In the past decade, the emerging market economies have essentially been levered plays on developed market growth. In the next decade, to cope with slower developed market trend growth and the supply-side constraints in emerging markets, these economies will likely need to find ‘growth alphas’ from within, through structural reforms.
It is not coincidental that more and more emerging market economies are choosing to reform. China and India have embarked on this risky but potentially rewarding journey; Brazil could be next. A remarkable but thus far unnoticed trend is the collapse in emerging market’s export growth since 2012. While it is not yet clear why export growth has stalled so suddenly, our guesses are centred on supply-side constraints that require supply-side fixes, not more demand stimulus. Resorting to additional demand stimulus will no doubt be tempting to the emerging market policy makers, but the sooner the countries realize the need for reforms, the more they will be rewarded by investors, in our view.
The case of Brazil is particularly interesting
The constraints on its aggregate supply are severe and have boxed the economy in a stagflationary trap. A prospective economic slowdown and a further correction in Brazil’s terms of trade could ironically be a blessing in disguise, to finally force a change in the national consensus in support of painful structural reforms in exchange for a better future. The economic fundamentals for the BRL are not good, and the currency is still about 10% over-valued on our measures. However, a change in the national consensus in support of reforms could trigger a replay of what happened in India last month (May 2014), potentially propelling the BRL sharply higher. Further, repressed inflation due to price controls in the months leading up to the elections in October will need to be released next year; an inflation and nominal interest rate spike in 2015 seem unavoidable and should in theory further support the BRL.
In short, we have been bearish on the BRL since mid-2012. But we can see a scenario in which BRL could perform well if the economic conditions deteriorate enough to force a change in the national consensus.
The bottom line
In the past decade, emerging markets was powered by ‘perspiration.’ But in the next decade, they will likely be powered by ‘aspiration.’ It is not coincidental that China and India have embarked on structural reforms, five years after the great financial crisis. The reason is that they have realised the ‘levered play on developed markets’ has run its course. As developed market’s potential growth rate slows and as the emerging countries experience their own supply-side constraints, it will be increasingly difficult for the emerging countries to postpone or avoid structural reforms, not even for Brazil – the country of the future.
The above article is an extract from our research paper “Emerging market growth engine shifting from beta to alpha: the case of Brazil” published on June 10, 2014.
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