CHAPTER 5

Divergence: Leading Emerging Markets Are Headed in Different Directions

Alexander Kliment and Christopher Garman

As the advanced economies in Europe and North America settle into a potentially lengthy period of slow growth, investors are looking toward the most exciting emerging markets to pick up the slack. But though these economies are poised to outpace the advanced economies over the next several years—at about 6 percent growth against barely 2 percent, according to the IMF—the outlook for emerging markets like China, India, Brazil, and Russia is hardly a uniform one.

For one thing, emerging markets (EMs) remain exposed to a global slowdown. Fragile, export-oriented economies, such as Ukraine and Hungary, that depend directly on European demand and credit face significant economic dislocation in coming years; and commodities exporters, like Brazil, are also vulnerable to a Chinese slowdown. Oil producers are for the moment relatively well off as supply concerns and worries about the possibility of an Israeli strike on Iran buoy prices. But across the board, even in markets that are driven more by domestic consumption and less by global dynamics, emerging markets are headed for slower growth.

But such an outlook also means policy makers in emerging markets are likely to confront starker economic and political trade-offs than they have faced in many years. Politics has always played an outsized role in shaping economic outcomes in the emerging markets, but amid fresh challenges the importance of politics is rising—and with it the degree of political risk that investors face. Governments with widely varying degrees of popular support must adjust to a grimmer global environment while grappling with new socioeconomic and political challenges at home. Economies accustomed to dizzying growth will now have to adjust to more modest output. Will they implement long-shelved economic reforms to lay the groundwork for sustainable long-term growth? Will they veer toward greater economic nationalism or populist measures, or will they just stand pat, accept somewhat lower growth, and do nothing?

Overall, we argue that their policy paths and economic trajectories will increasingly diverge—particularly in a lower global growth environment. At some level this is already reflected in the ever-thickening alphabet soup of acronyms applied to subsets of emerging economies: BRICS, MIST, CIVETS, and the rest. But even within these groups there will be greater variety, requiring increasing sophistication and attention from investors.

Broadly speaking, the key variable for the quality of policy making will be the level of political capital that incumbents have to spend. Many of the emerging market economies are entering into electoral cycles ahead of 2014 or 2015 national elections, creating sets of political incentives that may not always align with prudent macroeconomic management.

MARKET-MOVING THEMES

First, the decade-long global era of abundance for EMs is over. Over the past ten years, many of these markets enjoyed a period of robust economic growth amid soaring commodity prices and cheap capital. Politically, that generated a number of policy repercussions—chief among them, a strong measure of complacency. The painful structural reforms that many EMs pushed through in the 1990s were crucial for enabling the prosperity of the decade that followed. And in the early 2000s, policy makers consolidated those reforms and looked to build on them.

But then many of them got too comfortable. Investors and pundits often criticized countries like India, Brazil, Russia, and even China for having “wasted” a window of opportunity to conduct tough reforms when times were good. But that misses the crucial difference between good policy and good politics. From a political perspective, good times weaken the incentives to enact difficult reforms. Much as we are seeing in Europe, policy makers only begin to consider painful adjustments when the near-term costs of inaction become disastrously high.

In fact, as we saw across the EM world during the 2000s, strong growth strengthens the appeal of economic nationalism, at times tempting governments to boost support for state-owned enterprises and domestic national champions, and to claw back concessions made to foreign companies in earlier periods of economic weakness. This was certainly the case in Russia and China. In Russia Vladimir Putin—who began his first term with a slew of critical economic reforms—muscled the state back into control of the oil and gas industry and substantially expanded the government’s role in the banking sector. In China the government has also played a much more active role in promoting domestic national state-owned champions. Even in Brazil, which is significantly less state capitalist than China and Russia, the Lula government much more actively used the state development bank BNDES to spearhead an ambitious industrial policy while at the same time granting state-owned oil company Petrobras an outsized role in developing the country’s new deepwater oil reserves.

Not all EMs veered toward state capitalism in equal measure, but the appeal of this system and of resource nationalism has clearly broadened over the last decade. The 2008–09 global financial crisis naturally added to this appeal, throwing a harsh light on the shortcomings of unfettered, deregulated markets, while recovery from the crisis dramatically expanded the role of the state in national economies everywhere, particularly in the Organization for Economic Cooperation and Development (OECD).

Second, while we expect some countries to respond to a slowdown in growth by embarking on a new round of reforms that increase economic efficiency, we will not get a return to the types of reforms seen in the 1990s. It is important to place the current economic picture in perspective. It is a slowdown rather than a full-blown crisis, making the urgency of reform considerably lower than it was in the 1990s, when the real risk of insolvency all but forced many EMs to make painful adjustments. These countries are now much better prepared to weather slow growth than they were a decade ago. Insolvency risk is low for most EMs, debt-to-GDP ratios in the large EMs are generally low, and central banks command large reserve cushions to support their economies and defend their currencies against attack. So while the coming years promise slower growth than we have seen in the past decade, the risk of outright crisis and contraction is low. As a result, economic reforms will tend to be more microeconomic than structural—specific to individual sectors rather than broad based.

Third, for many EMs—and all of the large ones—the domestic social and political landscapes have changed substantially over the past ten years. Economic growth has created new constituencies and, in many cases, new grievances. Perhaps the most striking change is the growth of a new EM middle class that is accustomed to rapid growth. Policy makers face the twin demands of managing the middle class’s expectations and responding to its emergent political interests.

In Brazil, for example, the massive new middle class created by social spending and credit liberalization in the mid-2000s is now demanding better public services and more transparent governance from a political class historically marked by extensive patronage networks and cronyism. In China, the middle class will test the resilience of the authoritarian growth model at a time when policy makers also face the challenge of rebalancing the economy toward a growth model based more heavily on domestic consumption. In Russia, a middle class that emerged during the oil boom years is now turning on the government of Vladimir Putin, giving rise to a new protest movement that has raised unprecedented questions about Putin’s legitimacy. In Indonesia, a consumer economy has taken root, providing the broader economy with some cover from global turbulence, but also staying the government’s hand on key fiscal reforms, such as eliminating fuel subsidies. In India, the growth of the middle class is also indirectly exacerbating the political salience of a series of corruption scandals that have rocked the current administration.

The political repercussions of a growing middle class will grow larger as this part of the population grows in emerging markets. According to the OECD, the advanced economies accounted for about 54 percent of the world’s middle class in 2009. By 2020, that share will fall to 32 percent. More than three-quarters of that growth will come from emerging markets in Asia.

Third, as EM policy makers seek to meet new economic challenges, the advanced economies no longer present a compelling or consistent model for policy. At the moment there is unparalleled monetary heterodoxy in developed markets and talk of restructuring fiscal liabilities, coupled with a rancorous debate in Europe about the merits of fiscal austerity. Whether the developed world’s models are appropriate for EMs is certainly open to question, but in practice the much higher policy variation in advanced economies suggests that EM policy makers will also feel emboldened to experiment with more unorthodox approaches.

With these basic parameters in mind, what can we expect from the key emerging market groupings and economies over the next several years? Policy divergence. In some countries we may actually see a relaxation of economic nationalist policies and greater progress on economic reforms, but in others we will get a deepening of existing policies, or policies undertaken with short-term political and economic horizons. That will then require close attention on a country-by-country basis. It was never wise to group all EMs together, but the distinctions among them are now set to become ever more obvious.

THE BRICS

The BRICS grouping of the largest EM economies—Brazil, Russia, India, China, and South Africa—has lost some of its luster as the stratospheric growth rates of the 2000s have given way to more modest output. The extent to which that slowdown is structural or cyclical is a matter of debate for economists, but from the political perspective, it would be a mistake to view the group from a uniformly negative or bullish perspective. There will be considerable policy divergence within the BRICS, owing to differing political constraints. Broadly, we are more bearish on the policy outlook in India, Russia, and South Africa than in China and Brazil.

In China, a new generation of leaders will take the helm amid slowing growth and an increasing need to tackle the key long-term challenge of rebalancing the economy from exports to domestic consumption. Beijing appears willing to accept growth rates in the range of 7–8 percent for two reasons. First, the conventional wisdom that growth below 8 percent would stoke unemployment to unacceptably high levels has not, thus far, proven correct. Second, the new leadership—mindful of what happened after the 2008–09 crisis—does not want to take new stimulus measures that could create economic imbalances, and political headaches, over the medium term. Of course, accepting slower growth presents political challenges: the new leadership will assume office in a context of a more vibrant civil society and growing demands from a large set of stakeholders, from both the public and the private sectors, who have come to expect growth rates in, or near, double digits.

But on the longer-term challenge of rebalancing the economy, the new leadership is unlikely to take bold steps in its first year in office. Tackling this monumental task will require politically sensitive moves to liberalize financial markets and structural reforms that threaten the interests of powerful state and private actors in the export sector. The newly ensconced leadership will need to move cautiously and carefully build consensus before taking any of these steps.

In Brazil, President Dilma Rousseff commands the highest approval ratings of any freely elected incumbent in the emerging market space (77 percent), giving her considerable political leeway to seek a new footing for economic growth as the gains of the past decade’s credit and commodity booms wane. In response to deeply disappointing numbers for 2012—in which Brazil will be lucky to grow 2 percent after an average of 4.3 percent between 2007 and 2011—her economic team has begun to craft a more broad-based approach to boost the economy over the next several years.

President Rousseff’s controversial insistence on a long-term strategy to lower Brazil’s sky-high interest rates remains firmly in place, and in August 2012, the government unveiled an ambitious new program to attract private investment in federal rail and highways. While there will surely be delays in execution, the move is a real attempt to tackle the country’s severe infrastructure bottlenecks and to increase investment as a percentage of GDP.

At the same time, the economic team seems to be shifting its tax relief strategy away from an unpredictable and uncoordinated sector-based approach to a more “horizontal” approach that seeks to lower costs to industry across the board. If growth doesn’t pick up in 2013 this tax relief agenda entails an implicit trade-off that the government will have to argue convincingly to investors: that a lower fiscal surplus is the result of measures that actually increase economic efficiency. And Rousseff will also try to argue that a potentially lower primary surplus is excusable in a context where she is simultaneously using her political capital to hold the line on wage demands from Brazil’s powerful unions. But there are limits to her appetite for political battles: her government will not embark on key structural reforms to the pension system or to the labor code, which are at the heart of Brazil’s competitiveness woes.

In India, political deadlock augurs poorly for coherent policy, even as the world’s largest democracy sputters and ratings agencies are circling with threats of a downgrade from investment-grade status. On the one hand, Finance Minister Palaniappan Chidambaram has strong reformist credentials, and Prime Minister Manmohan Singh has brought on the well-respected economist Raghuram Rajan as his economic adviser. Such moves could herald an attempt by the government to push through piecemeal structural reforms and improvements to the business environment for foreign investors. But ahead of 2014 national elections, Manmohan Singh’s government faces high political obstacles.

Lack of a clear consensus on reforms within the Congress Party, continued disunity within the ruling United Progressive Alliance coalition, fierce partisanship by the opposition Bharatiya Janata Party, and a severe 2012 monsoon season (which has driven up food prices, a politically sensitive issue) mean there will be significant resistance to key fiscal reforms—chief among them the critical need to diminish fuel subsidies. As the 2014 polls draw closer, the government will in fact be tempted to hike spending. As a result, the government is unlikely to coherently and consistently tackle many of the economic reforms that Standard & Poor’s and Fitch have stated are necessary to prevent a downgrade. In all, the Congress-led government, for external as well as internal reasons, looks poorly placed to tackle key structural impediments to greater growth. In fact, the national elections cycle will make prospects for reform worse.

In South Africa, whose 2011 addition to the BRICS group was more politically than economically driven, is already suffering the effects of depleted European demand for commodities and manufactured exports. President Jacob Zuma is increasingly hemmed in by nationalist and populist demands. Until now, Zuma has done a relatively good job of maintaining market-friendly macroeconomic policies on the one hand and fending off pressures for more populist measures within his ruling African National Congress (ANC) coalition. But he faces growing opposition from more statist elements within the ANC and demands from coalition partners in the powerful Congress of South African Trade Unions (COSATU). Despite an unemployment rate of 25 percent and increasing agitation by the urban jobless, these demands will only grow. This is particularly true following the August 2012 violence at Lonmin’s Marikana mine, for which Zuma is held partly responsible. In other words, a potentially more prolonged lower growth outlook comes at a critical juncture in South African politics, where Zuma could be more vulnerable to populist demands within his coalition. A shift toward economic nationalism is likely in the next several years, particularly ahead of national elections in 2014.

In Russia, the urgency of decreasing the country’s outsized dependence on crude exports, as well as tackling endemic corruption, is blunted by high oil prices and Putin’s increasingly delicate political position. While the leadership pays lip service to reducing Russia’s dependency on oil exports—the budget now balances at more than $110 a barrel, almost triple the break-even price in 2007—there is little appetite for substantive economic adjustments and no interest in political reform. Russia currently commands more than $500 billion in international reserves, and with a debt-to-GDP ratio below 20 percent, the government has ample room for borrowing.

Meanwhile, at the political level, Putin remains the most powerful and popular politician in Russia, but the rise of a middle-class-driven protest movement based in Moscow has pushed Putin to lean more heavily on his remaining pillars of political support: the financial/industrial elites around him and the broader, conservative working-class and lower-middle-class populations outside of the capital. Significant economic reforms—whether to root out corruption, cut subsidies to inefficient industries, or slash the bureaucracy—would threaten the interests of both of these groups and are therefore simply not on the table. Rather, we will continue to see incremental reforms in the financial sector, perhaps very cautious adjustments to the pension system, and a marginal opening to international oil firms that can help develop tight-oil or liquefied natural gas (LNG) capacity. If the economy falters further, the government will probably override the new fiscal rules to limit spending to head off unrest among a broader section of the population. That said, there is minimal risk of severe instability outside of a low-likelihood, big effect (“fat tail”) economic or political shock.

WHAT ABOUT THE SECOND-TIER EMS?

While sentiment on the BRICS economies has soured somewhat, investors are increasingly keen on the next tier of countries below them. These second-tier EMs—countries like Mexico, Turkey, Thailand, Colombia, and Indonesia—have enjoyed strong growth, but just as there is likely to be growing differentiation in the quality of policy making within the BRICS, the same goes for the next tier of EMs. While we are quite optimistic on the policy outlook in countries like Turkey and Colombia, where politics is unlikely to interfere negatively, Indonesia and Thailand are particularly vulnerable to negative intrusions of politics. Mexico is somewhere in between. We expect positive economic reforms, but the upside may not be as large as many expect.

Indonesia has shown strong growth and its developed consumer economy offers it some protection from the global dynamics that are hurting its more export-oriented neighbors. But the political calendar is limiting the leadership’s appetite for tackling key reforms. President Susilo Bambang Yudhoyono, whose second and final term ends in 2014, is already bordering on becoming a lame-duck president as popular support for him and the ruling Democrat Party wanes amid insufficient efforts to stamp out corruption. As Yudhoyono and his party look to shore up support ahead of 2014, there is little chance of politically unpopular reforms on key issues such as fuel subsidies. Overall, the electoral cycle is compressing the time horizon for Indonesia’s policy makers.

Thailand, for its part, faces some potential fat-tail risks that are potentially underappreciated. Prime Minister Yingluck Shinawatra has fared well in office, holding relatively high approval ratings even after severe floods hampered growth in 2011. And the government’s massive infrastructure plans, welcomed by industry, are fueling growth. But politically, the prime minister’s goal of managing the return of her fugitive brother, former prime minister Thaksin Shinawatra, could be a potential trigger for destabilizing conflict with the monarchy and the military. To curry support, Yingluck’s government raised the minimum wage to 300 baht in Bangkok and six other provinces in April 2012 and will expand that to the rest of the country by April 2013, raising hackles among bosses in the manufacturing export sector. A lower growth outlook would make her opponents smell blood, making for a challenging 2013—particularly if the king’s health doesn’t hold.

In Mexico, it’s less a story of political risk and more a story of how the upside to a good reform agenda may not be as large as investors hope. Enrique Peña Nieto from the Institutional Revolutionary Party (PRI) won the presidency in July, and he will assume office in December. His administration will certainly move forward on much-needed economic reforms, but we think expectations in the private sector have moved beyond political reality. While the PRI should be able to cobble together a coalition in congress to approve tax reform and potentially an energy reform for downstream investments, a constitutional reform to open upstream oil production to private investments looks unlikely.

CONCLUSION

As economic doldrums in the advanced economies drag down global growth, the emerging markets offer potentially lucrative opportunities. By the middle of the decade, emerging economies will contribute as much as three-quarters of global annual growth, on a PPP (purchasing power parity) basis, according to the Economist Intelligence Unit.

But that growth comes along with political environments that may complicate sound economic policy making. Governments are facing a lower growth equilibrium globally while facing new challenges at home, and many incumbents face potentially bruising electoral cycles over the next several years. As investors seek to harness the power of emerging markets, a keen understanding of the political contexts, and risks, within these markets is more important than ever.