A brighter outlook for the BRICs

Mainly positive revisions to the emerging market (EM) outlook this quarter, with growth upgrades everywhere but India, and inflation expectations pushed down across the board.

To a large extent this represents positive data surprises in the first half of the year (and the opposite in India). In Brazil and Russia improvements in the outlook for politics and oil prices, respectively, help lift projections. The battle with structurally high inflation appears to be going the way of the central bank in India, Brazil and Russia, driving our changes for future price growth but also establishing a more positive environment for EM. Part of this more positive environment is the scope for permanently lower interest rates, leading to expectations of deeper cuts everywhere but China, where deleveraging efforts persist.

China: slowdown imminent
Second quarter GDP growth surprised to the upside in China, unchanged from the previous quarter at 6.9% y/y. All else being equal, this compels us to revise our growth forecast for 2017 higher. We continue to expect a slowdown in the second half of the year, given the credit tightening we have seen, but it is worth examining why we have been wrong so far on Chinese growth.
Our expectation was that the end of stimulus, replaced by tighter credit conditions, would weigh on real estate investment, and potentially infrastructure investment. This part seems to have played out in a limited fashion so far. Further, the support provided by the external backdrop looks set to weaken: global demand is likely to be softer in the second half of the year as Japan, the US and China slowed. This could weigh on manufacturing investment.
Meanwhile, expectations of currency depreciation have similarly been dashed, year to date. Our own expectations for CNY depreciation rest on the assumption that a slowdown in growth in the second half of the year leads to renewed pressure on capital outflows, and injections of liquidity by the People’s Bank of China, whilst trade rhetoric from President Trump also poses a risk. So for now we still expect depreciation going into the year end.

Brazil: pressing ahead with reforms, just
Happily for Brazilian growth, President Temer has survived so far, and still seems able to pass reforms. Labour market reforms, for example, passed a vote in early July. Business and consumer confidence did waver amidst the heightened uncertainty, but we now expect this to stabilise and recover. This should mean consumption and investment largely maintain their upward momentum, but with some loss compared to a counterfactual of uninterrupted reform progress. We marginally revise up our growth expectations for this year and next, on this modest improvement in outlook.
Another positive has been the continued improvement in inflation dynamics in Brazil, increasing the scope for further cuts to the main policy rate. Though some currency weakness did result from the political noise, it has proven short-lived and is unlikely to generate any significant inflation pass-through. Headline inflation is now at its lowest since 1999, and inflation expectations have also adjusted a long way. In its more recent communications the central bank has suggested that market expectations for interest rates remain overly hawkish, prompting a significant downgrade of our rate view: we now expect rates to be cut to 7.75% by year end, from 9.25% currently.

Russia: delivering positive surprises
Overall activity picked up strongly in the second quarter, accelerating to 2.5% y/y from 0.5% the previous quarter. A relatively simplistic model exploiting the strong relationship between oil prices and Russian GDP growth suggests the reading was not in fact wildly abnormal. Using the market implied path for oil prices, this also allows us to construct a potential path for Russian GDP growth. Obviously the model is not perfect, but in general the direction of travel is correct. From here, oil prices would suggest a gradual slowing into 2018 when growth revives somewhat. Still, we acknowledge the chance for an upside surprise to our already upgraded growth forecast of 1.3% in 2017.
Inflation data has also been delivering some positive surprises (aside from a short-lived weather induced food spike in June), prompting a downward revision to our inflation outlook this year and next, and also increasing the scope for central bank rate cuts: we see rates at 8% by year-end.
To touch briefly on geopolitics, the new US sanctions approved in early August tighten restrictions on lending to blacklisted companies (a mix of state banks and energy companies) and raise the possibility of further sanctions against other state companies. Indeed, it provides specific authorisation to the Trump administration to do so. All of this has the potential to weigh on foreign direct investment and domestic investment, which had begun a tentative recovery. Perhaps more worrying for Russia is that the US Treasury is required to report on the impact it expects from hypothetical sanctions to Russian government debt. Russian central bank data shows foreign holdings account for approximately 30% of Russian government debt, so action here would be painful for Russia.

India: policy induced headwinds
A very significant downgrade to Indian growth expectations this quarter, with 2017 growth revised down to 6.9% from 7.4% following two key events. The first was a large downside surprise in the first quarter of 2017, with the data released shortly after our last forecast update. GDP grew just 6.1%, a full percentage point below consensus expectations.The second factor weighing on the growth outlook is the implementation of the Goods and Services Tax (GST), implemented at the start of July. The Indian PMIs suggest considerable short term disruption. Hard data is more lagging, but June industrial production contracted for the first time in four years ahead of GST implementation. We would expect, all in all, the impact to be transitory, so our outlook for 2018 is less affected.

Happily, as in Russia and Brazil, the disinflation trend continues in India, allowing the central bank to provide some support as growth flags. With inflation well below the 4% target at 2.4% in July, the central bank implemented a 25 basis point cut in August taking the headline rate to 6%. We also expect a further 25 basis point cut later in the year given the weakness of growth, though there are risks to this from food prices should the monsoon disappoint.
Longer term, the main variable we see affecting growth is the state of the domestic banking sector. With banks providing around 80% of financing, at least part of the reason for weak investment seems likely to stem from the parlous state of bank balance sheets. Around 12% of bank loans are non-performing or distressed, but difficult obstacles block an early resolution. It is estimated that a recapitalisation would cost the government $90 billion, which it is unwilling to pay given the mockery it would make of the fiscal deficit target. Absent a more decisive systemic approach, credit growth seems unlikely to provide much support over the next 12 months. A positive development here is the main risk to our 2018 outlook.

Craig Botham – Emerging Markets Economist – Schroders