BRICS NEED TO CHANGE THEIR TUNE / THE WALL STREET JOURNAL

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December 26, 2012, 1:30 p.m. ET

BRICs Need to Change Their Tune

By LIAM DENNING

 

Brazil, Russia, India and China are the John, Paul, George and Ringo of the emerging markets—a neatly packaged group of disparate individuals that sometimes inspires hysteria.


This year, the BRICs turned 11 years old, so they have outlasted the Beatles, who notched up a decade. Like the band, the BRICs have enjoyed enormous success. In 2002, BRIC stock exchanges accounted for 3% of the total market value of members of the World Federation of Exchanges. By 2011, they represented one-fifth.


But 2012 for this foursome was hardly fab—apart from India, those markets trailed the S&P 500 significantly and economic strains appeared.


The calling card of the BRICs, high growth rates, remains valid but is curling at the edges. Between 2000 and 2008, they averaged annual gross-domestic-product expansion of 8%, almost six percentage points above the average for G-7 countries.


This year, the International Monetary Fund forecasts average BRIC growth of 4.5%, with the spread having shrunk to 3.1 percentage points. All the BRICs, even poster boy China, have seen a marked decline. Next year, growth is put at 5.5%- not bad, but a marked step down.


Up to 2008, emerging markets enjoyed average export growth of 20% to 30% a year. Europe and the U.S. enjoyed credit-funded consumption binges, sucking in imports from emerging markets which in turn fuelled investment in the latter.


Now, the euro zone is undergoing a drawn-out existential crisis and the U.S., while doing better, still suffers from high unemployment and wrangling over deficits. Exports from emerging markets are likely to shrink this year, according to UBS strategist Bhanu Baweja, and grow by between just 5% and 10% next year. This also is likely to curb investment as companies won't need to expand capacity so quickly.


This will hit all the BRICs, though Brazil and Russia look most exposed immediately because both are big commodity exporters.


Russia presents a conundrum. Its corruption problems and demographic decline are well known. But at about 6 times forecast earnings, Russian stocks look dirt cheap compared with 15 to 18 times for the other BRICs (or 14 for the S&P 500).


The problem is that two of the biggest influences on Russia's performance—the oil price and the euro-zone economy—present big risks in 2013. Bulls point to internal measures such as a recently launched anticorruption drive. But even if that proves successful—a Russia-size "if"—it could in the near term exacerbate capital flight, a persistent headwind in 2012.


Brazil looks better than Russia. But having been the hot story of recent years, its fall from grace in 2012 has been hard: Stocks are down 6%, the worst of the BRICs.


Third-quarter GDP growth of 0.6% was half what was expected. The big problem is low investment)—public and private—running at about 19% of GDP. This would need to rise to 22% for Brazil to get back to the 4.5% GDP growth rate it enjoyed for much of the past decade, according to Deutsche Bank .


The government has several grand projects planned, such as expanding Brazil's ports. But the state's heavy hand also is part of the problem. A complex tax code and web of regulation keep Brazil near the bottom of the World Bank's index for ease of doing business in Latin America. Energy subsidies in the form of price caps curb efficiency and constrain investment by the likes of oil major Petróleo Brasileiro .


India and China, meanwhile, ought to benefit from falling commodity prices. India, in particular, could use the help to tame inflation which still runs above 7%. Worryingly, inflation remains high even though GDP growth this year is expected to be just 4.9%, well below the average of 8% before the financial crisis.


Stubborn inflation reflects infrastructure bottlenecks arising from weak investment. High fiscal deficits, running between 5% and 6% of GDP since 2009, crowd out private-sector investment. And little of the government's spending represents genuine investment, which could improve productivity and curb inflation, providing room to loosen monetary policy.


Moreover, money that goes to subsidizing things like fuel to ease the burden of inflation takes away from investment in what is arguably India's greatest resource: its large, young population. Without policy changes, reaping India's demographic riches isn't a foregone conclusion, according to UBS's Mr. Baweja, who says India has "two choices: Employ these guys or subsidize these guys."



Unlike the other BRICs, China's problem isn't a legacy of low investment. Far from it: between 2003 and 2007, investment was about 42% of GDP. That is higher than the levels seen in Japan in the decade to 1974 and South Korea in the decade to 1997, at the height of their industrial development, according to Charles Dumas of Lombard Street Research. In response to the financial crisis, Beijing unleashed a stimulus effort that pushed the ratio to 48% in 2011.


The side-effects can be seen in trade friction, especially with the West, arising from overcapacity in manufactured goods ranging from steel to solar panels, as well as rising wage inflation and bad debts lurking in the financial system. Beijing's newly installed leaders appear to recognize the problem, with the latest five-year plan calling for domestic consumption to play a greater role in economic growth.


Such a plan is laudable, and problematic. First, shifting the burden of growth from investment and net exports—51% of GDP—to consumer spending, which accounts for just over a third of the economy, necessarily entails slower growth overall. For a one-party government with a wary eye on the potential for social unrest, it will be tempting to fall back on the old model of lending money to state-owned enterprises to build stuff, return on capital be damned.


The flip-side is that, if Beijing stays committed, the transition is unlikely to be smooth and will certainly hit sectors tied to construction. The boom in prices of raw materials such as copper and iron ore, especially, looks numbered even allowing for the occasional relapse in Beijing's resolve.



Unlike previous crises, the BRICs aren't teetering, thanks to relatively clean balance sheets. But a decade in which they could do little wrong is well and truly over. Each must now grapple with the problems of reforming themselves for a changed world.


And increasingly, the political and economic differences between them—obscured in the bull market—will become clearer, throwing the whole idea of the BRICs into question.


For fans of the band, there is no guarantee they will love them as solo artists in the years to come.