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June 2019

Emerging markets: The path to reform

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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Key points

  • Emerging markets offer investors appealing demographics, potential for growth, and potential diversification benefits in a multi-asset portfolio.
  • Economic reform is a critical component of future economic growth and development in many EMs, and warrants close monitoring.
  • Our preferred EM countries include Brazil, Indonesia, India and China. We describe their reform efforts below.

After a run of key elections in the past few months, investors in emerging markets are looking forward to more political certainty this year. The path to pro-market reforms in these countries can be challenging as they transition from low-wage industrial economies to high-skilled, consumption-based economies. However, a successful transition can lead to better economic growth, stronger future earnings, and a lasting, structural improvement over peers. Here, we review the reform momentum across four countries: Brazil, Indonesia, India, and China.

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Brazil: All eyes on the pension reform

Pension reform has been the bane of every Brazilian government for the past two decades, and the newly elected administration is not an exception. The prior efforts to fix the pension problem pushed by President Michel Temer, who left the office early this year, ended in 2017 when a corruption scandal decimated his popularity and derailed his agenda. Since President Jair Bolsonaro was elected last October, both domestic and foreign investors have been focusing on the new administration’s commitment to push through new changes to the country’s social security system.

Why is the pension reform so crucial to South America’s largest economy? Brazil is one of the most generous countries in the world with men receiving 70% of pre-retirement earnings, while women get 53%. Pensions account for roughly 45% of the government’s total expenditures and are growing 5% annually in real terms. At this pace, Brazil's pension spending will consume the entire fiscal budget by 2030.1

The proposed reform agenda by Bolsonaro’s administration will be met with a lengthy legislative process during which the president has to convince both top lawmakers and Brazilian citizens to accept reduced social benefits. If successfully passed, the new pension plan could save the government more than one trillion reals — or about $270 billion U.S. Dollars — over a 10-year period. This could lead to improved investor confidence and a rally in Brazilian assets

Figure 1: Brazil’s real GDP growth and equity performance

Figure 1: Brazil’s real GDP growth and equity performance

Source: BlackRock, Banco Central do Brasil, IBGE, as of June 2019. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Indonesia: Strong reform momentum

Since the 1997 Asian financial crisis, Indonesia has gradually improved its commercial regulatory framework. In recent years, Indonesia made starting a business easier by combining different social security registrations and by reducing fees involved in the process. Starting a business in Jakarta now takes just 22 days compared to 181 days in 2004.2

Broader financial conditions are also improving. Credit access has continued to deepen, while insolvency resolution has improved considerably. Cuts to energy subsidies have also helped finance infrastructure spending, which could continue to support long-term GDP growth. In addition, Indonesia is reinvigorating its agrarian reforms to distribute forest lands to communities and farmers.3 In short, an eased regulatory burden along with more efficient allocation of resources — both capital and labor — are leading to greater macro stability and stronger growth.

Investors are optimistic that steady economic growth will continue after Joko Widodo secured his presidency in April’s re-election this year. However, as the country pushes ahead with economic reforms, greater fiscal measures are required. Indonesia remains vulnerable to swings in global liquidity and risk appetite due to a persistent budget deficit that has left foreign ownership of its debt near 33% (Figure 2).4

Figure 2: Persisting current account deficit is a source of vulnerability for Indonesia

Figure 2: Persisting current account deficit is a source of vulnerability for Indonesia

Source: Bank Indonesia, Statistics Indonesia, OECD, IMF, Oxford Economics and BlackRock, as of June 2019. 2020-2022 data are estimates projected by IMF.

India: Modi-fication 2.0

In the largest democratic election in history, 900 million Indian voters showed up at the polls this April. Although many opponents pointed to broken 2014 campaign promises and increased violence against minority groups under his regime, Narendra Modi successfully won re-election, the first time an Indian prime minister has won back-to-back majorities in Parliament since 1971.

Modi’s government pledged to start the new term by building on some of their prior successes. For example, PM Modi claimed to have brought electricity to all 600,000 of India’s villages and improved sanitation by building 92 million toilets across the country. He plans to follow up by bringing safe drinking water to every Indian home by 2024, broadening health insurance for the poor and giving subsidies to farmers.

As the country is currently troubled by slower economic growth in the past three quarters (figure 3), India’s economic reform agenda will need to focus on boosting investment and growth while addressing fiscal constraints.

Over the past five years, Modi’s government has had some policy successes: The long-awaited national goods-and-services tax (GST) replaced a web of local duties and could raise up to $50 billion, in turn boosting India's low tax-to-GDP ratio by 2% by 2020.5 India’s ranking in the World Bank's Doing Business report has also improved, after the administration streamlined regulations on bankruptcy and foreign direct investment.6 If Modi can turn his campaign promises into real policy successes, such as easing restrictive labor laws, reducing corporate tax, and privatizing inefficient state-owned companies, investors are hopeful that stronger economic growth will result as reform momentum could lead to higher productivity and greater investment.

Figure 3: Contribution to India’s GDP

Figure 3: Contribution to India’s GDP

Source: Thomson Reuters, BlackRock, as of June 2019

China: Facing new challenges

Economic growth and reform momentum have slowed in China, the world’s second largest economy. China’s GDP grew by 6.6% last year, the slowest pace in 28 years, while the leadership in Beijing has lowered the growth target to 6-6.5% for 2019.7 On the reform front, the state-owned enterprise (SOE) reform is “backsliding”, especially after the government’s deleveraging campaign in 2018 hit the private sector harder than the state sector, according to the Asia Society’s “China Dashboard”, which tracks China’s reform goals.8 Yet China is now also facing one of the biggest challenges in recent history: escalating trade tensions with the United States that creates pressure on China’s economy and investor sentiment.

To help stabilize the economy while facing trade uncertainty, Chinese leaders have pledged to continue efforts to contain financial risks, to reduce overcapacity in industries like coal and steel, and to reduce poverty. This year, Chinese policymakers have rolled out a number of monetary and regulatory easing measures to help support the economy. For example, tax cuts for business and individuals have started to boost industrial profits and investment (Figure 4).

While economic tensions with the U.S. are likely here to stay for the longer term, China is on course to open up its market gradually. China has recently eased restrictions on foreign ownership to allow foreign companies to form wholly owned companies in China. Additional improvements in the business environment and the development of free trade zones could offer more opportunities for foreign companies to enter China and encourage domestic competition.

Figure 4: Industrial profits and property investment directly benefit from tax cuts and credit expansion

Figure 4: Industrial profits and property investment directly benefit from tax cuts and credit expansion

Source: Wind, BlackRock, as of May 2019. Note: dotted line represented estimated improvement in industrial profits due to tax policy changes.