CEME Senior Fellow Paul Schulte (F'88) responds to Foreign Affairs Article "How the BRICS are Crumbling"

The November/December 2012 edition of Foreign Affairs Magazine had an article called “How the BRICS Are Crumbling”.  The tone of the article – by a fund manager from Morgan Stanley – seems off the mark.   The BRICS are slowing because they are trying to SLOW DOWN credit growth due to their dollar link.  They are trying to slow down credit growth while the West desperately uses zero interest rates to SPEED UP credit growth.  So, the West and the BRICs are operating at cross purposes. The BRICs countries have dollar-linked currencies, so when interest rates are zero in the West and high in BRICs countries, they will be bombarded with capital seeking a higher return.  This causes the currency to appreciate, jeopardizing growth.  Or the BRICs countries must intervene domestically to force banks to slow down credit as these banks are filled with cash.  Either way, they are encountering forces which cause the currency to rise and credit growth to accelerate.  This is a classic cocktail for a real estate bubble and accelerating inflation. Brazil and China are experiencing the same phenomenon now.  Both are essentially trying to slow down their respective economies, although China has been more successful.

This is not all bad.  These two countries have brought entire provinces of their respective countries  -- literally hundreds of millions -- out of poverty in the past ten years and have welcomed competition in many areas of the economy which were off limits only ten years ago. China is now the world’s second largest economy globally and Brazil is now the sixth largest economy.  They are both essentially trying to slow down growth in order to keep inflation from getting out of hand.  Both of their currencies have appreciated substantially and both continue to have significant inflows.  The RMB keeps on hitting new highs. And the Real is weaker after hitting a high of RS1.5/$1 last Summer.

And yet.  Both of these countries are moving to the next chapter of growth.  They are looking for alternative currency arrangements to escape their slavery to the US Dollar and a zero interest rate policy which is suicidal for developing countries with functioning banks.  These zero rates are a poisonous recipe for asset bubbles and inflation – and eventually uncompetitive economies.  Both countries are being forced – often prematurely – to move up the value-added curve in order to preserve competitiveness.  Both are struggling to create the intellectual firepower on a mass scale to accommodate this climb up the value ladder.  This is socially stressful and causes societal fear and dislocation.

And they are both trying to reform their economies in the areas of police procedure, judicial review, monopolistic practices and state intervention. This takes time.  We should not despair about how long this takes given the history of the US and the UK.  Both the US and UK had a history of crony capitalism, horrendous poverty, police brutality, extra-judicial killings and state-sponsored sabotage of unions. Let’s look at a few examples of how these two great countries overcame appalling poverty, police brutality, judicial disgraces and state-sponsored crony capitalism.

At the height of its imperial power in 1900, almost 70% of the world’s reserves were denominated in British Pounds.  The sun never set on the British Empire.  The country was wealthy beyond imagination.  And yet, according to Pulitzer Prize Winner Barbara Tuchman in her wonderful book The Proud Tower, “one third of the country’s population was living in chronic poverty. …Families of 9 lived in a space of 1,200 cubic feet (often with four to a bed). …A piece of paper on the floor served as a toilet.  ...Workman had a 12 hour day, seven days a week.” ..Taking a day off without permission landed you in jail.  And the Tory government was happy to keep it this way.  The election of 1906 was a signal for reform that cleared out the Tory Party and brought in reformers who legalized unions and offered state support to help alleviate the unspeakable poverty of the period.

In the US, we see the same thing.  Books like the Gangs of New York by Herbert Asbury, Oil by Upton Sinclair (which inspired the movie There Will be Blood) and L.A. Confidential show the ways in which government, judicial and police were corrupt beyond belief from the late 1800s to the 1960s (and arguably into the 1980s) and were cleaned up by peaceful (and sometimes violent) means to bring about reform.  (These books have strong grains of fact in them and the movies based on these books are MUST SEES to show how far the US has come).  And yet, the US continues to have large pockets of poverty throughout the country.

Progress is messy.  Corruption is everywhere – always has been and always will be.  The history of the UK and US is a forward moving panorama of progress away from appalling corruption and crony capitalism, sometimes glorious and sometimes messy.  Brazil and China are examples of nascent political and economic powers which have quality problems of redistributing wealth, reforming judicial systems, allowing greater democratic freedoms and cleaning up police enforcement.  

The chances of both countries pulling this off peacefully are pretty good.  It seems both are on track to push forward for greater transparency and reform.  It is being played out on the front pages of Chinese and Brazilian newspapers every day.  The darker side of political reform is often a good sign. Both countries are naming and shaming and have the confidence to do this.  Russia and India are slightly different stories – more on that next week.   

Paul Schulte is a Senior Fellow at The Fletcher School of Law and Diplomacy at Tufts University and an Adjunct Associate Professor of Finance at the Hong Kong University of Science and Technology.  He is CEO of SGI Emerging Markets research and can be reached at SGIemergingmarkets@gmail.com

Back to IBGC News