing and higher bond yields.
Conversely, politically stable nations often enjoy lower bond yields and reduced inflation volatility.
Emerging markets are more likely to attract foreign direct investment if they are politically stable, says Tiant. “Polarisation can result in policy gridlock, volatility or uncertainty, leading to negative economic consequences. For instance, disagreement on clean energy transition policies can result in missed economic opportunities and hinder job growth.”
The International Monetary Fund (IMF) found that political instability significantly reduces economic growth and discourages physical and human capital accumulation.
Overall, the negative effects of political instability on sovereign credit are significant, adds Tiant.
“Conflicts and geopolitical divides can disrupt economic activity, discourage investments and impact growth. For investors, it's crucial to consider a country's resilience, adaptability and ability to navigate geopolitical challenges while remaining competitive. This includes trade, access to financial markets and consensus-building on domestic policy agendas.”
Infographics: Schroders
