Are the BRICS+ investable?

Horizons article
September 26, 2023

A few weeks ago, the BRICS, an intergovernmental organization by Brazil, Russia, India, China and South Africa became the BRICS+ by adding Argentina, Egypt, Ethiopia, Iran, Saudi Arabia and the United Arab Emirates. For investors, the rise of the BRICS+ raises the question whether these emerging markets are actually investable. Russia, of course, is no longer investable for most investors and increasingly, so is China. But what about the rest of them? Better yet, how should we think about investing in emerging markets more generally? Surprisingly, we find that economic growth is not a predictor of investment opportunity in emerging markets. Political instability, a well-known risk, is equally overrated. Instead, investors should pay more attention to the details of the changes occurring within these countries.

Conventional wisdom among investors about emerging markets is that economic growth (as measured by the growth of “gross domestic product” or GDP of a country) creates investment opportunities. Yet there is solid scientific evidence to suggest this is not true. The following graph shows that for emerging markets, the correlation between economic growth and stock market returns is actually insignificant. The most likely explanation is that economic growth does not necessarily boost the profitability of businesses, which is what investors like to see:

Source: Jason Hsu, Jay Ritter, Phillip Wool, and Yanxiang Zhao. "What Matters More for Emerging Markets Investors: Economic Growth or EPS Growth?" The Journal of Portfolio Management 48, no. 8 (2022): 11-19.

If not economic growth, what matters for emerging markets? Before we continue to look at these countries themselves, it is important to notice that emerging markets only seem to attract a significant amount of capital when investors find developed markets too expensive. For example, if investors find little investment opportunity in American or European markets, they are more likely to allocate capital to cheaper less-developed Asian or Latin American markets. See the following graph, in which the difference between the stock prices of emerging markets versus developed markets is highly correlated to the performance of emerging markets:

Courtesy of Robeco

When it comes to investing, however, we should never merely focus on the potential of higher returns. After all, with higher returns comes higher risk. Indeed, many investors pay little attention to emerging markets because of the perceived higher level of risk that comes with weak political systems, which may lead to unpredictable policy changes, violence between ethnic groups and unstable currencies. However, it is important to see many of these perceived risks are not necessarily relevant to stock market returns. Somewhat surprisingly, the political risk that is relevant for investors seems to be highly concentrated in a single type of risk: a government that does not protect the freedom of the market.

Research suggests that the highest level of volatility in stock market prices occurs whenever investors fear aggressive government interventions in the economy (see references at the end of the article for examples from the United States, Germany, Hong Kong and Poland). What follows is that whenever governments take more action to protect the freedom of the market, their stock markets should perform relatively well. Indeed, there is solid academic research that supports this view. In the following graph, we can see that in the period from 1970 to 2000 (the more up-to-date Economic Freedom Index which we use later in this article was created later on in 1995) stock market returns were highly correlated with economic freedom, which here is mainly measured by the level of regulations for credit lending by banks as well as for other businesses:

Source: Stocker, Marshall L. "Equity Returns and Economic Freedom". CatoJournal 25, no. 3 (2005): 583-594.

The crucial question for investors is, if an emerging market has a government that protects the freedom of the market, how are its businesses actually benefiting from this? To answer the question, we should turn to the work of the Japanese author Kaname Akamatsu. In 1962, Akamatsu presented the “flying geese” theory. He argued that the rise of Asia should be understood as a pattern in which the leading country (the “leading goose” being Japan) takes over production processes from western countries and, as the country grows more advanced, eventually moves this less-advanced production to its lesser developed neighbors (South Korea, Singapore, Taiwan and Hong Kong) – and the pattern continues. The leading goose of our time is China: its businesses have benefited from production moving away from the western world as well as from Japan and South Korea. A key question for the future is which country is most likely to take over production processes from China to become the next leading goose of Asia.

Let us take our findings and apply them to the two most probable candidates: India and Indonesia. In recent years, India has become investors’ favorite emerging market because of its large, young and growing population, which is a sign of its high economic growth potential. However, as we have shown, if this is why you invest in India, you are taking significant risk with your capital. Perhaps more importantly, despite India’s opening up to the world in the previous two decades, the country still ranks relatively low in the index of economic freedom, behind countries like Angola and Niger – and it has not made any progress in recent years. This does not bode well for the future of Indian markets:

Source: The Heritage Foundation, The Wall Street Journal

As we can see in the graph, Indonesia (which has declined to join the BRICS) ranks relatively high on the index of economic freedom (60th compared to India’s 131st, ahead of countries like Italy and Mexico). Meanwhile, Indonesia’s relationship with China has grown stronger in recent years. An important aspect of their relationship is that China’s world leading businesses in batteries (CATL) and electric vehicles (BYD) are investing in Indonesia to support the Indonesian government’s policies of building domestic battery- and electric vehicle production facilities. Interestingly, Indonesia attracts far less attention from investors than India.

All of this shows that investors should reconsider some of their core assumptions about emerging markets. Instead of focusing on economic growth (for returns) and political stability (for risk), investors should pay more attention to the attractiveness of emerging markets versus developed markets, as well as to the details of the changes occurring within these countries. Most importantly: are governments taking action to protect the freedom of the market? And if so, in what way are the country’s businesses benefiting from this?

  • Akamatsu, Kaname. "A Historical Pattern of Economic Growth in Developing Countries." The Developing Economies 1 (1962): 3-25.
  • Bittlingmayer, G. "Output, Stock Volatility and Political Uncertainty in a Natural Experiment: Germany, 1880-1940." Journal of Finance 53 (1998): 2243-2257.
  • Chan, Y.-C., and Wei, J.K.C. "Political Risk and Stock Price Volatility: The Case of Hong Kong." Pacific-Basin Finance Journal 4 (1996): 259-275.
  • Chen, Carl R., and Ying Sophie Huang. "Economic Freedom, Equity Performance, and Market Volatility." International Journal of Accounting & Information Management 17, no. 2 (2009): 189-197.
  • Hsu, Jason, Jay Ritter, Phillip Wool, and Yanxiang Zhao. "What Matters More for Emerging Markets Investors: Economic Growth or EPS Growth?." The Journal of Portfolio Management 48, no. 8 (2022): 11-19.
  • Kutan, A.M., and Zhou, S. "Political Turmoil and Financial Market Behavior in Reforming Market-Oriented Economies: The Case of Poland." Applied Economics 25 (1993): 757-763.
  • Robeco, The alpha and beta of emerging markets equities, April 2022
  • Stocker, Marshall L. "Equity Returns and Economic Freedom." Cato Journal 25, no. 3 (2005): 583-594.


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