The cracks in the BRICs

Emerging markets are back in fashion, with the heavyweights Brazil, Russia, India and China the BRICs in the limelight. The MSCI BRIC index has risen by 31% since last autumn. Yet more liquidity from central banks explains much of the surge, while emerging markets' faster growth rates remain appealing.

But investors in emerging markets, especially the BRICs, are too bullish, argue Deutsche Bank's John-Paul Smith and Mehmet Beceren in a recent report. They are ignoring structural flaws in the BRICs that threaten to undermine these economies' and stocks' long-term outlook.

The authors note that over the past two years consensus estimates for the BRICs' sustainable medium-term growth rate the maximum speed that doesn't cause inflation to flare up have been revised down. Brazil's has come down to around 4% from 6% and India's is at 6%-7% from around 9%.

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The reason? "The neglect of growth-enhancing reforms." The BRICs have not pushed through so-called supply-side measures to boost their productive capacity.

India needs to liberalise laws governing inward investment, but "the political situation is unlikely to permit any more than halting progress" on this front before a 2014 election. Brazil struggles with ageing infrastructure and a shortage of skilled labour. Russia needs to diversify its economy away from oil dependency. China is too reliant on state-directed capital investment.

The fall in the BRICs' sustainable growth rates means that there is less scope than widely assumed for central banks to cut interest rates in response to the current global growth slowdown. "Investors are far too optimistic about the potential for monetary easing." The pick-up in inflation over the past two years is structural, not cyclical.

Meanwhile, the state's enduring influence on many listed companies in the BRICs tends to mean that these companies are often run with national objectives, rather than shareholders' interests, in mind. Brazil's Petrobras and Vale, for instance, are clearly being used to help build up a domestic manufacturing base.

Constant government interference is undermining efficiency and making firms all the more reliant on top-line growth potentially also a near-term problem given the still-shaky global outlook. BRIC investors should tread carefully.