Weather shifts and white elephants: How climate risk is moving the goalposts for emerging market investors

Droughts and water shortages used to be associated with the world’s poorest countries. Now middle-income economies are suffering the effects of extreme weather too, with significant implications for investors, says Will Ballard.

Weather shifts and white elephants: How climate risk is moving the goalposts for emerging market investors

In 2007, when FIFA announced Brazil would host the 2014 World Cup, President Lula da Silva saw an opportunity. Buoyed by strong commodity prices, international investment flows, an appreciating currency and low inflation, Brazil’s economy was growing at seven per cent annually and showed no sign of slowing down. Lula wanted to use the football tournament to showcase his newly prosperous nation on the international stage.

Brazil spent an estimated $12 billion on its preparations for the World Cup, with around $4 billion lavished on building or refurbishing 12 stadiums. The most egregious expense was perhaps the $300 million that went on the development of the Arena da Amazônia in Manaus, a city nestled in the Amazon rainforest. Three lives were lost in the construction of the 40,000-seat stadium, which hosted only four matches.1

This massive white elephant project was not the only policy mistake Brazil made as the tournament approached. By 2014, the government – now led by Dilma Rousseff – was struggling to balance the books. With the commodity super-cycle at an end, it was no longer able to rely on exports to fund its profligate spending. Making matters worse, President Rousseff faced a corruption investigation. Brazil’s exit from the World Cup that summer, following a humiliating 7-1 defeat to Germany, was symbolic of a sharp reversal in the country’s fortunes.

Gathering storms

Throughout these troubles, there was one risk no-one had anticipated – a change in the weather. The early signs of El Niño were originally spotted by fishermen off the coast of South America; a reduction in the upwelling of nutrient-rich cool water in their fishing grounds meant slimmer pickings than usual. This periodic warming in sea-surface temperatures across the Pacific was to have broader climatic implications for global temperatures and rainfall.

The rise in inflation during El Niño coincided with a sharp decline in equity performance

The El Niño oscillation occurs every two to seven years, and for Brazil it means hotter, drier periods. When it fell between 2014 and 2016, the impact was unprecedented. The resulting drought caused both water and power shortages, as energy usage spiked due to greater demand for air conditioning. Hydropower stations were unable to operate due to low water levels. At one point, the four reservoirs in the Paraiba system, which supply tap water to Rio De Janeiro, dropped to one per cent of their measured capacity, their lowest-ever level.2

Agriculture accounted for over 70 per cent of water usage in Brazil, so it was no surprise the sector was badly impacted by the drought. In 2014, corn production fell by 26 per cent and sugar cane by 12 per cent. Yields of soy, one of the country’s largest exports, fell 17 per cent.3 The coffee bean crop was similarly hard hit, shrinking by eight per cent in 2014 and a further five per cent in 2015.4

Brazil had been one of the fastest-growing economies in the world; now it was suffering its worst recession since records began. Inflation spiked to over ten per cent, with food inflation peaking at 17 per cent. GDP contracted 5.5 per cent. The currency collapsed. The chart below shows the rise in inflation during the El Niño period, which coincided with a sharp decline in Brazil’s equity market performance relative to other emerging markets.

Figure 1: Brazil CPI; MSCI Brazil versus MSCI EM Index
Brazil CPI; MSCI Brazil versus MSCI EM Index
Source: Bloomberg. Chart shows year-on-year change in CPI and relative performance of MSCI Brazil vs MSCI Emerging Markets Index over the period, as measured by net total US dollar returns

Turkey and La Niña

Brazil wasn’t the only country affected by these dramatic shifts in the weather. As well as El Niño, the warm phase of the El Niño-Southern Oscillation phenomenon has an opposing effect: La Niña. Where El Niño leads to above-average sea-surface temperatures in the Pacific Ocean and warmer, drier periods in Latin America, La Niña tends to bring drought to other parts of the world, including another middle-income economy – Turkey.

Like Brazil, Turkey has its share of white elephant projects. The most visible is the $12 billion Istanbul New Airport, which opened in 2018. A new runway is currently under construction, despite the effects of the coronavirus pandemic on international travel.

Turkey's credit continues to grow alarmingly even as international trade has gone backwards

Between March and October 2020, the Turkish government announced it had spent $6 billion on domestic infrastructure.5 As with Brazil, the profligate Turkish administration under President Erdogan has seen its budget deficit widen. Credit continues to grow alarmingly even as international trade has gone backwards.

Meanwhile, the drought is taking its toll. Turkish cities are running out of water. The situation is particularly acute in Istanbul, the country’s largest city with over 16 million inhabitants. As of January 13, 2021, estimates put the water supply at less than 50 days at current usage rates.6 The potential impact of water shortages cannot be overlooked in a country whose economy is already struggling.

As with Brazil, the clearest sign of impending economic danger is inflationary pressure. In December 2020, inflation rose to nearly 15 per cent, with food and non-alcoholic drinks prices rising over 20 per cent. At the same time, Turkey’s equity market has started to underperform other emerging markets (see Figure 2).

Figure 2: Turkey CPI; MSCI Turkey versus MSCI EM Index
Turkey CPI; MSCI Turkey versus MSCI EM Index
Source: Bloomberg. Chart shows year-on-year change in CPI and relative performance of MSCI Turkey vs MSCI Emerging Markets Index over the period, as measured by net total US dollar returns

Climate risk

The United Nations estimates 3.2 billion people live in agricultural areas that experience water shortages. The UN’s Sustainable Development Goals seek to ensure the availability and sustainable management of freshwater and sanitation for all. Despite this, freshwater resources have declined by 20 per cent per person over the last two decades, while demand is only increasing.7

What both Brazil and Turkey show us are the real-world implications of these trends for middle-income countries. And the situation in these nations is especially concerning given that extreme weather events are becoming more frequent due to climate change.

Climate change is making droughts and floods more destructive during the El Niño cycle

While El Niño and La Niña are natural phenomena, human-driven climate change worsens their effects. According to a recent study published in the Proceedings of the National Academy of Sciences in the US, climate change is making droughts and floods more destructive during the El Niño cycle.8 And yet the worst-affected countries persist with policies that damage the environment. Under its current president, Jair Bolsonaro, Brazil has accelerated deforestation in the Amazon.

Drought and water scarcity were historically seen by investors as issues only poorer countries in East Africa had to deal with. In the era of rampant climate change, this is no longer the case: middle-income economies now look vulnerable too. Recent events in Brazil and Turkey show governments that fritter away money on white elephant projects may lack the resources to react when a crisis hits, risking serious damage to their economies, markets and asset prices. Investors should take note.

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