Via Goldman Sachs, some commentary by Jim O’Neil on BRICs:

In late 2008 and early 2009, there were two reasons why some of us found it relatively easy to go against the prevailing view that a worrying global depression was around the corner. In fact, the inevitability of an aggressive fiscal stimulus in many countries, combined with the ongoing rise of the so-called BRIC economies meant that early 2009 was an excellent time to invest. Over three years later, the prevailing view is that all western economic policy levers are spent as the consequences of that fiscal stimulus have worn off, and in some cases reversed, under the pressure of bond markets (or at least the perception of pressure). Interestingly, there is also a creeping perception that the great BRIC economic surge has come to an end. I want to concentrate on this latter theme this week, although I will make reference to other topical issues as well.

As readers will be aware, in recent weeks, I have attempted to put the Euro Area crisis into what I thought was an appropriate global context. I have pointed out that in 2011, China’s nominal $GDP rose by 1.3 trillion, equivalent to creating an economy the size of Greece every 111?2 weeks and an economy the size of Spain in not much more than a year. The BRIC countries collectively contributed around $2.2 trillion, not too far off the equivalent of another Italy.

But what happens if the BRICs stop contributing to global growth at this pace?

It is undoubtedly the case, with the exception of Russia, that Q1data in the BRIC economies has been disappointing. Growth in Brazil and India has been especially weak. Ongoing economic releases, notably another soft PMI for China published Friday, adds to the sense that things are not going as well as the optimists hoped.

Russia is Holding Up.

Ironically, as I mentioned, Russia was the only one of the four that positively surprised in Q1, with real GDP rising 4.9 pct year on year. This has not stopped a fresh swathe of media commentary that the “R” doesn’t deserve to be in the phrase BRIC as the return of President Putin and his early decisions appear to confirm another era of policy leadership shrouded in opaqueness and lack of clarity of purpose. Some commentary even cites Putin’s failure to turn up at the meeting of the G8 leaders as a specific reason to think less of the country’s merits. I find this sort of mentality rather indicative of the narrow-minded approach to the country and the changing world. When Hank Paulson became US Treasury Secretary he actually skipped the first G7/G8 Finance Ministers meeting, apparently regarding it as not a key priority. As someone who has believed for the past decade that the G7 and G8 meetings have outlived their usefulness, I am not sure that this particular argument in favor of removing the “R” makes sense at all. What is clear about Russia is quite simple pointers. In order to justify the “R” in BRIC, Russia needs to grow by 4-5 pct over the current decade. In US$ terms, this rate implies that its contribution to global GDP will be bigger than the combined total of the Euro Area. In this context, Russia simply needs to avoid a crisis. This suggests that the biggest threat to Russia is a sharp fall in oil prices, which I think is possible at some time. To mitigate this risk, Russia must undertake steps to diversify its economy, boost the rule of law, including corporate law, and proceed with most of its planned privatizations in a transparent way. On Thursday, The Financial Times ran a most interesting article on the people surrounding Putin and his Cabinet. Reading this explains to me why he probably couldn’t see the value of the G8 meeting as he needed to get the counterbalances right for his complex government. I have been assuming that we will get a clearer outline of Putin’s plans at the forthcoming St. Petersburg Forum, which promises to be more interesting than usual. But while I can see why many foreign investors continue to express concerns about how Russia is governed, this should not equate to why it shouldn’t be considered a BRIC.

Brazil disappointing.

Brazil is certainly facing more genuine challenges in its effort to achieve the growth rate that satisfies our criteria for BRIC status. We are assuming Brazil will grow by a bit more than 5 pct this decade. It got off to a very good start by virtue of its exceptionally strong performance in 2010. However, the second half 2011 and the first quarter of 2012 have clearly disappointed. It is important to realize that in order to satisfy our expectations, Brazil is the only one of the four BRIC countries whose average growth rate over the current decade must increase relative to the previous decade – which was only 3.3 pct (its strong nominal $GDP growth rate was boosted significantly by the remarkable rise of the Real). In addition to reducing the role of government spending, Brazil faces two additional challenges. One is to reduce its vulnerability to “Dutch disease”, i.e., to be less reliant on a persistent improvement in its terms of trade due to rising commodity prices and to avoid spending actual or perceived revenues from its commodity prowess on government projects. Russia, of course, faces a similar challenge. The greater diversity of Brazil’s commodity endowment, however, makes the Brazil situation somewhat different. Second, Brazil needs to lose its overvalued currency or it will become more and more dependent on commodities and, in some ways, the ”old” China. In this regard, the aggressive reduction in interest rates initiated by the Central Bank of Brazil last Autumn is to be welcomed, as this undermines the bullish case for the Real. While the significant decline of the BRL is a step in the right direction, it would seem to me that a level in the 2.40 vicinity would be closer to where it would be helpful to Brazil’s non-commodity industry. While many Brazilian policy observers think that the central bank has gone “soft” on inflation, I don’t see any real evidence of this. As I wrote upon my return from a recent trip, it appears to me that Brazil’s central bank has shifted from being “Royal Bank of New Zealand-like” to “Royal Bank of Australia-like” in regard to the flexibility of its Inflation Targeting. In addition to weakening the Real, lower real interest rates should allow for a better environment for private sector investment.

So while ongoing Brazilian economic data disappoints, the decline of real interest rates and the Real should be viewed positively from a medium-term perspective.

India, the most disappointing of them all.

As I have talked about for years, in many ways, India is the most complex of the BRICs and certainly the most contradictory. It easily has the best long-term growth potential of these four countries simply due to its spectacular demographics. Beyond this decade, we assume that India will be able to grow at a much faster rate than the other BRIC countries – just below 5.3 pct, and for this decade, around 6.9 pct. To unlock this potential, however, India must allow its cherished democracy to actually function and get things done.

As I have also written about a lot in the past year, on many credible measures of productivity, India scores the lowest among the BRICs. On the Goldman Sachs Growth Environment Score (GES), an index of 18 variables relevant for productivity and sustainable growth, India scores 3.9 on a scale of zero to 10. This is much lower than the 4.9 score for Russia and the 5.4 score for both Brazil and China. In addition, India’s fiscal position is much weaker than the others. In fact, the steady increase in India’s fiscal and current account deficits over the past couple of years may place India in line for the kind of ill-treatment that traditional emerging markets can sometimes experience, and that is currently being dished out to the Club Med countries.
India’s leaders also suffer from another commonality with much of Europe in that they cannot seem to get anything done. Hopefully, the sizable nature of the recent disappointments will finally force some of their key policymakers to start making some decisions. The reversal of some of the mistakes made in late 2011, particularly in regard to foreign direct investment, seems key to me.
China, actually still the beacon of light.

While so many people continue to fret about some sort of hard landing, China displays plenty of evidence of the “softer” variety. While it now looks as though Q2 real GDP growth will be weaker than Q1’s “disappointing” 8.1 pct, our proprietary leading indicators have turned upwards in the past couple of months. It is quite clear that Chinese financial conditions are starting to ease. It is very interesting in this regard that, in contrast to the dreadful month that most global stock markets displayed in May, China had a decent month. As of Friday, June 1, the A-share market is up 7.9 pct year to date, clearly above all the other BRIC markets, and with one or two exceptions in Asia, has been the market with the strongest performance year to date.

In terms of comparisons to 2008/09, I think it unwise for people to expect another big infrastructure- based stimulus, for two related reasons. First, the 5-year plan assumes China will grow by 7.0 pct. This year, Premier Wen suggested real GDP growth of 7.5 pct would be likely. At the moment, the “slowdown” looks to deliver real GDP growth above this level. Second, policymakers want to engineer an era of better-quality growth based on higher consumption and lower energy-consuming and polluting production as I have talked about repeatedly. Therefore, past fiscal solutions designed to support investment are not going to dominate. We are much more likely to see more specific steps to encourage consumption, especially if they tie in with other goals, as well as efforts to ease financial conditions. In this regard, news earlier this week that the government is stepping up measures to subsidise the use of more energy-efficient cars is more typical of what is likely to occur.

Let me also repeat in this context that the continued usage by many observers of the old China data releases, which may have once served as an ongoing guide to how the country was doing, appears increasingly misplaced. Published indicators like Industrial Production, and other interesting ones like electricity consumption, as important as they are, may not deserve the same level of consideration today. Indicators of consumption, including monthly retail sales (despite all its shortfalls), are becoming more important.

Most importantly, looking forward, I don’t see as of yet any reported (or anecdotal) evidence suggesting that the “new” China is disappointing. The 7.5-8 pct real GDP growth, led by the consumer, that we have assumed for the decade seems set to continue. In a global context, this assumption translates into an addition of around $8 trillion in real terms to world growth, about the same as the US and Europe put together, or in the context of the Brazilian and Indian “disappointments”, about 2/3 of the BRIC total that we are forecasting.

I would become much more concerned if I saw evidence of both sharply slowing Chinese consumption and the absence of measures to support it.

The Rest of the World. Poland, Not Quite an N11, but nearly a Growth Market

Of course, there are other exciting countries beyond the BRICs, including the Next 11, as we defined
them, and some others too.

This week, I made a brief visit to Poland, my first ever. I was asked to speak at two events, one involving a number of leading figures from the country and policymakers. I was asked to place Poland in a global context.

It is especially fascinating to think about Poland at the moment given the chaos that is going on to its west in the Euro Area, and the remarkable fact that Poland has yet to experience a recession, unlike virtually every major western economy in Europe and beyond.

Poland doesn’t have enough people to warrant inclusion in our defined N-11 grouping. Add another 10 million people on top of its 38 million and it would. Despite this, it is much closer to warranting “Growth Market” status as its economy is not far off from 1 pct of global GDP. If policymakers can do things to further boost the country’s productivity, perhaps Poland will become one. With a GES score of 5.7, it is already higher than all the BRIC countries, and above that of all the N-11 with the important exception of Korea. As I have suggested to policymakers elsewhere in the world recently, trying to understand how Korea has done what it has done, which has led it to achieve the same level of wealth as some of the G7 countries, is something Poland should do.

Thinking about the future of EMU is a fascinating thing to do in Warsaw. Here in the UK, it is remarkably fashionable to blame much of our economic ills on the problems in the Euro zone. Poland, of course, is subject to many of the same influences (perhaps less trade and banking exposure to Club Med) and doesn’t seem so fragile. In addition to this, listening to many of the people I spent time with, it seems as though Polish intellectual leaders don’t wallow in the fact they also aren’t part of the Euro, although they do believe that currency flexibility has helped them cope with external pressures in recent years. In fact, many of them assume that the Euro will not only survive, but that Poland will join it. Most interesting.

Japan and the Yen-again.

Japan had an especially challenging May with stock market weakness. Despite some better than expected Q1 GDP data, markets are clearly worried about Japan’s ongoing developments, not at all helped by the ongoing recovery of the Yen.

I met with an ex-BOJ official this week, having also met with some current representatives the week before. It seems to me that economic policy in Japan is in a very fragile state. (Where is it not I suppose?) As has become evident with some public statements, the BOJ isn’t currently prepared to have its new, and now formal, 1 pct Inflation Target dominate every aspect of its purpose. To some extent, this reflects the underlying caution of the BOJ lifers. Unless economy-wide productivity significantly improves, an active BOJ policy will succeed in not just creating 1 pct inflation, but perhaps even higher levels. To solve Japan’s core problems, monetary policy is not especially relevant. The trouble with this view is not whether or not it is true, but that a smaller and smaller number of people stick with it. These days, the BOJ lifers are facing a battle not just with politicians and some Ministry of Finance bureaucrats but also increasingly with corporate Japan. It is the latter which strikes me as especially important as Japan’s internationally renowned corporations of the past 30 years will not willingly continue to go down a slippery slope without putting up quite a fight. This fight actually centres on the Yen because they need a weaker currency to regain competitiveness. The BOJ can’t achieve 1 pct inflation without a weaker Yen either.

One Japanese contact put it to me earlier this week that, ultimately, Japan’s productivity won’t start to rise until the country allows Korean companies to take them over. Given the sensitivities to that notion, I would imagine quite a few policy developments lie ahead.

Troubling Signs in the US?

This week has been a disappointing and troubling week for the US economy and we are going to have to reconsider our relatively optimistic forecast for this year that we have held since December. Our 2.5 pct GDP forecast for 2012 looks now rather difficult to achieve after the downward revision of Q1GDP to just 1.9 pct, the disappointing ISM survey published on Friday, and the much weaker-than-expected May payrolls also published on Friday. The approaching year-end, post-election fiscal cliff didn’t seem that big a hurdle when there was evidence of rising job creation and improving private sector confidence. But as these trades are waning, the fiscal cliff looms as a more genuine challenge.

About the only two positives from all of this that I can see are: (a) the Fed is much more likely to introduce more QE, although given where bond yields are, I am not sure what help that will provide, and (b) oil and other commodity prices have fallen quite a bit, so at least the real income of those lucky enough to have jobs will face less of a squeeze.

Which Leaves the Sorry Mess that is Europe.

The crisis just rolls on without any apparent shared solutions from Europe’s leaders, adding to the financial market turmoil. Germany seems to continue to rule out its involvement in any true pan-Euro Area solutions in the near term. This means that markets continue to express their fear that the Euro project is no longer sustainable.

I have been immersed in many discussions on topics related to the Euro yet again this week, and in some ways I am none the wiser. However of possible interest:

1.    There was a very interesting Pew Opinion Poll survey published earlier this week which covered 1,000 people in eight different European countries; five Euro members (the big four of France, Germany, Italy and Spain, plus Greece), and three non-member countries (Poland, Sweden and the UK).

As with all polls, there were oddities and some contradictions. Despite this, all five Euro member countries responded that they preferred being in the Euro than not. All of these countries except Greece have a favourable view of Germany and, separately, its leader, Merkel. While many answers appeared to contradict the finding that its member citizens enjoy being in the Euro, there was not much support offered to those that argue people simply don’t want it. And the most eye- catching fact I noticed was that 49 pct of Germans polled believed that Germany should support “bail outs.” This was up from 42 pct the last time they were asked.

2.    As I mentioned earlier, I was in Warsaw this week, and I also spent a few hours in Brussels, attending the latest BRUEGEL research think tank board meeting, on which I sit. My takeaway from both experiences adds to my view that there is no belief in the inner circles that the Euro is close to its terminal days. I interpret a large part of the apparent “inaction” from Germany as stemming from two reasons. First, more than 49 pct of the German population must be prepared to support higher bailouts. In this regard, perversely, the more fear of turmoil the better. Second, Germany and others, including the ECB quite strongly believe that to achieve a lasting solution, other countries need to be allowed to go close to the brink before they will change their behaviour. At some point, we are going to get the all-swinging policy response that many talk about, and I outlined last week.

3.    As it relates to Spain, I think there is widespread belief outside of Spain that all they need to do is ask for an outside programme and they will get financing. This might even initiate more systematic pan-Euro Area initiatives that will mutualise some of the problems of Spain and others. But sticking to the view that all problems can be fixed on a case-by-case basis a? la Bankia is not going to get a sympathetic ear.

4.    The Greek electorate have to decide on June 17th whether they want a life where they have strong support from their current Euro Area friends or not, plain and simple.
It all looks rather grim doesn’t it? And it isn’t even May any more. But, as I saw from a broker note this week, if you look at the valuation of many European markets, their current level relative to the CAPE (cyclically adjusted price earnings) are at such low extremes that this could be close to one of the best investment opportunities in a long, long time. Our own CAPE analysis suggests the same.