Corruption: The ugly truth for EM and ESG investors

I ask the professional institutional investor — does corruption bother you?

Corruption causes economic inefficiency, tax revenue loss, lower retention of and investment in all forms of capital.

Does corruption bother you?

I ask the professional institutional investor, not the woke consumer or spiritual guide, in you.

We all say that of course it does but, in practice, is this or should this be the case?

These questions are particularly relevant for emerging markets and ESG investors (in emerging and developed markets). I struggle with the response to these questions but make the following suggestions:

1. Corruption does not always inhibit investment returns on the time frames institutional investors are rewarded on, but the negative effects of corruption ultimately catch up with a country (comparing Brazil over two time frames, 2012–19 and 2016–19, show that equity performance can veer in a wildly different direction to corruption metrics);
2. Measuring corruption, proving the link between corruption and poor economic performance, and identifying what counts as sincere anti-corrupt policies are all problematic (for example: China’s corruption scores, since 2012, have improved meaningfully in the World Bank’s Control of Corruption index, but barely moved in Transparency International’s Corruption Perceptions index; China’s poor scores on corruption have not inhibited higher growth more than large emerging market peers; movements in the World Bank measure, since 2000, are in the opposite direction to changes in the rate of economic growth; and most would agree the anti-corruption drive under President Xi Jinping has been motivated at least as much by concentrating power as by cleaning up the political economy); and
3. ESG investing needs to acknowledge the inconsistency and incompleteness in supposedly objective measures of corruption and, equally importantly, to treat corruption in developed and emerging markets consistently (by acknowledging that illicit financial flows from supposedly corrupt emerging markets end up in supposedly clean developed ones).

How can something so wrong feel so right?

“When you see that money is flowing to those who deal, not in goods, but in favors — when you see that men get richer by graft and by pull than by work, and your laws don’t protect you against them, but protect them against you — when you see corruption being rewarded and honesty becoming a self-sacrifice — you may know that your society is doomed” (Ayn Rand, Atlas Shrugged, 1957).

A slow and silent killer

Almost everyone would agree that corruption is a serious negative for a country’s investment case because it causes:

• Economic inefficiency (eg bribes have a much bigger impact than simply making up for low salaries in the public sector, capital is allocated not to the most efficient operators but the most privileged, productivity declines because it is not fairly rewarded, and active rent-seeking increases);
• Lower tax collection (and usually higher tax rates on incomes and wealth that are officially documented); and
• Drives capital of all types (human, physical, financial) overseas (whether legally or illicitly) with a relatively small offset in the form of remittances (whether via official or undocumented channels).

Corruption catches up with a country, ultimately

Countries that score poorly in corruption metrics, even where these scores deteriorate, may nonetheless display high economic growth and/or offer institutional investors very high returns on the time frame on which they are rewarded.

The issue of time frame is critical.

Ultimately, high, and worsening, levels of corruption catch up with a country. For investors, it is a question of whether the period before this day of reckoning (the catalyst for which could be civil disruption, currency collapse or flight of hot capital), is long enough to build and exit portfolio positions in an orderly manner.

Consider the example of Brazil compared with large EM peers:

2016–19 out-performance

• Brazil’s Transparency International Corruption Perception Index score fell by 13% between 2016 and 2019. In real terms. GDP did not grow. But the MSCI Brazil equity index increased by 135%.
• Over the equivalent 2016–19 period, in the seven other largest markets in EM (which make up over 75% of the MSCI EM index), the average change (weighted by GDP) in the corruption index score was a 2% improvement, combined real GDP expanded by almost 25%, but the MSCI EM index was up merely 40%.

2012–19 under-performance

• Brazil’s corruption score fell 19% between 2012 and 2019, real GDP expanded merely 2% and MSCI Brazil decreased over 15%.
• Over the same time period, the other seven largest markets in EM saw an average change (weighted by GDP) in the corruption index score was a 6% improvement, combined real GDP expanded almost 60% and the MSCI EM was up over 20%.

Of course, being able to predict the exact moment when well-understood vulnerability is exposed is exceedingly difficult (which is why, in my strategy work generally, I tend to focus, instead, on valuations relative to history — this does not help with timing but it indicates what compensation there is for downside risk).

This report first appeared on Tellimer.com. To read the full report today, click here.