Country Governance Research Commentary – February 2017

Country Ranking Trends

  • Magni completed a review of Turkey’s regulatory environment. The review resulted in an upgrade for their banking supervision based on better capital adequacy and liquidity requirements. Their banking supervision is now comparable to the standards in the EU. Insurance supervision has also strengthened; however, additional improvements are required to warrant an upgrade in this area. Anti-money laundering requirements have also improved; however, the remaining regulatory and supervisory challenges are sufficiently important to prevent an upgrade in this area.

Turkey: a Tale of Two Trends

  • It is the best of times and the worst of times in Turkey. Its economic infrastructure continues to improve, while the international pressures and internal political changes cloud its future. Last month’s commentary highlighted several sources of concern for Magni. Fitch has now downgraded Turkey’s sovereign debt to “junk”, eliminating its last remaining investment grade.
  • Implications: Magni will continue to upgrade or downgrade Turkey as its economic infrastructure changes. At some point, Turkey’s many challenges may cause degradations to its economic infrastructure. Magni will be watching key “sign posts” such as the level of independence for the financial and supervisory authorities. Leaders who centralize power often reduce the independence of financial functions which in turn adversely impact a country’s prospects.

China Must Overcome Corruption to Achieve its Global Goals

  • After finishing 2016 as one of the worst performing stock indexes, Chinese stocks have reversed course to become a leader in returns so far in 2017. Better economic data and expectations of improving corporate earnings have been the near-term catalyst as they allay concerns about an economic hard landing that dominated last year. Given the improved linkages and easier fund flows between domestic and offshore listed stocks, it is noteworthy that domestic listed stocks have so far significantly underperformed their offshore listed counterparts. The onshore market is still dominated by local retail investors and valuations are relatively high, which has kept away many foreign investors. However, the valuation gap between dual-listed stocks trading on China’s and Hong Kong’s exchanges has fallen to multi-year lows, as an influx of mainland capital boosts shares trading in Hong Kong. This convergence in valuations and China’s eventual full inclusion in global benchmarks could be halted if the recent trend towards increased capital controls continues. MSCI is expected to resume consultations soon on including onshore Chinese A shares in their indexes, and the ability of investors to easily move capital out of the country remains one of the largest remaining obstacles.
  • Implications: The Magni Country Score for China remains among the lowest in the investible world. Liberalized capital flows, inclusion of Chinese A shares in MSCI indexes, and similar efforts will continue to place constructive pressure on their economic infrastructure. Such pressure can help force improvements, such as increased transparency, greater conformance to international standards, and better regulations/supervision that reduce corruption. Sometimes resistance to change, particularly from those profiting from opaqueness, corruption, and/or crony capitalism, can overcome the constructive pressure and halt the improvements or even take a country backwards. Either way, Magni is watching for changes.

Can South Africa Remain a Leader in the Emerging Markets?

  • To narrow its budget deficit, finance minister Gordhan called for tax increases aimed mainly at wealthier South Africans. He also called for structural reforms necessary to boost economic growth. Demonstrating progress in reducing the debt will be important as credit-rating firms will soon be reviewing South Africa’s investment-grade status. South Africa narrowly avoided a downgrade to junk at the end of 2016. However, budget reforms may fall victim to a rivalry between the finance minister and the President Zuma. There has been talk of a cabinet reshuffle that could see Mr. Gordhan lose his job and his successor could unravel many of the measures already implemented.
  • Implications: The structural reforms are critical to South Africa’s prospects. South Africa has one of the better economic infrastructures across the countries of the emerging markets. The reforms are important to keep South Africa’s leadership position.

Achieving European Progress Now to Avoid a Five Star Problem

  • Paolo Gentiloni, is now Prime Minister following the defeat of the constitutional referendum and the subsequent resignation of the referendum’s champion, Matteo Renzi. Mr. Gentiloni faces a difficult task ahead, with the European Commission warning Italy it could launch sanctions procedures over the country’s growing debt if Rome does not quickly adopt new budget cutting measures. The latest Commission forecasts showed Italy’s public debt would rise this year to an all-time high of 133.3 percent of gross domestic product. The country also faces sluggish growth and lingering issues with bad loans at domestic banks. Italy is expected to come to an agreement with European authorities over a state bailout of loss-making bank Monte dei Paschi di Siena. A general election should happen in the next twelve months, with the ruling Democratic party facing the populist Five Star Movement, which has vowed to call a referendum on euro membership.
  • Implications: The recent news reinforces the existing trends for Italy and the overall European Union. Discussions of bailouts, austerity, and related topics are important to address short-term issues. Reform is required to generate a healthier economic environment and to enable the sustainable wealth creation that overcomes the recurring financial problems. The slow dissolution of the European Union may eventually lead to these reforms, though the EU does currently provide governance benefits to the weaker member states and these states would face near-term downgrades if they voted to leave.