Dilma’s Smoke, Modi’s Mirrors

For most of the first-half of this year, investors in developing economies had a spring in their step. The bond and equity markets in countries known as emerging markets (EMs) enjoyed a surge in inflows because of expectations that the world’s main central banks, including the U.S. Federal Reserve, would maintain their ultra-loose monetary policies. The excess capital floating around had to go somewhere, and the higher-yielding bond markets of Brazil, Indonesia, Mexico, and other EMs still seemed like an attractive place to park their money.

And investors had good reason to have faith in these countries. The prospects for meaningful reforms in EMs — in particular public finance and labor market reforms as well political and institutional overhauls to root out corruption and improve governance — looked bright following the overwhelming victory of the business-friendly Narendra Modi in India’s month-long parliamentary election that ended on May 16. In the first five months of this year, India’s main equity index surged 15 percent. In July, investors were given another reason to cheer when Joko Widodo, the popular governor of Jakarta, won Indonesia’s presidential election on promises of far-reaching political, institutional, and structural reforms. Indonesian stocks have risen by a whopping 24 percent this year.

For a while, it seemed like Brazil was about to follow suit. In the closest and most bitterly fought presidential election in recent memory, Dilma Rousseff — the country’s center-left president who is deeply mistrusted by both financial markets and most members of Brazil’s business community because of the interventionist policies that were the hallmark of her four years in power after taking over from her popular predecessor, Luiz Inácio Lula da Silva — won the run-off on Oct. 26 by the skin of her teeth.

Rousseff’s victory was enough to spook an already jittery financial community. Brazil’s stock market had bounced up and down like a yo-yo during the last two months of the presidential campaign because of uncertainty about whether Rousseff would win. The staggering 37 percent rise in the Bovespa, Brazil’s main equity index, between mid-March and early September showed the extent to which investors can get ahead of themselves.

The day after the election, the real, Brazil’s currency, slid to a nine-year low against the dollar. Brazilian stocks, which have fallen 11 percent over the past three months because of fears that Rousseff would win, dropped nearly 3 percent. And the impact of Rousseff’s victory is being felt far beyond South America. By winning re-election, she set back the cause of economic reform in EMs around the world. In the space of five months, "Modi mania" has given way to "Rousseff revulsion."

To be sure, sentiment towards EMs was already deteriorating by early September because of renewed fears that the Fed was likely to start hiking interest rates sooner than anticipated. The rate-sensitive yield on two-year U.S. Treasury bonds, which has been a reliable gauge of investors’ appetite for increasing their exposure to so-called "risk assets" (such as EM equities and bonds), shot up from 0.41 percent on Aug. 15 to nearly 0.59 percent on Sept. 24.

After falling sharply in the first half of October because of mounting fears about the threat of deflation, particularly in Europe, it has since risen again and now stands at 0.51 percent as investors once again bet that a strengthening U.S. economy will force the Fed to tighten monetary policy in the middle of next year. If market interest rates rise, in particular short-term interest rates, this is a sign that there is a stronger likelihood that official interest rates will soon go up.

This means markets are likely to remain volatile in the coming months, with investors forced to pay more attention to countries’ economic fundamentals, such as inflation and balance of payments, which are invariably glossed over during periods of low volatility.

For EMs, this is not the best time to be under closer scrutiny. Following Rousseff’s victory, two uncomfortable truths about developing economies have been brought into sharp relief: First, the politics of economic reform matter as much — if not more — as the reforms themselves. Second, the quality and credibility of economic governance matters hugely.

Rousseff won Brazil’s election because she was able to portray her two main opponents in the campaign as enemies of the poor who, if elected, would have endangered Bolsa Familia, the popular social welfare scheme set up by Lula da Silva in 2003 which has lifted millions of Brazilians out of poverty. The experience of Enrique Peña Nieto, Mexico’s president since December 2012 and probably the most radical reformer among the leading EMs, is an even more cautionary tale. Despite undertaking a sweeping overhaul of the energy sector, Peña Nieto has managed the politics of economic adjustment badly. Not only did his fiscal policies contribute to the sharp slowdown in Mexico’s economy last year, he is perceived by many Mexicans to be living in an ivory tower, aloof from the drug-related violence and crime ravaging the country. The lesson here is that while Peña Nieto may be a bold economic reformer, Rousseff just got re-elected because she was more attentive to the everyday concerns of ordinary Brazilians.

On the policy side, things are even tougher for EM presidents and prime ministers. Brazil is stuck with excessively tight monetary policy — the central bank was forced to hike interest rates on Oct. 29 to a punishingly high 11.25 percent in an attempt to shore up confidence — and a lack of faith in Rousseff’s economic policies. India, on the other hand, has a dream team in place following Modi’s victory in May’s parliamentary election: a central bank led by the highly regarded Raghuram Rajan, whose inflation-fighting credentials have allowed it to reduce interest rates and an inspiring and charismatic prime minister who has already started to liberalize energy prices and appears committed to fiscal and structural reforms.

And yet, overall, the stocks of developing economies have fallen 7.5 percent over the past three months (15.5 percent in the South America) mostly due to a deterioration in EM growth prospects and concerns about the fallout from a rise in U.S. interest rates. But this pessimism is unwarranted. While the resurgence of the dollar will keep EM currencies under pressure, bond markets have been faring relatively well due to the strong presence of domestic institutional investors who, unlike their foreign counterparts, are less likely to reduce their holdings of debt when market conditions deteriorate.

Even in Brazil, there are signs that Rousseff will appoint a more market-friendly finance minister in the coming weeks with a view to placating markets. The Bovespa has already risen 7.5 percent since the election. Investors may be taking the view that Rousseff’s second can’t possibly be any worse than her first. Still, her victory has thrown the challenges of implementing reforms in EMs into sharper relief. It has been a cold shower for those investors who were giddy with excitement after Modi’s victory.

The lessons are clear: Investors should lower their expectations — even if business-friendly candidates win elections — and should pay more attention to the politics of economic reform. As Rousseff’s win demonstrated, the fear of change can be as important as the yearning for it.