Political Risk: An Underestimated Macro For Emerging Markets.
If you are an investor who owns index funds, you are invested in whatever markets the index tracks. If you want to invest in specific countries, you should understand at what stage of development these countries are. You can choose to invest in ‘Developed’ markets such as the U.S. or Germany or in ‘Emerging’ markets such as China and Brazil. But these classifications are subjective and I happen to disagree with some of them. In particular, I think that the classification of South Korea, Hong Kong, and Israel as developed markets is a mistake.
All three countries have their own emerging-market issues, but what they share is underappreciated political risks to their markets. Here is an overview of how different rating agencies – and Macro Affairs – classify these markets:
As you can see, only South Korea gets classified as emerging by the rating agencies (only MSCI does). There is no single definition or hard lines for what frontier, emerging, and developed markets are, but here are the MSCI criteria.
In general, developed markets have more liquid financial markets and more credible ownership rights backed by stable government. Emerging markets have more graft and bribery, weaker institutions, and can have a more economically authoritarian government which can limit foreign ownership of companies. Emerging economies can also have a higher risk of social unrest or regime change. In general, the emerging market label is used to indicate a higher risk for capitalists than ‘traditional’ capitalist countries such as the U.S. or western Europe.
South Korea, Hong Kong, and Israel all have markets that are exposed to typical emerging market risks. Here is why they should be classified as emerging markets:
Why South Korea Is An Emerging Market
South Korea has typical emerging-market corruption scandals. The previous president Park Geun-hye from 2013 to 2017 was sentenced to 24 years for corruption. Her predecessor Lee Myung-bak from 2008 to 2013 is currently facing life for bribery, embezzlement, and tax evasion. His predecessor Roh Moo-hyun from 2003 to 2008 committed suicide while being investigated for bribery and corruption. And those were just the last three presidents, not to mention corruption by lower-level officials. Even if these presidents were innocent of corruption and bribery, the fact that they all went down for corruption signals undemocratic, political fighting. Corruption is not just a drag on the country, but it erodes trust in South Korea’s young institutions. These are typical emerging market issues.
Then there is the threat of war with North Korea or a possible re-unification. A war would devastate Seoul by North Korean artillery, killing perhaps a million people and causing enormous damage to South Korea’s financial markets. A re-unification with the north would mean that the South would carry the heavy burden of building almost everything new in a dirt-poor country. North Korea is a big, macro threat that looms over South Korea – and South Korea should not be considered a developed market until the situation is normalized.
Why Hong Kong Is An Emerging Market
Hong Kong was a British territory until 1997, when the Sino-British Joint Declaration went into effect and sovereignty over Hong Kong was given back to mainland China. The Sino-British treaty specifies that Hong Kong will be a Special Administrative Region (SAR), administer itself independently and that its economy will be capitalist – but that it cannot have its own military or foreign affairs. Hong Kong has continued to prosper economically since. But the treaty and the SAR status of Hong Kong is set to expire in 2047 without any specifications of what comes after. What seems likely for now is that China will continue to move in the direction of Hong Kong, catching up economically, and the two territories will merge in 2047. But it appears that China is exerting more and more influence over Hong Kong and violating the treaty.
Today we are more than 20 years into the 50 year treaty and mainland China is beginning to meddle more in Hong Kong’s internal affairs, leading to protests. China vets the presidential candidates in Hong Kong and has abducted and disappeared Hong Kong citizens critical of Beijing. Hong Kong for its part is worried about what will happen in 2047 and wants to assert its SAR rights and likely claim an indefinite quasi independence after 2047 — opposing Beijing’s plans for the Island.
The people of Hong Kong are very much opposed to the political re-unification with the mainland that Beijing has already started. We should expect significant social unrest in Hong Kong as we get closer to the expiring of the treaty in 2047 when China will take over.
Why Israel Is An Emerging Market
Israel is a small country that is constantly threatened by (and threatening) its neighbors. It often provokes its bigger neighbors Syria and Iran and continues to annex more Palestinian land by forced eviction of the native Palestinians. Had Israel not been backed by Britain and the U.S. through military and diplomatic aid, it would simply not exist. Should the U.S. withdraw its support today, then Israel would be fully dependent on its nuclear arsenal for its survival. Because of Israel’s wretched aggression against other states — having attacked all five of its neighbors within 50 years of its founding— Israel now has to waste 5.8% of its GDP on defense. In the view of MacroAffairs, this 5.8% of GDP spent on militarism represents a huge potential for investment in peaceful development activities. This could include infrastructure, co-operation with neighbors, foreign aid in the region, and desalination and forestation efforts.
Israel is considered to have a modern form of apartheid. About 20% of the Israeli population is Arab and 12% identifies as Palastinian. The Palestinians in Israel have a lower legal and socio-economic status, hampering their contribution to the development of the economy. Then there are 1.8 million Palestinian prisoners in the Gaza Strip and 3.2 million Palestinians living in the West Bank. Palestinians in the West Bank and Gaza – until now squeezed by sanctions – also represent a huge potential of untapped human capital with Palestinian enrollment in higher education one of the highest in the world. Ending the state of apartheid would bring to market a wave of human capital, something typical of emerging markets.
A country that has large spending on defense, is fighting with neighbor states, and oppresses a large portion of the population should not be considered developed. For Israel to become friends with its neighbors, divest its huge military spending to peaceful development, and to enable its human capital currently suppressed by apartheid would unleash a level of development that is typical of other emerging markets. Such positive developments would also cause a lifting of the silent boycott of Israel.