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Emerging Markets Struggle

Brazil’s government debt is now rated junk, only seven years after it gained investment-grade status. The country’s currency is plunging yet recent trade surpluses have become trade deficits twice the size due to the crash in commodity prices. As capital flees, the economy is facing its biggest recession in at least a generation. To the north, Venezuela is sinking under its worst-ever crisis – inflation exceeds 1,000% and the economy is expected to shrink 10% this year. Mexico’s currency is at its weakest since redenomination in 1993 due to the plunge in oil prices.

In Asia, China’s financial sector is fragile, economic growth could well halve from the double-digit rates of recent years, capital is departing and the country is running through foreign reserves to support the yuan. Malaysia is strained as the price of its oil, gas and palm oil exports drop. The debt-heavy country’s ringgit is trading at 17-year lows. Turkey’s economy is stagnating, its currency is diving and inflation looms as a threat. Not far away, Russia’s economy is contracting at a 5% clip after a currency crisis sparked by sanctions and lower oil prices battered consumer and business spending.

Other emerging countries, from South Africa to Indonesia to Argentina, are struggling too. What could fix these countries? Economists and others suggest many cures. These countries, they say, could stop relying on cheap currencies and one main export, typically a commodity. They could empower domestic competition by curtailing oligopolies and monopolies. They could implement tax reform. But to look only at economic solutions is to miss the underlying ill in emerging countries. It’s politics that’s the core problem. Leaders in many of these countries are autocrats who preside over crony-based scandal-prone states where institutions are weak and economic incentives are warped. The autocratic nature of such governments will need to give way to a more liberal democratic system before these countries can develop a sustainable economic model.

To be sure, a sound political system is no guarantee of wealth and Singapore appears to have done well for decades under an autocratic government. Many democracies in advanced countries are defective – the EU, for instance, was built against the wishes of voters – and many have weak institutions – look at Greece’s inability to collect taxes. It could be argued that some of the struggling emerging countries such as Brazil have democracies no more flawed these western ones. Political progress has been made in the emerging world as shown by how eastern Europe and Latin America are now home to democracies rather than the dictatorships of a generation ago. It’s just that they and other emerging countries need to further evolve their political systems. Time has shown that liberal democracy best promotes the public institutions that allow economies to flourish over the long term and that it’s the political system that best implements reforms.

Solid institutions?

What does a country with good institutions look like? It’s one with a competent, honest and impersonal bureaucracy at every level of government, where a driver’s licence is issued after testing rather than due to a $100 bribe slipped in an official’s hand. Education standards are high enough to ensure that bureaucracies are staffed with adept people. Functioning utilities offer everything from clean water to reliable power. It boasts a proper public health system. The police force is honest, capable and more powerful than organised crime. Civilians have control of the military, not the other way around. The tax burden is fair and the system treats everyone equally to ensure confidence and compliance. Public finances are transparent. Rule of law prevails because the judiciary is independent. The media is free.

A country with good institutions is essentially one where the “government governs,” as US academic Samuel Huntington (1927 to 2008) described it in his 1968 book, “Political order in changing societies”.1 By this he meant that if rulers make a decision it’s implemented through the bureaucracy in an impersonal way. For that to happen, a country must be a political community. The political system must be seen as legitimate. Leaders and citizens must share a vision of the public interest and they must agree on the principles on which politics is based. Political institutions such as the constitution and political parties must be robust and public participation high.

These descriptions certainly don’t depict most countries in developing Asia, Africa, peripheral Europe and Latin America. Many of the leaders in these countries usurped power or have perverted the democratic process to remain in control. In many emerging countries, the barrier to a unified and functioning political system is that people are more tied to tribal, religious, ethnic or cultural groupings rather than to states drawn up by colonial powers, states that have no natural coherence. In other countries such as Thailand, it’s rural poor versus city elites that are poisoning politics and the development of institutions. In places such as Russia its oligarchs, who got rich by looting the country, who are contaminating politics.

Such politically illegitimate rulers can’t build proper institutions or be banished easily. Venezuela’s incompetent and corrupt ruling Socialist Party, for instance, has monopoly control of the judiciary, military, legislature and executive and will be hard to remove from power even via an election due on December 6 because it has gerrymandered the electoral system, controls government financing and media and could extend its rule by decree if it loses the vote. In corrupt Mexico, drug cartels are beyond the control of authorities including the military. Turkish President Recep Tayyip Erdogan is destroying the country’s parliamentary democracy and its institutions to prolong his rule.

The combination of a lack of institutions and murky politics breeds the graft that is such a hallmark of the emerging world, as global corruption rankings show.2 Among the countless corruption allegations swirling in the emerging world, Brazil’s President Dilma Rousseff is skirting with impeachment over a multi-billion-US-dollar bribery scandal. Malaysia’s Prime Minister Najib Razak is fighting off graft allegations over suspicious deposits worth nearly US$700 million in his personal account. In Guatemala, Perez Molina in September was forced to step down as president amid allegations he accepted bribes to issue tax breaks that cost the government US$100 million in tax revenue. South Africa’s President Jacob Zuma is mired in scandals including one over a state-funded home renovation.

The countries that are home to proper institutions generally operate as western liberal democracies such as Australia. The free association, free media, rule of law, stability, flexibility and wealth accumulation provided by the liberal democratic system cultivates such institutions over time. Somehow emerging countries need to fix their political systems to create the public order their societies and economies need to flourish.

The reform edge

Emerging countries must enact reforms to fix their economies, societies and politics. Western democracies barely appear to be models of how to implement the changes needed to encourage the dynamism and innovation that drives capitalism. Upper houses, often appointed or elected under a different voting system than that of lower houses, block legislation. Minority governments often fail to achieve the necessary numbers on the floor of parliaments. Pressure groups have perfected the technique of rallying enough opposition to block changes. Vested interests use their money to influence the political process. Short-term political imperatives always seem to trump the long-term public interest. The centre appears to be disappearing in many countries including the US as the fringes of politics radicalise.

Such challenges are systemic of how hard it is to instill reform. Change is difficult because it creates winners and losers. (“Win win” situations are mostly spin.) The histories of liberal democracies, however, show change is possible over time, even if it is more incremental than ideal and the changes are often compromises that please no one. The losers will generally accept their defeat if the process is transparent, they had a fair hearing, elected officials moulded the outcome, basic rights are protected by the system and people have faith that governments are operating for the greater good. (Losers are far harder to placate if courts decide an outcome.)

The problem for emerging countries is that vested interests are powerful enough to thwart adjustments that threaten their wealth. Typically no one is more in thrall to these power blocs, whether it be business groups, oligarchs or the military, than the autocrat in charge. Despots are often more trapped in the short term than elected leaders because these insecure rulers have to survive each day, not until a poll in three years’ time.

China under its one-party dictatorship provides two glaring examples of how hard reform is in autocracies. The first surrounds its ambition to become a modern consumption-driven economy. To do this, Beijing needs to correct the mispricing of the key ingredients of economic growth; namely, land, labour and capital (or money, broken down into the exchange rate and interest rates). But a free-floating yuan that rose would upset the many politically influential, state- and military-owned companies that export or compete against imports. Higher wages would rattle the export and import-competing sectors in the same way. Liberalising interest rates poses a challenge to the banks, companies and local governments that now enjoy artificially low interest rates. Tackling the corrupt grabbing of land across China will smash the finances of local governments and the profits of developers.

Another big challenge confronting Beijing is fixing bloated state companies. These giants often require propping up as they misallocate capital and stifle the innovation, entrepreneurship and competition that China needs to modernise. But revamping state companies is almost impossible for the Communist Party of China because it would be removing a major prop to its power and a major source of employment for party members.

China is just one of the many emerging countries failing to embark on political reform. President Xi Jinping, who only took charge in 2013, has used an anti-corruption drive to purge rivals and is already regarded as the most powerful leader since Mao Zedong. But some developing countries are strengthening their political systems and their institutions. Brazil’s judicial success in pursuing the scandal involving state energy company Petroleo Brasileiro that could lead to Rousseff’s impeachment shows checks and balances are gaining more sway over Brazilian society.

Guatemala’s Molina was driven from office by international (and US-backed) anti-corruption bodies and protesters there are calling for more reform. Malaysia’s opposition is showing backbone. Venezuela’s election could herald political change for the better. In many emerging countries, the expanding middle class is pressuring governments to improve its governance and services. These are the shifts to watch to see which emerging countries will overcome their economic troubles. by Michael Collins, Investment Commentator at Fidelity

1. Samuel P. Huntington. “Political order in changing societies.” Yale University Press. 1968. Page 1. 2. Transparency International. Corruption perceptions index 2014: results.

Financial information comes from Bloomberg unless stated otherwise.

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Reproduced with permission of Fidelity Australia

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Emerging countries are struggling

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