Sunday, October 10, 2010

The Bear's Lair: Broken BRICS

¹²The Bear's Lair: Broken BRICS

With Brazil's election apparently a big victory for the [far] leftist candidate Dilma Roussef, Russia facing increasing political and economic uncertainty, India in the grip of spiraling inflation and even China's growth prospects seemingly dimmer, the great growth story of the last decade is acquiring a few dents. For the first time, it is reasonable to ask: are the BRICs broken?
By Martin Hutchinson | 4 October 2010

Brazil is the most straightforward case. Its finance minister Guido Mantega this week denounced the "currency war" he saw developing among the world's major economies, by which each country attempts to devalue its currency to reflate its economy. Such a war was a minor but contributing factor in the Great Depression but, at present, since all the major economies seem likely to succeed in their devaluations, it will merely cause a nasty burst of global inflation. In any case, Mantega's true motivation in proclaiming a currency war was to protest the Brazilian real's rise above Rs.1.70=$1, and divert the Brazilian electorate from the country's true economic situation ahead of Sunday's election.

The real is rising because of the mass of hot money flowing into Brazil, attracted by its apparent rapid growth and commodities wealth. In a well-run economy like that of Chile, currency inflows of this kind are 'sterilized' by the government creating a 'rainy-day' fund, which can be used when commodity prices drop back. However that requires the government to keep public spending under control.

As Mantega perfectly well knows, being finance minister, Brazil has done nothing of the sort. While official public spending has been kept nominally under control, lending by the state development bank BNDES and investment by Brazil's 118 public sector companies, financed by borrowing, have been allowed to explode ahead of Sunday's election— both are up 30-40% on the previous year.

The Brazilian public lulled by the popularity of outgoing President Luis Inacio Lula da Silva and apparent prosperity, are giving their votes to Dilma Roussef, Lula's former development minister, an avowed Marxist who believes in the rapid expansion of state control. You can already see the result in the Petrobras share sale, in which $42.5 billion of the nominal $70 billion of proceeds was paid to the government in return for overpriced 'oil rights' which Petrobras had thought it already owned. This kind of seizure, accompanied by meddling, can be expected to affect Brazil's other resource behemoths going forward, even those nominally in the private sector such as the iron ore giant Vale and the forest products titan Fibria.

With Roussef in charge, far from being an emerging world superpower, Brazil will relapse fairly quickly back into its habitual third world chaos. The respected central bank governor Henrique Meirelles, whose monetary policy of double-digit interest rates has kept the Brazilian economy stable throughout Lula's reign, is unlikely to last long. Once he goes interest rates will drop and the inflationary forces will become overwhelming.

If natural resource endowments per capita are overwhelming as in Argentina and Venezuela, bad governments can combine with a resource boom to produce a semblance of normality— albeit with gradually worsening living standards, violation of property rights and soaring inflation rates (suppressed in official statistics.) A country with successful private sector companies and perhaps a private pension system can provide loot for the socialists and mafiosi for several years, as Argentina has shown. However Brazil's economy is less dominated by natural resources because of its immense population; hence the descent into chaos is likely to occur more quickly. As for the country's fate if and when the current resource bubble bursts, it does not bear thinking about.

Russia, next, is a much simpler case, economically if not politically. Its economy is more resource based than Brazil's because of its oil and gas wealth. However its propensity to use its gas resources as a political bludgeon has caused its potential customers to search frantically for alternative sources of supply. And the availability through new technology of massive shale gas deposits in Poland and China suggests that customer freedom is not far off.

Economically, the Russian economy will survive, though hardly likely to be a beacon of growth while the relatively moderate albeit corrupt President Medvedev remains in power. The Economist team of forecasters project growth just above 4% in 2010 and 2011, but those two years combined will not make up for the 7.9% drop in GDP suffered in 2009. Then in 2012 the presidential election allows the probable return to power of Vladimir Vladimirovich Putin.

Putin is a true wizard at the nastier forms of power politics, but his economic understanding is negligible. He has turned Russia into a kleptocracy for his cronies in which independent forces who achieve wealth but do not make their escape to Knightsbridge are likely to end up in jail with their property stolen. Russia under a renewed Putin regime is Venezuela without the nice weather and with a more effectively aggressive foreign policy.

Countries of the former Soviet Union should rightly fear Putin's efforts to restore it. The domestic economy will be a swamp of inflation, expropriation and declining living standards. Oil output, no longer buoyed by major international investment and technology, will follow the same path of accelerating decline as has Venezuela's. In the short term, Russia is an important enough oil supplier that this may prop up global oil prices. In the long term, alternative energy sources [[eg, shale gas: normxxx]] will be found and Russia's oil export earnings will go into terminal decline.

The other two members of the BRIC quartet, India and China, would benefit from a decline in commodity prices, but they have other problems. India has enjoyed rapid growth for the last decade thanks to the reforms brought in by Atal Bihari Vajpayee in 1998-2004. However the foolish ingratitude of the Indian voters in 2004, replacing his government with the Congress party, responsible for half a century of stagnation, and then re-electing Congress in 2009, is now bringing its just reward.

Prime Minister Manmohan Singh is a gentleman, and in a mild way reformist, but he has no effective control over the corrupt leftist barons who control the Indian government. These 'powers' are led by the odious Gandhi family and their stooge, finance minister Pranab Mukhergee, whose previous term as finance minister was in 1982-4, the most benighted era of Indira Gandhi's state-controlling quasi-dictatorship. The chaos over the Commonwealth Games venue has brought Indian corruption to the notice of the western public, but it has always been notorious to those doing business there.

Under Mukhergee, the "permit raj" is back in full operation, with public spending soaring out of control and a public sector deficit this year, national and local of over 10% of GDP, in a year of 8% growth. Inflation has been running well into double digits for more than a year, while interest rates are held down artificially low at around 6%. India is due for a gigantic blow-up, with either hyperinflation or a massive foreign exchange crisis, when enthusiastic foreign investment can no longer stem a growing current account deficit. Like Brazil, India needs to rein in its public sector, but shows no sign of doing so.

Unlike Brazil and Russia, where political and cultural norms currently seem insuperable, India has a reasonable chance of long-term growth and prosperity— but it must go through an economic crisis first, in order that the Indian electorate can come to its senses and elect a reasonably pro-market, less corrupt government. Since, absent a major crisis, its first chance to do so is only in 2014, the current outlook must be negative.

Finally there's China, the only one of the BRICs where prospects remain reasonably good. Even here, the Asian Development Bank (ADB) caused a stir by suggesting that China's growth rate could slow sharply from its current 9-10% to 5.5% per annum over the 2010-2030 period. [[And that could prove disastrous in a country with no 'safety' net; perhaps 3-4% must be subtracted from Chinese 'growth' for it to be equivalent to US GDP.: normxxx]] That contradicts Goldman Sachs' forecast of the Chinese economy surpassing the U.S. economy by 2027, pushing that momentous cross-over point out past 2040.

The ADB's rationale is that the capital deepening of the Chinese economy has passed its most productive point, and that the country's reserve of working-age labor will grow only slowly in the years ahead because of low birth rates after 1980. That looks right, and of course the effect of lower birth rates is wholly positive [[at least for the rest of the world: normxxx]] in a country of 1.3 billion people whose living standards have only recently risen above subsistence level. An ageing China is a more stable China, less likely to engage in military adventurism because it will not have immense supplies of surplus youth for its armies.

There are other reasons to expect Chinese growth to slow. Because of its size, the country has forced up commodities prices worldwide, a factor that itself will produce consumer price inflation and possible resource shortages. Further, the immense Chinese export machine is running into increasing resistance in the West. [[As Japan has learned to its sorrow, you can't export your way to being number one; the rest of the world won't allow it!: normxxx]]

With European and U.S. growth subdued for several years, it is likely that various forms of protectionism and "voluntary restraint" will restrict its further growth. China must increase domestic wages and thereby consumption, but by doing so it will find its export industries undercut by cheaper competitors in India and elsewhere [[Thailand and Viet Nam spring to mind.: normxxx]]. Finally, China's banking system, state sector and commercial real estate industries are a massive mess of corruption and undeclared losses.

The ADB's estimate of 5.5% growth for China. [[using actual, not "communist doctored" figures: normxxx]] over the 2010-2030 period is probably on the high side. China's trajectory is likely to be one of financial crisis followed by several years of very slow growth and adjustment, followed by a much healthier "catch-up" period. Both China and India probably have a healthy long-term future, but it is not quite as smooth and untroubled as current markets seem to assume/predict.

For the West, the BRICs' troubles will be something of a relief— their extraordinary growth in the last few years has caused huge stresses in Western economies that require time to adjust. The process of wage differential shrinkage between western and emerging markets will continue (there are, after all many emerging markets beyond the BRICs, most of which have not yet enjoyed their fastest periods of growth) but maybe at a slightly slower pace. Provided interest rates are regularized within the next year, so that saving in the West can resume and its de-capitalization cease, the period of BRIC setback can be one of global rebalancing, in which the inevitable tensions of a changing balance of global economic power can be defused.

Certainly two, maybe more of the four BRICs are by no means 'broken', but they will all suffer some damaging blows in the years ahead. Naturally, those who have rushed ahead too fast to embrace the new world of the BRICs will lose their shirts. But then that is the fate of pioneers; as the immortal Saki said: "It's the early Christian that gets the hungriest lion."

The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

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