Eurasia Group Outlook

New phase of politics will lead to emerging markets divergence

Originally published in the June 2013 issue

Politics will matter more than ever in emerging market countries (EMs), and much has to do with the fact that many EMs are entering a fresh cycle of politics defined by three new realities.

First, the era of economic abundance that preceded the financial crisis, and even defined the year subsequent to the crisis, is now coming to an end, with meaningful policy repercussions. Second, a decade of rapid economic growth fostered a middle class with new political grievances and demands which is radically altering the requisites of political survival. Third, unorthodox economic policies currently at play in the developed markets encourage EMs to experiment but give no clear examples of policy effectiveness. All of these factors demand increased attention from investors, as they herald greater policy divergence in EMs over the coming years. Some countries will respond with constructive economic policies which will surprise investors positively, while others are likely to be mired in growing governance difficulties which will inevitably translate to poor policy. Much will depend in particular on the interplay between the level of political capital incumbents have – which allows policymakers to make decisions without having to worry about near-term political survival – and the extent of the economic slowdown in their countries.

After 10 years of unprecedented growth, EMs are much better prepared to weather an economic slowdown today than they were, for example, two decades ago: insolvency risk is minimal for most EMs as debt-to-GDP ratios are generally low, and central banks command large reserve cushions to support their economies and defend their currencies. Even so, EM policymakers must suddenly come to terms with growth rates that are lower than what they have been over the past decade. Given the compelling development challenges and rising expectations, even a modest slowdown in growth could generate significant pressure on the political class. The slowdown from near 9% yearly GDP growth to 6%–7% in countries such as India and China, for example, has generated significant concern within their respective leaderships about the ability to meet growing social expectations over the medium and long term. More broadly, a reduction in average growth rates of EMs from 7.5%–8.5% before the 2008-2009 global financial crisis to an average growth rate closer to 5%–7% will have important political repercussions.

That probably means policymakers are likely to be less complacent than in past years. One of the more important policy repercussions of higher growth in the EMs is that it reduced the incentives to advance additional economic reforms to boost productivity, competitiveness, and economic efficiency. Investors and pundits often criticize countries such as India, Brazil, Russia, or even China for having “wasted” an opportunity to conduct tough reforms during a period of abundance and growth. But that misses the crucial difference between good policy and good politics. From a political perspective, good times usually weaken the incentive to enact difficult reforms. As seen in Europe today, policymakers begin to consider painful adjustments only when the near-term costs of inaction become disastrously high. While minimal insolvency risk in the EMs and the current environment of abundant liquidity means that reforms will not be as deep as the structural adjustments of the 1990s, reforms will be back on the agenda.

The second reason to believe EMs are entering a new cycle of politics stems from socioeconomic changes in their societies. Economic growth has created new constituencies and, in many cases, new grievances and demands. The most striking change is the emergence of a new middle class accustomed to rapidly increasing income. The political implications of a rising middle class will be significant. In China, the growth of the middle class will probably represent the greatest test of governance of all EM countries, as this constituency confronts a closed political system at a time when there is a looming challenge of rebalancing the economy toward domestic consumption. In Russia, a middle class that emerged during the oil-boom years is now turning on the government of President Vladimir Putin, giving rise to a new, if still small, protest movement that has raised fresh questions about Putin’s legitimacy.

Finally, economic policy signals from developed economies will increase the unpredictability of policy in emerging markets. With central banks in Europe, the US, and Japan showing unprecedented monetary heterodoxy, and Europe engaging in a rancorous debate about the merits of fiscal austerity, economic policies in developed markets no longer serve as a steady benchmark for policymakers in emerging markets. That means developed markets will provide ample justification to either engage in more expansive fiscal policy to buttress growth, or experiment with new tools of monetary policy.

That is not to say EM policymakers will radically alter how they have been managing their economies – they will first and foremost enact policies according to lessons learned from their own economic histories. But greater experimentation in EMs should be expected going forward precisely because of the economic difficulties and policy divergence in developed economies.

All of the above suggest that politics will increasingly drive economic policy in years to come. But how policymakers respond to these new challenges will depend on the interplay between the extent of their countries’ economic slowdowns and the level of political capital they have at their disposal. The concept of political capital comprises several factors, including the level of popular support, the degree to which incumbents face an organized opposition, and the extent to which incumbents are hostage to vested economic interests capable of opposing government policy. The political calendar also matters, as elected governments early in their terms tend to have greater room to manoeuvre than those approaching elections. Broadly measured, political capital reflects leaders’ ability to make difficult adjustments during a period of relative economic difficulty.

Political capital directly affects two key policy dimensions: the ability to adjust to a slowdown by pushing forward reforms that increase the country’s growth potential and the propensity to engage in aggressive economic stimulus measures. Broadly speaking, incumbents with high political capital are more likely to respond to economic stresses by advancing a new round of economic reforms, and less likely to take aggressive stimulus measures to stoke growth.

Incumbents with less political capital, meanwhile, are less likely to advance economic reforms, or will face a harder time getting them approved if they attempt to do so. In addition, they are more inclined to stimulate growth with measures that stretch the boundaries of macroeconomic prudence.


Among the larger EMs, Brazil, Mexico, and the Philippines have incumbents with the highest degree of political capital. In all four countries, incumbents benefit from high levels of public support, face little opposition, or are early in their respective terms in office. As a result, the prospects for reform and macroeconomic prudence are accordingly good. That said, there are some important distinctions.

Mexico, which has the most positive outlook, is the only major EM willing and politically able to enact structural reforms that can materially increase the country’s growth potential. The sense of urgency amongst policymakers in Mexico is probably driven by the fact it didn’t benefit from the same cycle of high growth many other EMs did during the past 10 years. But with President Enrique Pena Nieto and his Institutional Revolutionary Party (PRI) assuming office with a strong mandate, he is likely to be able to work with the conservative National Action Party (PAN) opposition to approve a constitutional reform that would open the energy sector to foreign investment.

The policy outlook is a bit more mixed in Brazil. On the one hand, there is a more positive reform agenda than most investors appreciate. President Dilma Rousseff enjoys an extremely high approval rating and a reliable base of congressional support. Progress on tax reform and the privatization of logistics infrastructure reflect her administration’s economic pragmatism. As economic constraints grow the policy environment will likely become more constructive and market-friendly. Such a transition, however, may take longer than anticipated. While efforts to tame inflationary pressures through tax reductions will help keep inflation low this year, it also exacerbates the risk of entering 2014 – an election year – with higher inflation and little fiscal room to manoeuvre. In addition, with Rousseff still enjoying sky-high approval ratings, the administration probably under-appreciates the extent to which sentiment has soured in the private sector and could negatively impact the robustness of the recovery.

Economic reform will play out over the longer term in the Philippines as well, albeit for different reasons than in Brazil. President Benigno Aquino III has strong support and faces no organised opposition, giving him the political capital to push through reform. But robust remittance growth and foreign inflows reduce the urgency for reform. For now, government is focused on executing infrastructure investments and public/private partnerships (PPPs). If the economy falters, however, Aquino would be wary of excessive stimulus. Instead, he would likely expedite PPPs, simplify tax breaks for foreign investors, or even revisit a constitutional amendment that would remove restrictions on foreign investment in key sectors.

Leaders in China and Russia, meanwhile, have more modest reserves of political capital. The political leadership of both countries has a great deal of power in principle, but must contend with the constraints of maintaining centralised power and balancing privileged interests and support groups. The outlook for reforms and propensity to engage in more ambitious economic stimulus is accordingly mixed.

China probably has the largest governance challenges over the medium to long term. A new leadership takes the helm at a time of critical policy challenges – most importantly rebalancing the economy away from an over-reliance on investment-oriented sectors to one based on domestic consumption. And China’s leaders must do so while balancing strong vested economic interests and growing demands from a rising middle class. While the new regime is likely to accomplish modest progress on rebalancing the economy in areas such as energy pricing, the unwillingness to undertake political liberalization will seriously constrain China’s capacity to engage in broader reform that runs contrary to vested interests in the powerful capital-intensive and export-oriented sectors. The silver lining in the short run is that the leadership is likely to continue to show restraint on measures to stimulate the economy for fear of exacerbating the imbalances generated by the stimulus package introduced after the 2008–2009 crisis.

In Russia, Putin remains firmly in control and faces almost no institutional or structural checks on his power. But he faces new discontent from a disaffected urban middle class and economic growth is slowing. Absent substantive reforms, Russia is unlikely to achieve Putin’s 5-6% growth target (the economy ministry has already lowered its forecast for 2013 to 2.4%). Putin could in theory implement reforms quickly if he had a change of heart, but with the middle class abandoning him, the exigency of maintaining his support among elites and the working class restricts his ability to manoeuvre. This leaves government resorting to stimulus rather than reform to solve Russia’s near-term economic challenges. Potential stimulus measures include a weakening of the so-called budget rule and pressure on banks to compress their margins.

India and South Africa have governments with low political capital, so governance challenges there are likely to only rise. Their leaders lack popular support and face significant opposition. There is little prospect for reform, and greater danger of imprudent stimulus measures.

India certainly demonstrates that policymakers with weak political capital can indeed attempt to press forward with investor-friendly reforms. But many of the policies have little chance of being substantively implemented, without being watered down, if legislative approval is required. Prime Minister Manmohan Singh recently announced an increase in domestic diesel prices, opened multi-brand retail to foreign direct investment, and is likely to expand the partial privatization of a number of state-owned enterprises, all of which are positive. But the extremely fractious nature of Indian politics will not only limit the practical implementation of these measures.

The larger problem, however, is that the upcoming election cycle is unlikely to grant any incumbent a fresh mandate to push forward much needed reforms. While it is too early to say what governing coalition will emerge in the general elections that must be held by mid-2014, it is clear that disparate regional and state parties with highly parochial and sometimes retrograde agendas will gain unprecedented clout, forcing the new government to rely on a motley group of coalition partners to muster a parliamentary majority. Consequently, the outlook for structural economic reforms and significant fiscal consolidation is bleak.

Of all the countries considered here, South Africa’s leadership has the weakest political capital. President Jacob Zuma from the ruling African National Congress (ANC) faces significant pressure from within his own party and from wildcat strikes in the mining sector, along with growing public discontent with stubbornly high unemployment rates and economic inequality. Recent bouts of labour unrest reflect waning popular support for the ANC and its trade union allies. Although Zuma is still likely to win re-election as ANC president at the party’s congress in December, the policy environment for 2013 will deteriorate regardless of who emerges as the ANC candidate. The traditionally conservative Treasury and central bank will most likely lose clout as social pressures empower the party’s more populist factions in the run-up to general elections in 2014. Consequently, a slow and steady deterioration in fiscal accounts is likely, particularly if growth does not rebound to near 4%, as is more state intervention in strategic sectors such as mining. All of the above raises the odds of future credit rating downgrades.

EMs are moving into an environment of fresh domestic and global challenges in which politics will be the dominant factor shaping economic outcomes. As a result, over the next several years, policy divergence within these countries will lead to greater economic divergence as well. Investors with exposure to these markets therefore need new criteria to help them anticipate the intentions and capabilities of EM policymakers. The existing taxonomies of EMs – the alphabet soup of BRICS, CIVETS, and N11s – make for catchy names, but they do not capture the political drivers that will increasingly cause these countries to diverge in economic performance. More than ever, politics will dictate whether investors are going to face more negative or positive surprises at an individual country level.

Christopher Garman is the head, Alexander Kliment the director, and Jonathan Dill the researcher in Eurasia Group’s Emerging Market Strategy group. Eurasia Group is a global political risk research and consulting firm. For more information, please visit or email