By Sujata Rao
LONDON (Reuters) - Investors rushing headlong to emerging markets in search of yield could find future returns under threat as economic downturns and income inequalities spur a rise in political risks.
Emerging markets have been the global success story of the past decade, with booming growth and huge investments eroding old memories of the coups, debt defaults and hyperinflation associated with these countries throughout the 20th century.
This year investors fleeing near-zero yields on "safe" Western bonds have propelled $50 billion into emerging stocks and bonds, according to fund tracker EPFR Global.
Governments and companies in emerging economies are set for a record-breaking year of bond sales as investors stampede to lend even to countries such as Zambia and Guatemala which are rated as junk by credit agencies.
On the face of it the enthusiasm seems justified.
Debt levels are a fraction of the norm in developed markets and growth is faster, yet yields are robust. While risk premia have plunged over the decade, emerging sovereign dollar bonds pay an average 3 percentage points over U.S. Treasuries.
Yet many such as Greg Saichin, head of emerging debt at Pioneer Investments, reckon premia in many markets no longer compensate for risks simmering just beneath the surface.
This week geo-political risk has escalated in the Middle East with Turkey embroiled in the Syrian conflict, while in South Africa violent labor protests are spreading.
Anti-Japan protests in China, rural insurgency in India and unprecedented anti-Kremlin demonstrations in Russia this year are all symptoms of a coming storm, many risk watchers say.
"People look at indebtedness ratios, debt maturity profiles, growth differentials (in emerging markets) and say it's a no brainer, you are getting paid 2 percentage points more than elsewhere," says Saichin, who oversees $3.4 billion.
"But there is a lot of complacency in the market in terms of politics and what may happen with sovereign risk."
Many will argue, quite correctly, that risk, whether geo-political or corporate governance, has always been part of the deal in emerging markets. And recent riots in Spain and Greece show that the West now has plenty of political risk of its own.
Yet never before has so much money been at stake.
Bricks-and-mortar direct investment to emerging markets has tripled since 2000 to $6 trillion. And $250 billion has flowed to emerging equities since Boston-based EPFR started compiling data in 2006. Bond flows since 2003 total $125 billion, it says.
Rewards have been ample. Equity returns in the past decade are close to 350 percent, Thomson Reuters data shows, while emerging dollar bonds have earned 225 percent.
But much of those gains coincided with rock-bottom U.S. yields, which have been driven even lower by waves of money-printing.
"When we see U.S. spreads snapping back up, a lot of sovereign risk pressures which are subdued at the moment will start to come into focus again," Saichin said. "When spreads do normalize, there would be a very violent normalization."
As with last year's Arab Spring, political upheavals are usually a consequence of years of economic hardship yet often catch investors by surprise, wiping big chunks off portfolios.
Despite years of booming economies, income inequality actually rose in big emerging nations such as Russia, South Africa, India and China between 1993 to 2008, according to data from the OECD group of developed nations.
Brazil's Gini coefficient for instance, a gauge of wealth disparity, is twice the OECD average.
"Governing is getting trickier," said Gary Greenberg, head of emerging markets at Hermes Fund Management. "As economic growth slows, populations are less willing to forgive mistakes and corruption on part of governments."
The worry is that worsening politics lead to bad policies.
It would be bad news for investors if governments crank up spending to appease restless populations or pressure central banks into cutting interest rates. And as Brazil and Russia have already showed, big state-controlled companies are especially vulnerable to government raids on their coffers.
Greenberg finds it unsurprising a territorial dispute has triggered eruptions of anti-Japan fury across China where growth is slowing and protests in rural provinces have mushroomed.
"There are protests all over the country and the government is... worried," he said. "If history is any guide, it will look for some foreign nemesis to get the patriotic juices flowing."
Many such as Greenberg say political risk can offer buying opportunities. These risk-takers will point out that anyone who bought Egyptian equities in late 2011 would have made a killing this year from the stock market rebound.
South African stocks, despite seven weeks of mining strikes, are just off all-time highs and foreign holdings of local bonds are at a record. The cost of insuring exposure to South Africa via credit default swaps (CDS) has barely budged.
And debt defaults in Ivory Coast and Belize -- caused in the former by civil war and in the latter by pre-election pledges -- did not deter investors from placing $12 billion in bids for Zambia's $750 million bond, their eyes on its 5.6 percent yield.
"It's not about ignoring politics but about being desperate for yield," Jim Ross, a senior portfolio manager at Alliance Bernstein, says of the emerging markets rush.
Emerging economies are on the cusp of change, Ross says, moving away from the producing-for-export economic model towards domestically-generated growth. The process can generate turbulence as export-sector jobs go and incomes fail to rise.
"Some markets will manage it, others won't," he said. "So you have to be careful what country and stock you pick."
(Editing by Ruth Pitchford)