What role does governance play in EM external debt returns?

Issues surrounding governance for ESG investing in EM sovereign debt have direct impact on risk and returns, but measuring the effects of governance is far from straightforward

Eric Baurmeister and Warren Mar
Eric Baurmeister and Warren Mar

Interest in environmental, social and governance (ESG) factors in investing has grown dramatically.

Yet, the definition of ESG when applied to emerging market (EM) sovereign debt is still evolving and has yet to settle into a commonly defined approach.

Our research has shown that governance does matter for both risk premiums and returns, and that there are both ethical and performance arguments for focusing on change at the margin as opposed to absolute levels of governance. Furthermore, because key governance data is produced with a significant lag, investment firms are wise to advise against investors taking a strictly quantitative "paint by numbers" approach, and instead supplement hard data with expert qualititative research and monitoring.

Governance Focus

Our suggestion is that it is better for investors to focus on changes in governance, as opposed to absolute levels. There are both ethical arguments for this approach, as well as performance considerations.

The growing interest in ESG investing strategies reflects the developing trend that asset owners are increasingly focused on issues of sustainability and ethical considerations alongside investment performance. We believe that there is a strong ethical argument that ESG-focused investors should want to reward governance improvements, which may encourage further improvements. Finally, a strategy of investing in countries with the highest absolute governance scores significantly underperforms a strategy of investing in the countries with the best improvements in governance.

Risk Premiums in Emerging Markets

Governance scores have substantive explanatory power when looking at risk premiums in emerging market external debt. In our experience, given the relationship between wealth and governance, it is worth pointing out that GDP per capita has a relatively low fit with spreads, indicating that this is not simply a function of wealth. In sum, governance—especially regulatory quality, rule of law and government effectiveness—matters for emerging market risk premiums.

Returns in Emerging Markets

We find that countries with the greatest improvements in governance in a given year tend to outperform in terms of total returns, and countries that have the greatest slippage in governance tend to underperform. However, we caution against a "paint by numbers" approach to judging governance that relies solely on quantitative criteria. Hard data is often backward looking and released with significant lags. At Morgan Stanley Investment Management, we believe in supplementing this useful backward-looking data with regular monitoring and travel to countries in which we invest. This exercise lends credence to our long-standing belief that governance matters, and that as part of the investment process, it is worth trying to identify and anticipate changes at the margin.


ESG investing in emerging market external debt presents challenges in terms of broad data availability and latency. Qualitatively, we can see environmental and social factors at work in emerging markets, including issues as diverse as the risks of political unrest growing with inequality and a lack of opportunity, balance of payments concerns due to an overdependence on fossil fuels, or the fiscal risks of growing water stresses driven by the changing climate. Going forward, we will continue to do robust empirical work to quantify the impact of these factors for our asset pricing models.

However, we started our analysis of ESG with governance as it is often the most observable factor in our travel to emerging markets and discussion with policy makers. In addition, in our experience, there is a clear and intuitive link to risk premiums and returns. The broad scope and time series of the World Bank's World Governance Indicators makes it a useful tool for quantifying the impact of governance on emerging market external debt. Governance, and in particular rule of law, regulatory quality and government effectiveness, is substantively related to risk premiums. There are both ethical and performance arguments for focusing on changes in governance rather than absolute levels of governance. And finally, given the backward-looking nature of the hard data, investors wishing to harvest the return outperformance of the best improvers must focus on real-time change at the margin.


Eric Baurmeister is the head of and senior portfolio manager of the emerging markets debt team. He joined Morgan Stanley in 1997 and has 24 years of investment experience. Prior to joining the firm, he was a portfolio manager at MIMCO. 

Warren Mar is a portfolio manager and head of emerging markets corporate debt strategy on the emerging markets debt team, Morgan Stanley. Prior to joining the firm, he was the global head of emerging markets corporate research & strategy at J.P. Morgan Chase. During his time at J.P. Morgan Chase, he was part of the team that created the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified, which has become the recognized and most widely used market benchmark for the asset class.


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