Did Investors Overlook Governments in Emerging Markets?

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Investors in emerging and expanding markets are now facing the harsh reality of losses, after 9 years during which investments in the MSCI BRIC index saw a whopping return of around 227 percent — at least for those who had the foresight to invest.

However, this year has seen a $13.9 billion dollar withdrawal from equity mutual funds invested in Brazil, Russia, India, and China — commonly known as the BRIC countries — and investors may have significantly underestimated the risk that politics in these countries pose to their money.

Last quarter, the MSCI (NYSE:MSCI) BRIC index lost over 12 percent, and government bonds from BRIC countries slumped 0.6 percent, as interest rates rose along with unrest across the four economies.

For Brazil, battling this unrest means tackling the country’s expensive and inefficient public services sector, as well as addressing those policies hampering the profitability of companies there. Many in the middle class, tired of paying substantial taxes in exchange for abysmally poor services, began protesting when the government attempted to hike rates on public transit services in Sao Paolo and Rio de Janeiro.

Moreover, despite Brazilian oil company Petrobras having nearly the same refining capacity as Chevron (NYSE:CVX), the company has so far failed to turn a profit, losing $17 billion in the last two years due to government policies that distort its business model. Petrobras buys fuel at the global market rate, and then sells them to domestic consumers at an artificially low price manipulated by the government.

In India, the country continues to battle a devalued rupee, as capital outflows from the country have sapped significant value from the currency. India’s account deficit has reached 4.8 percent of GDP, which is double that of Greece, a country unable to avoid default without continued assistance from global lenders. The rupee has declined 8.5 percent this year from the downward pressure.

Vladimir Putin now represents one of the more tangible fears to investors in Russia, where declining oil prices are tempering the country’s expansion and prosperity.

The government under Putin is notoriously corrupt, and the government’s increasing involvement in the country’s economy, pay increases for public employees to bolster support, and ramped up military pay create less than ideal circumstances for the value investor.

It’s hard to put money into a country where so much of the economic direction depends on the whims of one person. With investors on the sidelines, Russia will be deprived of capital until the Russian president works to improve the business climate.

China is now the last bastion of substantial growth, with projections ranging anywhere from 7.5 percent to 7.7 percent this year. However, in relative terms, that is not at all substantial, and marks the slowest pace of Chinese growth in 23 years.

While its trading partners in Europe experience no growth — or mild growth in the case of the U.S. — China cannot continue to expand as rapidly as it once did, and government-driven easy credit is now being reigned in. In fact, the easy money caused Chinese firms to expand too much, too quickly.

With exports slowing, China is now being forced to transition to a model based on domestic consumption, but the one child policy distorts this model since familial dependence and the lack of a social safety net encourages workers to save. Two working people taking care of a family of five can’t exactly afford to splurge very often.

Greece, while outside the BRIC countries, represents a similar phenomenon. Leading up to the financial collapse in 2008-2009, the country was touted as one of the best performing countries over the last decade, according to the Organization for Economic Cooperation and Development.

In that report, the OECD still warned, “However, significant further reforms are needed to ensure that good performance is sustained in the years to come.” Those reforms didn’t come, the global economy fell apart, and Greece is once more on the brink, testing the singularity of the European Union.

The country has failed to meet almost all of its bailout criteria, despite needing more money, and its lenders have been getting increasingly testy as the governing coalition has shrunk amid ongoing austerity debates. Yet in 2007, gross inflows of foreign direct investment were over 6 billion euros, the second highest level in the last 9 years.

What seems to have happened is an unwillingness, or at least some kind of oversight by the investors who are just now selling, to accept that the governments in these countries would ever become an obstacle to their money. While the rapid growth experienced by the integration of these countries into the world economy returned substantial money for some, for others, the government ruined what the market was trying to give them.

Convoluted policy and poor government structure are now a more tangible risk than they perhaps were when the term “BRIC” was coined at Goldman Sachs (NYSE:GS) nearly a decade ago. And while these countries will no doubt continue to play a major role in the global economy — with the possibility of being collectively larger than the U.S. in 2015 — investors going forward will likely take a more critical look at these governments as 1.8 percent GDP growth in the United States becomes ever more attractive.

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