Zaks Investment Advisory Service

What Are the Prospects of BRIC Nations’ Growth?

We concluded our last program by posing the following two questions: what are the prospects of future BRIC (Brazil, Russia, India and China) nations’ economic growth, and are there other emerging markets outside BRIC that might be of interest to us?

I hope that my listeners understand that it is impossible to give a definitive answer to the first question. No one knows for sure how the BRIC nations’ financial markets will look in the future. However, we could still lay out a few thoughts on the matter. To begin with, let us determine what caused these nations’ stock exchanges to enjoy such strong recent growth. There are two reasons behind this. First of all, they started off from very low levels. Secondly, all of these countries launched, with varying degrees of success, a series of market economic reforms. These reforms resulted in overall economic growth, relative interest rate stability, and a rise in individual company profits. At the same time, as their economies grew and financial markets developed, investors decided that these countries were no longer as risky as they had seemed just a few years before. All these factors pushed up stock prices. Yet it is far from evident that these factors will continue to play a similar role in the future. First of all, current price levels on BRIC exchanges are far higher than before. Let’s take China, for example. Even after suffering a 40-percent fall off their October 2007 records, Chinese stocks still cannot be considered cheap by most standards. Moreover, current prices presume that profits of Chinese companies will continue enjoying rapid growth. Thus, future economic expansion becomes a vital factor in appraising these nations’ prospects: if growth doesn’t meet expectations, the market will suffer. But there are other potential complications. As we know, the stock exchange values individual companies rather than a country’s gross domestic product. For stock prices to continue rising, overall economic growth must lead to higher profitability of individual companies. This could happen only if the economy achieves a certain degree of structural maturity.

And here we have to go back to the reforms BRIC nations undertook in the 1990s. Although these countries’ political structures were (and remain) completely different, with some keeping to socialism and others enjoying relative degrees of democracy, in terms of economy all of them tried to accomplish the same goal: economic liberalization. But none of these nations succeeded in implementing reforms all the way through. In China, for example, the state continues to control numerous enterprises and frequently interferes in how the market functions. And recently, it froze prices on many products – this was how Chinese authorities decided to fight inflation. We, of course, know that inflation cannot be overcome in this manner – it will only result in a shortage of goods. But the Chinese authorities, trying with all their might to introduce a semblance of social harmony, are willing to take these drastic measures. The Brazilian economy, on the other hand, is more open and resembles a market one to a far greater degree than China’s, though it too suffers from state intervention. There, it is manifested in extremely high taxes. In Russia, the basic taxes are lower than Brazil’s (the government mostly lives off oil export tariffs), but the economy suffers from corruption. And, just like in other BRIC nations, the Russian government will not leave its economy alone. Corruption leads to an inefficient distribution of resources, while government intervention – to a significant drop-off in potential foreign investments. Attempts to expropriate oil and natural gas fields from foreign companies – or Domodedovo airport from a Russian one – also do the markets no favors. Neither does the issue of an arrest warrant for the head of one of Russia’s first and largest foreign investment companies. India, meanwhile, has its own problems. I mentioned that its enormous and quite active bureaucracy, which has ballooned at both federal and individual state levels, frequently keeps the country’s economy from developing on its own.

Besides the above-mentioned problems, there is one other feature inherent to financial markets of emerging nations: they are not transparent. Insider trading, which is practiced to a larger or smaller extent on all leading nation exchanges, scares off many investors and undercuts stock prices.

All of these are real problems. But they are also resolvable ones. Whether the BRIC nations want to overcome them is not something we can answer. But to a certain extent, these problems are not really all that grave. Brazil could alter its tax system to make sure that nearly 70 percent of private company returns do not end up in state pockets. India could reform its administrative system, simplifying business rules and disbanding its army of bureaucrats. Russia, if its society wanted, could create a more transparent system intended to benefit all rather than just the ruling elite, which currently controls both the state and gigantic monopolies. China is the least democratic state of the four and is therefore subject to the highest political risk. But even there, the government could gradually democratize both society and the economy. All of these problems cannot be compared to the ones facing nations such as Albania and Georgia, which are trying to build economies practically from scratch.

If the BRIC nations continue their paths to reform, their growth will extend into the future. At a certain point, the purchasing power of the middle class will reach a critical mass and these countries will be able to rely on domestic demand as an engine for growth, weaning off their dependence on exports. And at that point, we can safely predict that their stock exchanges will continue to grow.

Since we have not had the time to talk about other emerging markets, we will do so next. But with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.