How good governance improves financial returns

Does governance matter? Yes. Intuitively to many development practitioners, the link between governance and growth is established in the literature. But, what about hard-nosed financial investors? Is there a link between governance and financial returns? Initial cutting-edge research suggests that there is a link. And investors are increasingly paying attention to governance.

According to a study conducted by Global Evolution, an asset manager that specializes in emerging and frontier market sovereign investments, shows that governance may be a significant driver of sovereign bond returns. According to Ole Hagen Jørgensen, Research Director of Global Evolution, “improvements in a country’s Environmental, Social, and Governance (ESG) scores – and particularly the “G” of governance – significantly correlate to pricing of risk, credit ratings and return generation of sovereign bond funds in emerging and frontier markets.”

​For governments, this can mean cheaper to access to credit, helping create fiscal space.

Research to date had focused more on ESG factors in the equity markets. Beyond some risk mapping by the UN Principles for Responsible Investment team, considerations of government bond markets remain relatively as uncharted waters. However, as discussed at a workshop hosted jointly by the World Bank and Global Evolution last month, ESG considerations may merit the close attention of fund managers, and in turn, of emerging market governments. Incorporating ESG dynamics in a systematic way in quantitative valuation frameworks suggests governance variables hold some explanatory power in forecasting sovereign spreads and credit ratings.

Governance improvements directly translate to improvements in returns and credit rating adjustments.

What’s more, those at a low base level have most to gain because significant improvements in governance levels (and ESG levels more broadly) translate to the largest market returns. As discussed by William Maloney, Chief Economist for Equitable Growth, Finance and Institutions, this study may allow us to be able to quantify to governments how important governance is as a tool for development.

Big questions remain.

​Do we have adequate indicators of governance performance? Currently, investors are typically turning to a variety of composite indices, such as the Worldwide Governance Indicators. As governance efforts touch on so many factors, from increasing transparency and anti-corruption initiatives to building institutional capacity, there is a lack of clarity as to which of these governance indicators are most forceful in explaining the link to returns. For governments, this makes it harder to know where to target reforms to enhance their governance scores in the most impactful way in order to attract financing.

Judging from the interest from investors, IFIs, data providers, and credit ratings agencies in this workshop, there is a shared interest to explore such questions further. It also raises the potential of some interesting alliances in championing good governance. It can help to have the same message heard from different quarters.

​It will be intriguing to see country responses should financial investors send a clear and consistent message that governance enhancements and higher political stability are indispensable factors in their valuation frameworks.

This article is published in collaboration with The World Bank’s Governance for Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Michael Jarvis is a Senior Private Sector Development Specialist with the World Bank Institute. Christina Tecson is a consultant at the World Bank.

Image: A man walks past buildings at a central business district. REUTERS/Nicky Loh.