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Migrant workers eat their lunch outside a construction site in central Beijing, April 2, 2012. As the number of adults flowing into the workforce slows, China can no longer attract manufacturing with the promise that an unending pool of rural migrants will keep its wages down. (David Gray/Reuters/David Gray/Reuters)
Migrant workers eat their lunch outside a construction site in central Beijing, April 2, 2012. As the number of adults flowing into the workforce slows, China can no longer attract manufacturing with the promise that an unending pool of rural migrants will keep its wages down. (David Gray/Reuters/David Gray/Reuters)

Taking Stock

It's time to look beyond overhyped BRICs Add to ...

By now, even the most bullish of China watchers realize that this vital engine of global recovery is sputtering. Early indications are that its economy grew by about 8.4 per cent in the first quarter – terrific by any standards, except China’s. It would be the country’s smallest GDP expansion in nearly three years.

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Not surprisingly, Premier Wen Jiabao responded by promising to inject more stimulus into the economy, in the form of higher investment, more state construction projects and increased business lending. But that will not be enough to keep the great Chinese freight train on the high-speed rails.

“There’s a lot of faith that China’s growth rate will continue at above 8 per cent for the foreseeable future, that China is above business cycles because it’s a command-and-control economy and they can fix their growth rates,” says Ruchir Sharma, head of emerging markets with Morgan Stanley Investment Management in New York. “Yet, we could be at an inflection point here, for no other reason but that China now is squarely a middle-income country.”

Mr. Sharma insists he is no China bear, but a realist who thinks it’s high time for investors to drop their love affair not only with the China growth story but with commodities and the other vastly overrated BRIC nations – Brazil, Russia and, to a lesser extent, India.

“I’m not talking about extreme cases of a complete crash and financial meltdown, which some people speak about. I don’t think that’s the base case here.” What he sees instead, in China’s case, is a maturing economy coming back to earth after a long period of explosive growth off of an extremely low base.

One big investment theme of the past decade was the BRIC strategy, which stemmed from a view that the biggest emerging markets were the place to be because they were going to take over the world, says Mr. Sharma, whose new book, Breakout Nations, uncovers better growth opportunities in both the emerging and developed worlds. He takes a deft scalpel to each of the BRICs. But he reserves his deepest cuts for Brazil – “the un-China, with interest rates that are too high and a currency that is too expensive” – and Russia, whose slowing growth has exposed glaring contradictions that increasingly look “like a semi-permanent condition.”

He derides the BRIC play as a fad that investors should have abandoned some time ago. “The mistake that all of us make is this business of extrapolation. Because something has worked for a while, we think that’s the trend that’s going to work endlessly into the future. There are times when that does happen. But more often than not, it does not happen.”

Brazil never did live up to the hype, says Mr. Sharma, who does his research on the ground in each country he assesses. Even in the best of circumstances, growth rarely edged beyond 4 per cent, and the country’s chronic structural problems, unaffordable social net and lack of infrastructure could only be masked for so long by the commodity boom.

Getting back to the slowing Chinese juggernaut, it’s a straightforward matter of math. Mr. Sharma has carefully examined other rapid-growth stories over the decades, such as Japan in the 1960s and 1970s, South Korea and Taiwan. All of them slowed once per capita income passed the $5,000 (U.S.) threshold marking them as middle-income players.

The simple fact is that the richer a country gets, the harder it is to maintain rocket-propelled growth rates. Back in 1998, China could expand its $1-trillion GDP 10 per cent through a $100-billion boost in economic activity and consumption of 10 per cent of the world’s industrial commodities. By 2011, China’s $6-trillion economy could only reach double-digit growth through a $600-billion increase in activity and absorption of more than 30 per cent of global resource production.

The obvious question is what happens to emerging markets as a whole, if investors abandon the four heavyweights of the division en masse. So far this year, risk-hunters are again pouring money into emerging equities and bonds, after pulling out billions in 2011. Equity funds added a net $25.6-billion (U.S.) in the first quarter, the best start to a year since 2006, according to the number-crunchers at EPFR Global, which tracks fund flows around the world.

But surely the asset class would suffer mightily if people were to give up on the BRIC story? “My answer is no, because something new always comes up,” Mr. Sharma says confidently. “People forget that before the East Asian financial crisis [of the late 1990s] Thailand and Malaysia were the big [rising]stars. They used to account for 30 per cent of all investments into emerging markets from an equity standpoint.”

The key, he adds, is to be selective and not treat the asset class as, well, a single class.

Mr. Sharma sums up his relatively upbeat world view by quoting Antoine Lavoisier, an 18th century French scientist best known as the father of modern chemistry but also an economist and tax reformer: “Nothing is lost, nothing is created, everything is transformed.”

This, Mr. Sharma says, is what we should expect from China’s inevitable slowdown and the end of the long commodity boom: not disaster but change. “That’s the way of the world. Yes, trends change and it’s important to recognize that; but also not to be despondent, because new trends will always appear on the scene.”

Sure, a popular investment strategy – BRICs and commodities – is fast coming unglued. But certain emerging and frontier economies are poised to become the next sexy investment story. His list of potential stars in waiting includes Indonesia, Turkey, the Philippines, Poland and the Czech Republic. “You’ve got to pick your spots, rather than just assume that because you put a tag of emerging on a particular nation, it’s going to boom.”

Follow on Twitter: @bmilnerglobe

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