Potholes In The Golden BRIC Road
Emerging market investing has been a hot-and-cold investing subject for three decades, and the BRIC countries of Brazil, Russia, India, and China have really tended to dominate the discussion over the past 10 to 15 years. While it is true that there is incredible promise in these countries, there are also more challenges and dangers than many investors realize. Investors would do well, then, to take a closer look at these economies and consider some of the risks that could undermine these "once in a lifetime" investment opportunities. (Brazil, Russia, India and China are becoming more popular for investing, but there is still plenty of risk among BRIC countries. Check out Understanding BRIC Investments.) TUTORIAL: American Depositary Receipts
Poverty is a dangerous problem for any country to have, as it not only prevents people from maximizing their potential, but it also represents a dangerous store of resentment and potential political instability. Poverty is a significant issue in Brazil and India, as roughly one-quarter of those populations live below their country's poverty lines.
Unequal distribution of wealth is a similar problem, and perhaps even more problematic from an investment statement as a voting populace may look towards politicians that promise to address this inefficiencies with business-unfriendly practices (as has happened in Venezuela). Brazil scores very high on lists of inequality (as measured by the Gini coefficient), and China is quite high as well (many people do not realize how poor the Chinese living in the countryside are). In comparison, Russia and India are much closer to the standards of the Western world in terms of income distribution.
Where there are poor people and histories of authoritarian governments, there is often corruption as well. By its very nature, corruption does not usually leave a clear paper trail, so measuring it is difficult. Transparency International's Corruption Perceptions Index may not be a perfect methodology, but its insights are interesting all the same.
Brazil's ranking of 69 is too low to be seen as good, but it is the best among the BRICs - Russia scores the worst at a very low 154, while China and India come in at 78 and 87, respectively. In Russia, is not uncommon for organized criminals to own key companies (or control entire industries) right alongside government officials, while Chinese officials are often paid to look the other way when it comes to violation of laws and standards, securing contracts, or obtaining privileged access to capital or resources.
Rule of Law
The idea of the rule of law is closely related to corruption, but it in this case it refers to the clear and consistent application of laws and regulations to all parties in a country. In Russia, for instance, it is commonplace for companies that are "friendly" with government officials to get preferential treatment and for government officials to punish uncooperative companies through pseudolegal means. Although the worst excesses of Russia's erratic application of rules and laws seem reserved for internal matters (the infamous Yukos case, for instance), many Western companies like BP have run afoul of shifting rules and arbitrary enforcements.
Though not the same as rule of law, excessive rules and law can also be a significant problem. India is a good example of the inconsistencies and frustrations to be found in emerging investing. While India has a well-developed democracy, it also has a crippling bureaucracy, byzantine rules and regulations, and a depressing level of corruption (though a promising trend of improvement here). All in all, then, it is not hard to start a very small business in India, but trying to establish a large scale enterprise can be especially difficult.
While Brazil, India and China are thought of as emerging countries forever putting up new buildings and public projects, Russia has the opposite perception - a country that has seen its physical and intellectual infrastructure hollowed out by the collapse of the Soviet system and the inconsistencies of government policy since then. Much of Russia's infrastructure is frankly not in the best of shape and this makes transporting goods and conducting business more challenging. Along similar lines, while Russia used to turn out large numbers of talented engineers, the university system has fallen into disrepair and disrepute and Russia is often challenged to find the motivated and talented people it needs to compete in advanced industries.
India also suffers from a very large population, quite a lot of poverty (one-quarter of its people living below the country's own poverty line), and a relatively poor infrastructure. Access to clean water and sanitation is still problematic in some rural areas, and the traffic jams and overcrowded railways are legendary.
One common problem among emerging market economies is "Dutch Disease", an economic phenomenon where the earnings generated by natural resource exports undermine and discourage the development of consumer goods, manufacturing, and technology industries in the country. Ultimately, then, these countries become beholden to the vagaries of commodity prices and there is little internal demand to drive the improvements in education and training necessary for a modern competitive economy.
Among the BRIC nations, Dutch Disease is not a pressing problem for India or China, particularly as China has moved aggressively to transition from an assembler of low-quality/low-priced exports to a full-fledged industrial economy. Russia has some vulnerability in the wake of the hollowing-out of its industrial sector (and its universities) and the importance of its reserves of petroleum and industrial metals. Brazil, though, is the most at risk here. Brazil's economic growth has almost always been predicated on exporting natural products found within its borders - whether renewable resources like lumber or agricultural products, or mined resources like iron and petroleum. While Brazil does boast a strong regional steel industry, Brazil has yet to develop very many globally competitive companies in manufacturing, technology, or consumer goods.
It is still a very touchy and controversial subject, but there is an institutionalized classicism that still shapes India. A person's caste status can impact educational options, work options, social options (marriages and friendships) and access to capital and opportunities. Prospectively, then, millions of otherwise talented, capable and motivated Indians are shut out from their full realization of their talents. Classicism and racism are also problematic in Brazil and an under-appreciated issue in many parts of Russia and China as well.
The centralized government of China creates other problems as well. Planned economies have inherent inefficiencies and the direct interference of China's government in business has led to an inefficient allocation of capital. This is perhaps best typified by the current problems in the banking and property sector - property bubbles are a major threat in major Chinese cities and banks are saddled with billions in what are likely to become nonperforming loans.
The Bottom Line
These points are not meant to bury the BRIC nations, nor scare investors away from their investments in these markets. Rather, it is meant as a counterbalance to what is often an unrelenting barrage of positive news, hype and guidance that investors must invest here or be left behind. The risks that go with the BRIC economies feed directly into the gains that investors can expect, and so long as investors go into these markets with their eyes open and well aware of the challenges, there are still significant rewards to be had as these countries work to progress economically and socially. (You might be better off playing roulette if you don't understand the risks of investing here. Refer to Investing In Russia: A Risky Game?)