The crack in the BRICS

The 7th BRICS summit in the Russian city of Ufa is taking place in a chillier atmosphere than that of the last six summits. Growth in China is slowing and both Brazil and Russia are likely to contract this year. India is doing better, but the climate change is obvious. There is also a growing divide between the economic strategies in the BRICS. Russia, Brazil and South Africa are facing deeper challenges while India and China are pushing forward and embracing structural reforms. There is a crack in the brick.

The problems in Brazil and Russia are to a large degree home-grown. Brazil has been a success story. During the last decade, under both the Lula da Silva and the Dilma Rousseff administrations, growth has been strong, macroeconomic policy prudent and substantial investments in infrastructure have been made. Innovative social policies and a strong labour market have spread the benefits to wider groups in society. Even alarmingly high inequality numbers have been reduced somewhat. 

Over the last few years, however, problems have started to build up. Strong growth in China, with excessive reliance on low energy prices and driven by quasi-protected state owned enterprises (SOEs), has provided a commodity boom that has boosted Brazil. Slower Chinese growth and the push towards a more sustainable economic model means that the commodity turbo is gone and is not likely to return any time soon. 

Brazil and Russia

The Brazilian economy under Dilma has been built on a commodity boom and policies to push growth through public and private investments while protecting the domestic economy from global competition. The government has, at least until recently, been reluctant to deal with low productivity growth in the domestic sector.

The risk with this type of economic model is that credit is over-expanded in sectors that are not viable in the long-term and that public investment is used for short term political goals rather than long-term growth. The credit expansion from the government’s investment banks seems to have over-stretched domestic capacity and contributed to a growing current account deficit. At the same time, the lack of openness to international competition seems to have undermined productivity growth and competitiveness. The sheltered domestic service sector has created cost pressures that have further deepened the problem. 

The correction process has started. The central bank of Brazil is hiking rates to break the upward price spiral. Fiscal policy has made a 180-degree-turn and expenditures are starting to come under control. A combination of weaker growth and a substantial currency depreciation are also beginning to correct the current account imbalance. 

It is clear, however, that Brazil has further to go. The main challenge is to generate growth in the domestic economy without support from iron ore, oil and soya beans. This means that it is vital to increase productivity growth both in manufacturing sector and domestic services. Reducing regulations and barriers to market entry and increasing foreign direct investment in the export sector will also be crucial. Such a strategy would ensure that currency depreciation contributes to a rebalancing of the economy and the containment of imported price inflation. 

Political problems are a major obstacle. The Petrobras corruption scandal and the fact that the government had to back down from unrealistic election promises has weakened Dilma’s political capital, which makes executing on a u-turn in fiscal policy and major structural reforms very difficult. It will take time before Brazil returns to the growth levels of the last decade. 

The Russian story has some similar features. The last decade has been very successful. Between 2000 and 2010 growth was around 6% and to a large degree driven by commodity (oil and gas) prices. But a strong economic policy framework and low public debt have also been supportive. Structural reforms, particularly on the tax side, in the early stages of the Putin administration and a highly flexible labour market has also contributed. Increased openness to foreign direct investment also brought technology and higher productivity. When the Lehman recession began, Russia acted promptly, but also prudently and boosted domestic demand. The economic management of Aleksej Kudrin and Sergey Ignateyev earned them respect from the financial markets and the international community.

President Putin’s confrontation with Ukraine and the tail-spin in energy prices has effectively put a stop to the Russian economy. In a world where financial systems are integrated and foreign direct investments are the engine of technological transfers confrontation is extremely costly for Russia.

The problem for Russia is that the energy boom covered up some fundamental problems in the economy. The demographic challenge is huge. Even if the numbers have improved in the last few years, the Russian population has been declining for a long time. The population was close to 150 million in 1990 and is currently somewhat above 140 million. Fertility rates are low and high alcohol consumption is taking a toll on male life expectancy. The Ukraine-recession that Putin has brought on to the Russian economy is likely to undermine the belief in the future and break the prospect of improving fertility rates. 2050 it is more likely that Russia will have a population of 105 or 110 million.

The export sector hasn’t really grown outside the natural resource sector. Productivity in the domestic sector has been very weak. Growth was clearly slowing before the conflict in Ukraine. The Russian economy was sorely in need of a broad-based structural reform policy. Instead it got a collapse of oil prices and a loss of credibility.

It is clear that we all underestimated the political risks in Russia. The Obama administration tried to reset the relationship with Russia and the Medvedev administration signalled a willingness to bolster the business climate. Nordic countries invested heavily in Russia. Outside the energy sector the Nordic region was one of the key investors in Russia with Ericsson, Volvo, Carlsberg, Ikea, Fortum, Scania, Tele2 and many others making investments. During my eight years in the Swedish government, we had ambition plans to increase trade and investments in Russia. The shift in Russian politics has shifted the whole relationship into a different mode. 

The current Russian economic strategy will not work. Demographic factors in combination with low energy prices imply weak medium term growth until the Russian government abandons its confrontational strategy and move towards co-operation with Europe. Russia is a European state that can only grow with European cooperation, it might take some time before this become obvious to the Russian government. Peter the Great opened the door to the west, Vladimir Putin will not be able to close it for the long term.

The idea that Russia can build an energy-based import substitution strategy and substituting  Europe and the US with Euroasia will not work. First of all you can’t replace Germany and the Nordics with Kazakstan and Uzbekistan when it comes to investment, technology and manufacturing potential. If you want to boost growth in Russia you need cooperation with technology leaders. 

Secondly import substitution has never worked. Brazil and other Latin American nations have already tried this. If you create a manufacturing sector that is protected you will not create leading export companies. An economy with a low degree of openness to international competition is likely to be inefficient, not only in the export sector, but because over-regulation tends to contaminate the rest of the economy. When the initial growth impetus from protection and increased investment starts to fall, increased subsidies are necessary and that undermines public finances, increases inflation pressure, and pushes the current account into deficit. As problems gets deeper, the imbalances get unsustainable. And when the need comes to attract short term portfolio investment to replace a lack of Foreign Direct Investment you know that an economic crisis is just around the corner. Why embark on strategy now when everybody can see that it failed in Brazil? 

China and India

There’s a stark contract between Brazil and Russia on the one hand, and China and India on the other.

The Chinese approach is very different from the import substitution, energy reliance and political confrontation strategy of Russia. 2/3 of the jobs in the manufacturing sector over the last decades in China have been created in foreign companies. Productivity has been increased with imported technology and export production directed towards global markets. Openness to foreign ownership has also transferred soft technology in terms of better and more transparent governance models.

I’m convinced that the Chinese government will deal with the credit boom-bust cycle that we now are seeing unfold. With low household indebtedness, a high domestic savings rate, and a healthy current account, the Chinese economy should be resilient. If we look at how the Government and Bank of China dealt with the financial crises of the early 2000’s it’s reasonable to expect a strong and pragmatic policy response if this becomes necessary. 

Another important difference with Brazil and Russia is that the Chinese government has clearly signaled that it embraces the need for structural reforms. The increased use of market prices to allocate resources, the diversification away from subsidised SOEs, the strengthening of property rights, and increased investment in R&D are all important parts of the government’s strategy. 

Both India and China emphasise infrastructure investment but the difference with Brazil and Russia is that they are combining this investment with more openness and market reforms, and not using it as a substitute for lowering the cost of doing business and other structural reforms. Infrastructure in combination with structural reforms builds stronger production capabilities. Infrastructure investment as a way of concealing structural problems and artificially supporting domestic demand will end with fiscal and current account crises.  

The BRICS nations have a lot to discuss behind closed doors. There is a crack in the brick and without fundamental structural reforms it won’t be easily mended.  

Publication does not imply endorsement of views by the World Economic Forum.

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Author: Anders Borg is a Swedish economist and politician who served as Minister for Finance in the Swedish Government. He is the Chair of the World Economic Forum’s Global Financial System Initiative

Image: Russian President Vladimir Putin (L),  Indian Prime Minister Narendra Modi (3rd L), Brazil’s President Dilma Rousseff (C), Chinese President Xi Jinping (4th R) and South African President Jacob Zuma (2nd R) walk after the welcoming ceremony during the BRICS Summit in Ufa, Russia, July 9, 2015. Ufa is hosting the BRICS and the Shanghai Cooperation Organization (SCO) summits. REUTERS/Sergei Karpukhin