Structural reform is a powerful driver of the long-term investment case in emerging markets. It is sorely lacking at the moment.
A wish list of structural reform
Structural reform covers many policies;
Improving law and order and contract enforcement;
Enhancing central bank autonomy;
Privatisation and streamlining of state-owned enterprises;
Liberalisation of labour, product and financial markets;
Streamlining tax codes and improving tax collection;
Improving electricity provision and educational attainment; and
Facilitating easier terms for doing business for the private sector.
Overshadowed by crisis management
Structural reform has taken a back seat to crisis management of:
High fuel and food prices; and
Elevated sovereign debt across most of EM since the start of 2020.
For some, climate emergencies, eg floods in Pakistan, or droughts in India and China.
Very few governments have initiated policies that are unpopular with the mass population or challenge vested interests – Indonesia's Omnibus Act (labour, land, regulation, tax reform) is an exception. Some have gone into reverse gear, eg:
Brazil’s eroding efforts to rein in the fiscal deficit and high (domestic currency) government debt;
India’s roll-back of its agricultural reforms in the face of the farmers’ protests and in advance of state elections; and
Pakistan's removal of the reformist government led by Imran Khan.
Where governments have launched fresh initiatives to take on vested interests this has been motivated as much by consolidation of political power as economic reform; eg the regulatory crackdown on China Tech.
Weakening globalisation has not helped
In the era of globalisation, some of the shortcomings in domestic reform could be compensated for by the gains from more open trade, cross-border investment and technology transfer as financial and human capital migrated to where its return prospects were better, and countries were forced to compete in a global market.
However, as de-coupling (eg of the US and China, of the West and Russia), nationalistic regulation (eg in global tech and, potentially, global energy next) and greater regionalism set in, the impetus for externally driven reform is diluted.
The role of cross-border capital flows, motivated by geopolitics in a de-coupling world, as much as pure financial return, almost certainly does not lead to as efficient an outcome and as sincere a structural reform effort; Egypt and its inflows from the GCC, and Pakistan and its inflows from China, are two examples where tough reform decisions have been postponed because of support from 'friendly countries'.
Where might structural reform revive?
One way to judge the prospects of structural reform gaining momentum, once and if the global headwinds of commodity input prices and higher cost of funding subside, is the strength of the legislative mandate.
To what degree do governments have the capability to pass new laws, assuming they are of a reformist mindset in the first place? The effective legislative mandate might be quantified using two metrics:
The size of the legislative majority, measured, objectively, in electoral democracies by the percentage of seats in legislative assemblies (for comparability, we use lower house seats), or subjectively, in monarchies and autocracies by the degree of absolute power enjoyed by the ruler; and
The time left before the next (scheduled) election in democracies – to account for examples like Turkish President Erdogan, who may enjoy a legislative majority but the next election is within a year – with the maximum in the sample size of democracies assigned to monarchies, where rulers are in place until death.
Obviously, there are country-specific nuances, not captured in this framework, but given the heterogeneity of political systems this is a best-efforts attempt; eg
The balance of power between the executive and legislature and checks and balances exerted by the judiciary;
The influence of other actors behind the scenes, such as the military and intelligence services, or tribal, religious, landowning and industrial elites;
The potential for the mass population to protest (which requires a certain level of discontent, perhaps measured by youth unemployment, but also a legal and cultural environment that enables protest in the first place, perhaps measured by press freedom); and
The degree of insulation from international influence, particularly in quasi-client states, where political legitimacy or economic wellbeing is more dependent on external than domestic support.
We illustrate below a measure of political stability and absence of violence in order to identify which countries might be particularly sensitive, in terms of political stability, to structural reforms that challenge vested interests (although this metric could also be interpreted inversely, as pointing out which countries most urgently need structural reform to break the grip of those vested interests).
Our EM Country Index in this context
Our index weights c30 factors on growth (short and long term), policy credibility, politics, sanctions, ESG, equity valuation and liquidity.
The purpose is to rank the top-down investment case in about 50 countries.
Included in the politics component are metrics such as legislative mandate, youth unemployment, and income inequality.
The weights in the index can be changed in order to model different global themes and portfolio styles.