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Beware Membership of This Elite Club

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
December 5, 2012
Financial Times


A year ago, Brazil, Russia, India and China were the darlings of the world economy. Today, Brazil is barely growing, Russia is struggling and India and China are on course for their lowest growth in a decade. Although they are as different as they are similar, all four of the original Bric countries have contrived to stumble simultaneously. The lessons are that microeconomics can matter as much as macroeconomics – and that belonging to a prestigious economic club is hazardous.

The Brics, and emerging economies generally, deserve enormous credit for their macroeconomic management. In the 1970s and 1980s, one in two emerging and developing economies had double-digit inflation. Today, fewer than one in five do. As recently as the 1990s, the median emerging economy had public debt to gross domestic product of more than 65 per cent. In the past two years, the median has been below 40 per cent. Add in bulging foreign exchange reserves, debt denominated in domestic currency rather than dollars and (with China the big exception) flexible exchange rates, and the hype surrounding emerging economies seems almost reasonable.

Since the emerging market crises of 1997-2002, these strong macro foundations have delivered extraordinary performance. As the IMF noted in its October World Economic Outlook, the past decade witnessed the first time that emerging economies enjoyed longer expansions and shorter downturns than advanced economies. When the global financial crisis hit, emerging economies' budget deficits were small so the fiscal counterattack could be forceful. Inflation was quiescent so credit could be eased safely. In the 1990s, emerging economies that cut interest rates were punished with capital flight and currency collapse, triggering the bankruptcy of businesses with debts in dollars. This time, ample foreign exchange reserves offset capital flight and the shift away from dollar borrowing insured companies against depreciation.

That is the good news. But, as the rich world discovered in the wake of its own "Great Moderation", resilient growth encourages complacency. In the US, households borrowed too much and regulators grew indulgent. In Europe, this pattern was amplified by the "club effect" of euro membership. Countries that had tightened their belts to meet the criteria for accession went soft once they were admitted. With cheap foreign capital buoying living standards, there was no will to fix microeconomic problems such as sclerotic labour markets.

The Brics are following a version of this playbook. Macroeconomic management remains credible. China, in particular, has dramatically cut export dependence without suffering a hard landing. But macro success has bred micro complacency. Governments have permitted themselves to meddle destructively in markets. State companies have been allowed to stifle innovative competitors. The upshot is that the resilience of the Brics in the face of the 2008 financial shock has not been matched by resilience to an extended period of weak global demand.

Consider Brazil. It boasts moderate inflation, sober public finances and a partially flexible exchange rate. Its central bank has tried to revive growth by reducing its lending rate by 525 basis points over the past 16 months. But growth this year will come in at barely more than 1 per cent because a blizzard of micro meddling has damaged business confidence. Petrobras, the state oil company that accounts for a 10th of the economy, epitomises this malady. Despite the discovery in 2007 of lucrative offshore oil, it is losing money because of local content rules and irrational fixed prices.

The story is similar in Russia. The current account is in surplus, inflation is modest and the budget is in balance. But microeconomic policy is lousy. Corruption deters investors. State companies elbow out private ones. Plans to diversify the economy have been a failure. Instead of building manufacturing exports, Russia is exporting skilled workers.

In some ways India is the odd one out: it runs a chronic budget deficit but shares the microeconomic weaknesses of its brethren. Corruption is pervasive and dysfunctional regulation inflicted blackouts on 600m consumers in the summer. Supply side rigidities handicap India's economy so thoroughly that stimulus quickly causes inflation, which is close to 10 per cent. Last year the IMF projected India could sustain growth of 8.1 per cent per year. This year that has been revised to 6.9 per cent.

The IMF's estimate of trend growth in China has come down from 9.5 per cent to 8.5 per cent. As elsewhere, corruption and distorted prices are the key challenges. State-owned companies account for more than half the capitalisation of the stock market. They hog subsidised credit, hire the best graduates and lobby fiercely against deregulation. Li Keqiang, the incoming premier, recently said that China had used up its "demographic dividend" of plentiful labour and would now have to rely on a "reform dividend". But China has yet to act accordingly.

For all their macroeconomic resilience, the business climate in the Brics is unreliable. In the World Bank's Doing Business rankings, China comes in a shameful 91st, Russia 112th, Brazil 130th and India 132nd. By contrast, Rwanda, Oman, Colombia and Kazakhstan are all in the top 60. The Rocks could teach the Brics how to regain momentum.

The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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