LONDON (Reuters) - Pledges of reform in emerging markets have encouraged investors this year, but Brazil’s vote against any change at the top of its government is raising questions over whether the reforms will be delivered in hyped-up markets like India and Indonesia.
Leftist Dilma Rousseff won re-election as Brazil’s president by a slim margin over business favorite Aecio Neves. Her Workers’ Party is credited with lifting 40 million Brazilians out of poverty, but investors want to see bold pro-business measures to reverse the country’s deepening economic funk.
Brazil illustrates the challenges of the developing world. As economic growth and foreign investment slow, many countries are being pressed to cut deficits, ditch handouts and privatize - popular measures with investors, but fiercely opposed by poor voters who rely on subsidized food and fuel.
Markets showed their disappointment with the election result. Brazil’s currency, the real, suffered its worst selloff in a decade. Shares of Brazilian companies, some of the biggest in emerging markets, fell 5 to 10 percent on Monday, wiping $20 billion off the Bovespa index.
The Brazil outcome may well dispel the perception that many emerging governments are lining up aggressive economic reforms, says Bhanu Baweja, the head of emerging markets strategy at UBS.
Such expectations have brought billions of dollars into emerging markets, partly reversing last year’s selloff. India has taken in $35 billion and Indonesia $14 billion so far in 2014 from stock and bond investors cheering the election of pro-business leaders in both countries, for example.
“Amidst weakening earnings and growth, one of the issues that EM investors were pinning their hopes on was a wave of reform. The hope was that Brazil would follow India and Indonesia in moving towards policies that enhance and sustain long-term growth,” Baweja told clients.
That money will be getting jittery after the Brazil vote, he said. Consequently, emerging-market stock and bond indexes are likely to underperform developed peers this year, because Brazil is a major component in most benchmarks.
Morgan Stanley also warns of possible spillover from the election. The bank argues that the emerging-market asset class, fragile because of slower investment flows and growth, is only as strong as its weakest links. It cites Brazil, Turkey and South Africa.
“Like in India and Indonesia, an economic adjustment that reduced external balance sheet and structural risks is possible but needs a change in strategy from (Brazil),” they said in a note. “To the extent that such a strategy is less likely, the vulnerability of emerging markets as a whole has risen.”
Emerging-market equities were up 10 percent in dollar terms earlier this year as investors returned, lured by reform pledges in a range of countries, including China. India and Indonesia have been star performers, having surged 20 percent. For the most part, the promises are on track.
India has moved this month to slash fuel subsidies that cost it tens of billions of dollars every year. Indonesia has mooted ambitious subsidy cuts that could save it $13 billion. Both are also reforming their coal miners, vital for power generation.
But risks have become evident - Indonesian markets for instance, fell sharply this week on signs the government may have to put off tackling fuel subsidies.
“Markets react to the promise of reform, but if you don’t maintain the pace, you get a very negative reaction,” said Kerry Craig, global strategist at JPMorgan Asset Management.
In some cases, investors have already priced successful reforms into asset prices. Indian energy and infrastructure sharesare up 35 to 60 percent this year, for instance, and trade at exalted valuations, 20 to 30 times the expected earnings of the companies.
“Markets are forward-looking - they react to the promise of reform and to future earnings. You are paying for what you may get in future,” Craig said. “So if (governments) don’t deliver, markets will react.”
Investors say, however, they are aware of the balancing act governments must perform to keep voters happy while convincing markets of their intention to boost business.
In India, for instance, Prime Minister Narendra Modi shows no intention of dismantling a “right to work” law that guarantees at least 100 days of employment each year to every rural household. Critics of the law say it is a burden on taxpayers, fuels inflation and encourages corruption.
In Brazil, opposition candidate Marina Silva’s first-round poll lead over Rousseff ebbed as fears grew among poorer voters that she would do away with popular welfare programs.
Some pullback is therefore possible.
“It would be political suicide to remove things like (the Indian jobs scheme)” said David Cornell, a portfolio manager at India-focused boutique fund, Ocean Dial. “Modi is a capitalist, but he recognizes the need to keep the social machine moving.”
“There are an awful lot of things that need an awful lot of fixing in these countries and it is never going to happen at the pace investors want it to happen,” he said.
Reporting by Sujata Rao; Editing by Larry King