What is the outlook for Brazil, Russia, India and China (BRICs)?

The summit between Brazil, Russia, India and China (the BRICs) in the Russian city of
Yekaterinberg on June 16 marked the first such official meeting of a group largely
confined to the pages of economic analysis. Signals from BRIC members suggesting
they want to reduce their dollar assets and increase the use of domestic currencies in
international trade have attracted much media attention and added to pressure on the
dollar.

However, the inaugural summit focused primarily on forging common positions on

financial regulatory reform and climate change, rather than foreign exchange rate
management. However, this meeting remains more political than economic. While the
contribution of these economies to global growth is set to increase over the next decade,
their different interests suggest that forgoing common positions may be difficult.

The relatively more optimistic growth expectations for (most of) the BRIC countries
has analysts speaking again of the "decoupling" theory, which holds that parts of
Europe and Asia are detaching themselves from the U.S. economy. In particular, India
and China are expected to be among the very few countries that will grow at or above
5% this year, contributing the bulk of global growth even as most of the advanced
economies remain far in recessionary territory. The strong inflow of foreign investment
into local markets has already triggered central banks to intervene and start to build
international reserves once more.

While the policy responses of these countries have been relatively robust, and they may
outperform most others once a global growth recovery begins, they may be unable to
decouple for long. In particular, with the outlook for domestic demand varying widely
across these countries, each may again feel vulnerable to external pressures despite
fiscal and monetary stimulus. Chinese domestic demand, suppressed for much of the
past decade, does seem to be showing signs of growth from a weak base, encouraged by
government incentives.

However, there is a risk that government stimulus might be prompting asset bubbles
and not a real increase in domestic demand. Domestic demand in India and Brazil
shows signs of resilience. Russia, though, is likely to experience a growth contraction
of over 5% as domestic consumption and construction suffer. So, will BRIC domestic
demand hold up, and can it fill the gap from a reduction in demand among the G3--
especially the U.S.?

Despite their commonalities--mainly a desire for greater recognition of their weight in

the global economy--there are significant differences between the BRICs in terms of
their growth outlook, the channels through which they were affected by the global
recession and their future growth possibilities.

In particular, India and China are net commodity importers, while Russia and, to a
lesser extent, Brazil depend on commodity exports. Today, I survey the ways in which
these economies were buffeted by the financial crisis and global recession and assess
their ability to make the structural reforms needed to foster long-term growth.

The Brazilian Outlook is Improving … For Now

The Brazilian economy has certainly felt the pinch of the global economic crisis as
demand for its exports remains significantly lower, investments contracted sharply due
to a much tighter credit environment and business and consumer confidence were
damaged. Moreover, Brazilian corporations had significant dollar liabilities, leaving
them vulnerable to the fall in the Brazilian real.

Nonetheless, the overall performance of the economy has been somewhat resilient--
gross domestic product for the first quarter of 2009 was not as dire as consensus feared.
The improvement in Brazil's consumption in Q1 2009, especially on a quarter-on-
quarter basis, underpins the idea that there is some resilience in the dynamics of
consumption in Brazil.

Furthermore, Brazil might benefit from China's commodity demand, meaning that the
outlook for Chinese growth and the composition of its exports may be of even more
significance to Brazil than that of the overall global economy. In fact, China surpassed
the U.S. as the largest recipient of Brazilian exports earlier in 2009. However, Chinese
commodity imports could still be pricked by higher prices.

The Brazilian economy has experienced a strong pickup in foreign exchange flows via
both portfolio and direct investments in Q2 2009 and had a better-than-expected
performance of the current account. The Brazilian central bank has put in place a
considerably responsive monetary policy and monetary easing will likely add steam to
the recovery. The central bank is also back accumulating international reserves.
In the longer term, the Brazilian economy will only return to sustained growth if
reforms contribute to productivity gains. Such a framework would require a more
efficient tax system, increased trade liberalization, wiser government investments and a
more efficient set of labor laws, among other things.

Overall, Brazil now depends on credible macroeconomic policymaking and a sound

banking system. The expansion of the middle class and strength of the nascent housing
sector require large investments in infrastructure and education and adequate micro-
planning. The expansion of potential growth will only take place if this appropriate
framework is built. The abundance of natural resources may contribute to terms-of-
trade gains; however, these could limit the development of Brazil's non-energy sector.
Despite Chinese loans to Petrobras, the company still has significant investment needs
to exploit the recently discovered and expensive deep-sea oil.

India: Slow Reforms Constrain Potential Growth

Capital inflows and the IT boom played a large role in driving job creation, investment
and asset bubbles in recent years. India's high dependence on foreign capital and IT
exports increased its vulnerability to the global crisis. As a result, GDP growth in 2009
might fall to around 5% from the buoyant 8%-9% of recent years.

Yet, fiscal, monetary and credit measures are helping sustain growth. And a large
consumption base, especially in rural and semi-urban areas, has sustained demand and
corporate sales. Strong consumer demand and private sector investment plus a large
share of government spending in GDP will certainly help fuel recovery. Yet a sluggish
global recovery and lower credit growth would constrain the ability of private sector
spending to drive growth, leading to a U-shaped recovery.

The absence of benign global conditions might make a 9% GDP growth rate tough to
achieve in the coming years. But returning to above-potential growth may not even be
sustainable and will only accentuate inflationary pressures given supply-side
constraints. Increasing the potential growth rate from the current level will therefore
require raising infrastructure and energy investments, agriculture yields, government
savings, education spending and implementing labor law reforms. But most of these
reforms are politically challenging and will happen at a snail's pace in the coming years.

The large fiscal deficit (over 10% of GDP during 2008-09) could stifle recovery in the
next few years. Rising government borrowings could crowd out investment and invoke
further rating downgrades. But overcoming structural deficits requires politically
unviable measures like reducing farm and fuel subsidies. Instead, the government might
focus on expanding domestic production capacities and acquiring energy stakes abroad.

But reforms can help strengthen domestic demand and tie it to domestic--instead of
external--drivers. As the West de-leverages, India's large population can be a potential
source of new global demand. To do so, low-income groups need to be pulled up by job
creation and higher incomes, especially in the manufacturing and IT sectors. Rural
development is also essential as the government still struggles to bolster
industrialization and the private sector's role.

A large population and rising incomes will offer immense opportunities for domestic
and foreign investors ahead. As the recent Indian market rally shows, foreign
institutional investment inflows, which declined in 2008, will again be bullish for India
when the global recovery begins. While FDI has slowed in recent months, liberalization
and reducing red tape will help India attract more direct investment, reducing
dependence on hot money inflows. The current crisis will only strengthen India's
sequenced liberalization policy, whether in the financial sector or the capital account.
But accelerating financial sector development would improve the intermediation of
India's large domestic savings and help reduce its corporate dependence on external
capital.

India's IT sector may find it difficult to maintain its outsourcing competitiveness as cost
differentials with the West have waned since the last recession, other low-cost locations
have emerged and the U.S. plans to raise taxes on outsourcing companies. To keep up,
the sector needs to move to higher-end services and also expand the domestic client
base.

China: Elusive Domestic Demand

The Chinese government launched one of the most aggressive policy responses to the
crisis, rolling out fiscal and monetary easing beginning in the fall of 2008, which has
helped the economy accelerate from the near stall at the turn of the year.

The Purchasing Managers Index (PMI) reflects that the Chinese manufacturing sector
was the first to resume expanding, the property market is stabilizing on price cuts and
ample domestic liquidity and retail sales are increasing. However, inventory restocking
has almost been completed, meaning China could find it difficult to return to the 10%
growth of recent years should external demand remain sluggish.

So how effective is the stimulus? The most recent economic data continue to show a
mixed picture. The Chinese government has increased investment, which grew at
almost a 40% rate year on year in May 2009, pumped up by property sales. On the other
hand, exports continue to contract, a trend that will likely continue through this year.
Private sector investment also remains weak, pulled down by corporate finance issues
and low profits. Moreover, some of the policies may present costs in the future. The
extension of credit poses the risk of inflating asset bubbles and might increase the
number of non-performing loans in the future.

The real question: Can China pump up domestic demand soon enough? Chinese private
consumption's share of GDP fell steadily over the last decade to around 35%, meaning
it may have a long way to go to pick up the slack of the export sector and export-
oriented investment. The relative performance of retail and auto sales illustrates both
the ability of the government to influence public and private consumption and raises the
possibility that China may have had a stronger underlying domestic demand dynamic
than many credited. Yet the weakness of imports, despite price-induced commodity
demand, suggests domestic demand remains weak.

In fact, both Chinese economic and commodity demand growth might take significant
time to return to the 2007 and early 2008 trend. A more domestic-driven growth might
mean a slower pace than the 10% experienced in 2003-07, with 8% being a more likely
long-term growth trajectory. But such growth might not be beset with the sort of
overheating experienced in 2007 and 2008.

Even as China has taken some steps to support domestic demand, it is clearly trying to
support exports as well. China recently increased export rebates for the seventh time in
less than a year. The increase in these rebates boosts the disincentives to sell to the
domestic market, and with global exports weak, might be of limited use in supporting
the economy.

China has been relatively effective now and in the past at ramping up government
investment. Yet there is a risk that increased investment could contribute to domestic
(and global) overcapacities which could create deflationary pressures. Should China be
unable to absorb this new capacity (ranging from goods to refined fuels to processed
metals) at home, it might seek to increase exports, increasing a global supply glut.
Moreover, wider fiscal deficits will restrain spending later in 2010.

For a significant improvement in consumption, a shift in government spending away

from export-oriented manufacturing and expanding capacity is needed. In particular,
increased government spending to bolster and extend the limited social safety net is
required. Social programs account for less than 10% of the planned fiscal stimulus,
doing little to offset all of the structural incentives to save. Extending the
unemployment scheme, for one, could have long-term positive effects on consumption,
perhaps more so than the current approach of providing discounts and vouchers to
encourage spending. Over time, this will also mean a stronger renminbi, given China's
likely growth and productivity gains.

Unlike the other three countries, foreign investment in the domestic equity market is
limited in China, keeping it less affected by foreign portfolio inflows than its
counterparts. The development of a more significant domestic institutional investor
base could be crucial to reducing vulnerabilities to foreign investment flows and might
temper the speculative nature of the domestic equity markets.

Russia: Still an Oil Story

Russia, this week's host, often seems like the odd man out in the BRIC group and it
seems particularly so this year. The fall in oil production and revenue along with the
whiplash of the capital outflows on its heavy-borrowing banks and corporations will
lead Russia to a severe economic contraction in 2009. Despite the more than doubling
of crude oil prices since mid-March, Russia will have a difficult 2009 as financial sector
vulnerabilities persist, construction remains weak, job losses rise and real incomes fall.

Once again, Russia faces the challenge of managing hot money inflows surging into the
domestic equity market, which has outperformed other emerging markets. As a result,
the central bank is now intervening to keep the ruble from climbing too fast.

In the longer term, Russia faces several structural vulnerabilities that may restrain
growth, weak productivity, underinvestment in infrastructure relative to other emerging
markets and demographics that do not support long-term growth. Moreover, a sustained
high oil price might actually create challenges for Russia as it would allow it to keep
deferring the major structural changes to its non-hydrocarbon sector, especially
manufacturing. Russia has now absorbed the lingering overcapacities in the natural gas
and manufacturing sector from Soviet times, and further funds will be needed for
growth. International oil and gas companies may be wary of increasing investment in
Russia, given the uncertainty about the role of the state in the resource sector, which has
accounted for the bulk of FDI.

Despite some recapitalization of the banking sector, lending remains subdued, meaning
that sectors like construction, which drove domestic demand, are likely to be weaker for
some time to come. Falling real wages will weigh on consumption in 2009 even as
manufacturing continues to show signs of contraction.

Seeking a Global Role

All of these countries seek positions in international institutions more reflective of their
weight within the global economy. India and Brazil have vied for a greater role in the
U.N. Security Council. (China and Russia are already permanent members and are veto
players concerning North Korea and Iran).

The BRICs are expected to seek a common platform for advanced economies to commit
to deeper carbon emissions cuts than are currently pledged. India and Brazil have been
reluctant to join the global climate change regime that will replace the Kyoto Protocol.
India's climate policy stance has been criticized as it has abstained from signing the
global emission reduction norms. While China has taken unilateral action to encourage
the turnover of its auto fleet and reduce polluting heavy industries, it is reluctant to take
steps that might limit its potential growth.

India has also persistently delayed the Doha trade talks (together with Brazil) to protect
its farmers, even as the country scores high on the list of those imposing import tariffs
and anti-dumping duties. Now that Russia has announced its plans to join the WTO
only as a block with Kazakhstan and Belarus, its entry into the organization seems even
further in the future.
It is in global financial institutions like the IMF that the BRICs have most sought to
increase their influence. The BRICs contribution to the IMF's planned bond issuance
(up to $50 billion by China and about $10 billion each by the other three) could be a
bargaining chip toward a more significant role in the institution even as it helps meet
financing needs. Furthermore, it could help these countries diversify their reserve
holdings. While India already has a low dollar share in its foreign exchange reserves,
Russia, China and Brazil are trying to reduce their exposure. Russia has already been
reducing its dollar share with the Euro having overtaken the dollar at the end of 2008.

The leaders of China, Brazil and Russia have been very vocal about the vulnerabilities
of over-reliance on the dollar as a reserve currency, seeking to increase the use of
domestic currencies in trade. Yet there remain obstacles to more international or
regional uses of these currencies, in particular the lack of convertibility, suggesting that
changes are in the long term. It also remains to be seen whether these countries are
willing to bear the costs of a more flexible domestic currency and recent reserve
accumulation suggests they may be buying more dollars again.

As I have noted in The New York Times, China has taken significant steps to increase
the use of the renminbi beyond its borders, extending currency swaps in local currency
with several emerging market economies, and considering the use of the renminbi in
trade.

At the same time, allowing companies to hold on to more of their foreign exchange and to use
it to fund overseas operations could eventually imply a reduction in the management of the
exchange rate. With China's exports under pressure, an appreciation of the renminbi seems to
be an issue for the future. Yet despite the renewed verbal support from the BRICs for U.S.
treasury bonds, the U.S. may have to pay more to meet its financing needs this year, as higher
yields already indicate.

This Essay is contributed by Nouriel Roubini,

a professor at the Stern Business School
at New York University