Project Report on Risk Premium Analysis of BRIC Nations As Compared To India

SUBMITTED TO: IIPM, BHUBANESWAR GUIDED BY: - PROF. PRIYABRATA PRUSTY

SUBMITTED BY:Batch-Spring Summer Year- 2009-11

SHIVANI PANDA

ACKNOWLEDGEMENT
We acknowledge with gratitude and appreciation, our indebtedness to our mentor & guide, Prof Priyabrata for allowing us to work on a very intrinsic part of aviation sector, Risk Premium Analysis of BRIC Nations as compared to India we also thank his for the ideas and basic concepts he delivered and shared with us, as they helped us a lot in accomplishing this project.

It gave us enormous gratification to articulate our thankfulness and heart full sense of indebtedness to our dearest friends for the great support in completion of this project

ABSTRACT

Its not hard to see why Brazil, Russia, India and China (BRICs) have been the favorites of emerging markets investors for some time now. The BRIC economies, which encompass over 25% of the worlds land mass and house 40% of the worlds population within their borders, have been growing at a very impressive clip for the last 7 to 10 years.

In fact, a number of these economies offer value, growth and solid profitability, but they also come with some challenges such as liquidity, inevitability, transparency and volatility to name a few. However, before looking at the specifics of what smaller emerging and frontier markets can offer investors, its worth noting that such markets are still a bit of a world unto themselves in terms of performance and how investors initially view them.

Nonetheless, the rise of the emerging markets is more than just a BRIC story. Investors, while maintaining a core exposure to the BRIC economies, should not close their eyes to other growth areas in the emerging world.

CONTENTS
Page no. 1 2
Introduction India
Conventional growth model Global financial crises and its impact on India Centralized derivative clearing Factors affecting capital market in India 1 1 1 3 5 6 10 14 19 23 27

About BRIC
Details look at BRICs potential

4 5 6 7 8

Russia China Brazil Appendix References

INTRODUCTION
INDIA
India's growth model is unique when compared to China and other emerging Asian countries. A domestic focus offers greater stability and flexibility. India's domestic demand driven growth has left it relatively insulated from global downturns as witnessed during the ongoing recession and during the East-Asian crisis in the late 1990s. In India, private consumption accounts for 57% of GDP compared to 35% in China. Not only has this resulted in less volatile growth, but also meant that India has had to bring in a relatively smaller stimulus to pull its economy back into high growth gear. While China's stimulus package was around 6% of its GDP, India's measured about 3%. Furthermore, China relied heavily on its banking sector to extend credit, leading to fears of an impending asset bubble. Another advantage of being less dependent on exports is the lower need for managing foreign exchange rates. In contrast to the developed economies, India's working age population is set to expand by

138 million over the next 10 years, with 26.7% of that population projected to be under the age of 15 in 2020. China faces the risk of becoming old before becoming rich. Although China is expected to

add 33 million to its work pool over the same period, its demographics do not appear so favorable. While its population is ageing (population over 65 is expected to rise from 9.1% in 2008 to 12.4% in 2020), the one child policy since 1979 has arrested population growth. China's population grew 0.6% in 2009 compared to 1.4% in India and 1.2% in Brazil.

BYPASSING THE CONVENTIONAL GROWTH MODEL

India is now focusing on growing its manufacturing sector. India skipped the conventional growth model of Agriculture > Manufacturing > Services, jumping directly into services from being an agri-based economy. Much of the growth over the past decade has been led by India's service economy as illustrated by the development of IT industries.

Over 20 years the services sector has come to dominate the Indian economy, while the manufacturing sector's share to the GDP has declined. However, India needs to develop its manufacturing base further to create jobs for its large and growing labor pool.

India is gearing itself to benefit from manufacturing outsourcing's next wave. As opposed to China, India missed the first wave of outsourcing of the manufacturing value chain characterized by a need to mass produce goods at low cost. The next outsourcing wave, however, is expected to be in the production of high value goods requiring skilled workers and a sound environment for intellectual property rights protection; India is well positioned to offer both. Policy makers in India also are now according higher priority in an attempt to boost the manufacturing sector and achieve well rounded growth. Development of Special Economic Zones (SEZ) is helping India to become a manufacturing hub for high-value products. Exports of high value goods such as IT hardware, engineering goods, auto components, leather, gems and garments from SEZs grew over 122% to USD49.5 billion in 2009-10. SEZs largely export IT, IT hardware, petroleum, engineering, leather and garments.

GLOBAL FINANCIAL CRISIS: IMPACT ON INDIAN MARKETS

Before the world was slashed by the financial tsunami, global economies were

characterized by low interest rates, abundant liquidity, booming stock and real estate markets and low volatility. The financial crisis started with the sub-prime crisis in the US, and deepened with the collapse of Lehman Brothers, one of the largest financial institutions in the US. The problem was further aggravated by certain developed and developing economies slipping into a recession.

The impact of the financial crisis on the markets and the relative behavior of BRIC in comparison the developed markets of the US & the UK have been plotted below. All index prices are indexed to 100. Movement of key markets during Financial Crisis

Until July 2007, all the markets showed a positive correlation. From July 2007 to January 2008, BRIC markets continued to outperform their developed counterparts in the US and Europe and investors started to lose confidence in the value of securities mortgages. However, all markets hit their all-time highs during this period.

In January 2008, the collapse of major financial institutions jolted stock markets globally. The slowdown in global economic activity clearly indicated that the much-hyped decoupling theory was just that, a theory. Markets across the world witnessed stock prices tanking, foreign

money flowing out, currencies depreciating, and growth in some economies slowing down while most of the developed world went into a recession that threatened to spiral into a 1930stype depression

Market Performance MTD - May 2010 .

Country

May -10

USA UK

-11.2% -9.3%

China India

-8.5% -5.8%

Financial markets in India had outperformed the developed markets as well as most of the BRIC markets, except China, in 2007. The liquidity squeeze the enveloped markets at the beginning of 2008 made FIIs, which account for a large portion of trading investments on Indian bourses, to pull out their investments; the market plummeted by over 50% in 2008. In 2009, buoyed by bailout packages FIIs returned to the Indian markets wooed by the countrys longterm growth story; the market zoomed over 70% in 2009. However, May 2010 onward, markets have been on a downward spiral as the European debt crisis started to play out, but from the India angle, things still look better as its markets outperformed those in the US, the UK and in other BRIC countries.

CENTRALIZED DERIVATIVES CLEARING

In contrast to organized market-based trading, the over-the-counter (OTC) market is a decentralized one, where participants trade among themselves and not on a central exchange or platform. The trades are executed /negotiated over telephone or electronic networks instead of the stock exchanges. Instruments traded on the OTC include currency swaps, options, interest rates, equities and commodity derivatives, and credit default swaps.

The OTC market grew rapidly in the 20th century due to advancements in communication technology, de- regulation, a shadow financial system in which the non-banking financial institutions played a crucial role in lending money to business to operate, and off balance sheet financing. Banks and large institutions, such as investment banks and hedge funds, are the prominent players in these markets. Derivative trades on the OTC have grown at tremendous pace over the past decade, from a total notional amount of USD80 trillion to USD600 trillion at the end of December 2009. The money at stake is almost 10 times the global GDP.

According to Bank for International Settlements (BIS) estimates, global OTC derivatives contracts traded are eight times that of exchange-traded derivatives. These trades present a risk to the financial system if either party fails. In addition, OTC trades intensify counter party risk, add to complexity and reduce clarity of the interconnections in the financial system. This became apparent in September 2008, when the US market collapsed and big names such as Lehman Brothers and AIG felt the heat; Lehman went under, while AIG was placed on life support. Bruised badly by the global financial turmoil, regulators across countries have been discussing the need to strengthen OTC derivative trading norms. Main exchanges in the US and Europe are planning to implement trading and clearing functions for OTC derivatives. This would facilitate a stable and smooth transaction framework that will help lower risk. Central Counter Party clearing is a stabilizing element of sound market infrastructure. In 2009, several new CCPs for Credit Default Swaps (CDS) were introduced, such as the ICE Trust (owned by the Intercontinental Exchange) in the US, and the ICE Clear Europe, Eurex Credit Clear and LCH Clear net in Europe.

In the OTC market, transactions are routed across players in a multi-wire form, whereas in CCP, all transactions are routed through one central clearing party. This reduces risk, increases transparency and efficiency.

Outstanding OTC Derivatives

Factors affecting capital market in India:The capital market is affected by a range of factors. Some of the factors which influence capital market are as follows:-

A) Performance of domestic companies:The performance of the companys or rather corporate earnings is one of the factors which have direct impact or effect on capital market in a country. Weak corporate earnings indicate that the demand for goods and services in the economy is less due to slow growth in per capita income of people. Because of slow growth in demand there is slow growth in employment which means slow growth in demand in the near future. Thus weak corporate earnings indicate average or not so good prospects for the economy as a whole in the near term. In such a scenario the investors (both domestic as well as foreign) would be wary to invest in the capital market and thus there is bear market like situation. The opposite case of it would be robust corporate earnings and its positive impact on the capital market.

The corporate earnings for the April June quarter for the current fiscal has been good. The companies like TCS, Infosys, Maruti Suzuki, Bharti Airtel, ACC, ITC, Wipro, HDFC, Binani cement, IDEA, Marico Canara Bank, Piramal Health, India cements , Ultra Tech, L&T, Coca- Cola, Yes Bank, Dr. Reddys Laboratories, Oriental Bank of Commerce, Ranbaxy, Fortis, Shree Cement ,etc have registered growth in net profit compared to the corresponding quarter a year ago. Thus we see companies from Infrastructure sector, Financial Services, Pharmaceutical sector, IT Sector, Automobile sector, etc. doing well. This across the sector growth indicates that the Indian economy is on the path of recovery which has been positively reflected in the stock market. B) Environmental Factors:Environmental Factor in Indias context primarily means- Monsoon. In India around 60 % of agricultural production is dependent on monsoon. Thus there is heavy dependence on monsoon. The major chunk of agricultural production comes from the states of Punjab, Haryana & Uttar Pradesh. Thus deficient or delayed monsoon in this part of the country would directly affect the agricultural output in the country. Apart from monsoon other natural calamities like Floods, tsunami, drought, earthquake, etc. also have an impact on the capital market of a country. The Indian Met Department (IMD) on24th June stated that India would receive only 93 % rainfall of Long Period Average (LPA). This piece of news directly had an impact on Indian capital market with BSE Sensex falling by0.5 % on the25th June. The major losers were automakers and consumer goods firms since the below normal monsoon forecast triggered concerns that demand in the crucial rural heartland would take a hit. This is because a deficient monsoon could seriously squeeze rural incomes, reduce the demand for everything from motorbikes to soaps and worsen a slowing economy. C) Macro Economic Numbers:The macroeconomic numbers also influence the capital market. It includes Index of Industrial Production (IIP) which is released every month, annual Inflation number indicated by Wholesale Price Index (WPI) which is released every week, Export Import numbers which are

declared every month, Core Industries growth rate (It includes Six Core infrastructure industries Coal, Crude oil, refining, power, cement and finished steel) which comes out every month, etc. This macro economic indicators indicate the state of the economy and the direction in which the economy is headed and therefore impacts the capital market in India. A case in the point was declaration of core industries growth figure. The six Core Infrastructure Industries Coal, Crude oil, refining, finished steel, power & cement grew6.5% in June, the figure came on the23 rd of July and had a positive impact on the capital market with the sensex and nifty rising by388 points &125 points respectively. D) Global Cues:In this world of globalization, various economies are interdependent and interconnected. An event in one part of the world is bound to affect other parts of the world; however the magnitude and intensity of impact would vary. Thus capital market in India is also affected by developments in other parts of the world i.e. U.S. , Europe, Japan , etc. Global cues includes corporate earnings of MNCs, consumer confidence index in developed countries, jobless claims in developed countries, global growth outlook given by various agencies like IMF, economic growth of major economies, price of crude oil, credit rating of various economies given by Moodys, S & P, etc. An obvious example at this point in time would be that of subprime crisis & recession . Recession started in U.S. and some parts of the Europe in early 2008 .Since then it has impacted all the countries of the world- developed, developing, and less- developed and even emerging economies. E) Political stability and government policies:For any economy to achieve and sustain growth it has to have political stability and pro- growth government policies. This is because when there is political stability there is stability and consistency in governments attitude which is communicated through various government policies. The vice- versa is the case when there is no political stability .So capital market also

reacts to the nature of government, attitude of government, and various policies of the government. The above statement can be substantiated by the fact the when the mandate came in UPA governments favor ( Without the baggage of left party) on May 16 2009, the stock markets on Monday , 18th May had a bullish rally with sensex closing 800 point higher over the previous days close. The reason was political stability. Also without the baggage of left party government can go ahead with reforms. F) Growth prospectus of an economy:When the national income of the country increases and per capita income of people increases it is said that the economy is growing. Higher income also means higher expenditure and higher savings. This augurs well for the economy as higher expenditure means higher demand and higher savings means higher investment. Thus when an economy is growing at a good pace capital market of the country attracts more money from investors, both from within and outside the country and vice -versa. So we can say that growth prospects of an economy do have an impact on capital markets. G) Investor Sentiment and risk appetite:Another factor which influences capital market is investor sentiment and their risk appetite .Even if the investors have the money to invest but if they are not confident about the returns from their investment, they may stay away from investment for some time. At the same time if the investors have low risk appetite, which they were having in global and Indian capital market some four to five months back due to global financial meltdown and recessionary situation in U.S. & some parts of Europe, they may stay away from investment and wait for the right time to come.

About BRIC
BRIC nations already account for a quarter of worlds land mass and are a home to almost half of global population. They control about 13% of the global trade volume and have over 41% of the world's foreign exchange reserves.

Their single-minded pursuit of growth, inherent strengths in terms of demographics and domestic demand, access to vast natural resources, intent to reduce dependence on traditional trading partners in the west... are some of the reasons why BRIC bloc has emerged as a single most important group to watch out for in the second decade of this century.

If BRIC nations get their act together then the geo-political clout they would enjoy on the global stage, would be unprecedented in the history.

SAME BASKET, BUT APPLES AND ORANGES BRIC nations together account for a quarter of worlds land mass and little short of half of global population. They control about 13% of the global trade volume and have over 41% of the world's foreign exchange reserves. Between 2002 and 2007, annual real GDP growth averaged 10.4% in China, 7.9% in India, 6.9% in Russia and 3.7% in Brazil. In addition, they are worlds largest developing nations with huge demographic advantage and fast-growing middle class population compared to developed nations. They withstood the shock of global financial crisis and escaped relatively unscathed. Given the trend of last decade, the BRIC countries could be calling shots in the future even if their growth curves are likely to take highly divergent trajectories.

Economic Size _ In less than 40 years, the BRICs economies together could be larger than the G6 in US dollar terms. By 2025 they could account for over half the size of the G6. Currently they are worth less than 15%.

_ In US dollar terms, China could overtake Germany in the next four years, Japan by 2015 and the US by 2039. Indias economy could be larger than all but the US and China in 30 years. Russia would overtake Germany, France, Italy and the UK.

_ Of the current G6 (US, Japan, Germany, France, Italy, UK) only the US and Japan may be among the six largest economies in US dollar terms in 2050.

Economic Growth

_ India has the potential to show the fastest growth over the next 30 and 50 years. Growth could be higher than5%over the next 30 years and close to 5% as late as 2050 if development proceeds

_ Overall, growth for the BRICs is likely to slow significantly over this time frame. By 2050, only India on our projections would be recording growth rates significantly above 3%.

Incomes and Demographics

_ Despite much faster growth, individuals in the BRIC sare still likely to be poorer on average than individuals in the G6 economies by 2050. Russia is the exception, essentially catching up with the poorer of the G6 in terms of income per capita by 2050. Chinas per capita income could be similar to where the developed economies are now (about US$30,000 per capita). By 2030, Chinas income per capita could be roughly what Koreas is today. In the US, income per capita by 2050 could reach roughly $80,000. _ Demographics play an important role in the way the world will change. Even within the BRICs, demographic impacts vary greatly. The decline in working-age population is generally

projected to take place later than in the developed economies, but will be steeper in Russia and China than India and Brazil.

Global Demand Patterns

_ As early as 2009, the annual increase in US dollar spending from the BRICs could be greater than that from the G6 and more than twice as much in dollar terms as it is now. By 2025 the annual increase in US dollar spending from the BRICs could be twice that of the G6, and four times higher by 2050.

Currency Movements

_ Rising exchange rates could contribute a significant amount to the rise in US dollar GDP in the BRICs. About 1/3 of the increase in US dollar GDP from the BRICs over the period may come from rising currencies, with the other 2/3 from faster growth. _ The BRICs real exchange rates could appreciate by up to 300% over the next 50 years (an average of2.5%a year). Chinas currency could double in value in ten years time if growth continued and the exchange rate was allowed to float freely.

A More Detailed Look at the BRICs Potential

We have already highlighted some of the most striking results, though there are many other intriguing aspects. The tables and charts set out the key features of the projections, summarizing them in 5-year blocks. They show average GDP growth rates, income per capita in

US dollars, the real exchange rate and the main demographic trends. In each economy, as development occurs, growth tends to slow and the exchange rate appreciates. Both rising currencies and faster growth raise US dollar GDP per capita gradually and the gap between the BRICs and developed economies narrows slowly.

The impact of demographics varies, with labor force growth contributing relatively more to growth in India and Brazil and detracting from growth in Russia, where the US Census projections show the labor force shrinking quite rapidly. Where labor force and population growth is rapid, income per Capita tends to rise more slowly as higher investment is needed just to keep up with population growth.

To illustrate the shift in economic gravity, we also make comparisons with the G6. To do that, we use a less sophisticated version of the same model to project G6 growth. We assume a common 2% labor productivity growth rate across the G6, so differences in projected GDP growth are purely a function of demographics (and real exchange rates remain roughly stable). A shrinking working age population appears to be the biggest issue in Japan and Italy, whose growth rates are lower than the others, and the smallest issue in the US, which maintains the fastest growth. Our G6 projections allow us to compare the paths of GDP and GDP per capita in the BRICs with that of the more advanced economies in a common currency.

The shift in GDP relative to the G6 takes place steadily over the period, but is most dramatic in the first 30 years. The BRICs overtake the G6 through higher real growth and through the appreciation of BRICs currencies. About 1/3 of the increase in US dollar GDP from the BRICs over the period may come from rising currencies, with the other 2/3 from faster growth.

We also look explicitly at where new demand growth in the world will come from. While it takes some time for the level of GDP in the BRICs to approach the G6, their share of new demand growth rises much more rapidly. Because it is incremental demand that generally drives returns, this measure may be particularly useful to assess the extent of opportunities in these markets.

We measure that new demand growth as the change in US dollar spending power in the various economies, so again it incorporates both growth and currency effects. On these measures, the BRICs come to dominate the G6 as a source of growth in spending power within 10 years. Taking each of the economies in brief:

Brazil.
Over the next 50 years, Brazils GDP growth rate averages 3.6%. The size of Brazils economy overtakes Italy by 2025; France by 2031; UK and Germany by 2036.

China.
Chinas GDP growth rate falls to 5% in 2020 from its 8.1% growth rate projected for 2003. By the mid-2040s, growth slows to around 3.5%. Even so, high investment rates, a large labor force and steady convergence would mean China becomes the worlds largest economy by 2041.

India.
While growth in the G6, Brazil, Russia and China is expected to slow significantly over the next 50 years, Indias growth rate remains above 5% throughout the period. Indias GDP outstrips that of Japan by 2032. With the only population out of the BRICS that continues to grow throughout the next 50 years, India has the potential to raise its US dollar income per capita in 2050 to 35 times current levels. Still, Indias income per capita will be significantly lower than any of the countries we look at.

Russia.
Russias growth projections are hampered by a shrinking population (an assumption that may be too negative). But strong convergence rates work to Russias benefit, and by 2050, the

countrys GDP per capita is by far the highest in the group, and comparable to the G6. Russias economy overtakes Italy in 2018; France in 2024; U Kin 2027 and Germany in 2028. Although we focus on the BRICs, as the four largest developing economies, we do not mean to suggest that development elsewhere is not important. In the box on p11, we look at what our approach says for South Africa and the African region and other larger developing economies could also become important.

Are the Results Plausible?

The projection of a substantial shift in the generation of growth towards the BRICs is dramatic. Is it Plausible? We have looked at three main ways to cross check the forecasts, all of which give us broad comfort with the results.

First, the forecasts for GDP growth in the next 10 years are not out of line with the IMFs assumptions of potential growth in these economies (roughly 5% for Russia, 4% for Brazil, 8% for China, 5-6% for India). With the exception of Brazil, our projected growth rates are also close to recent performance. Brazils performance would have to improve quite significantly relative to the past.

Ensuring the Conditions for Growth This historical exercise highlights a critical point. For our projections to be close to the truth it is important that the BRICs remain on a steady growth track and keep the conditions in place that will allow that to happen. That is harder than it sounds and is the main reason why there is a good chance that the projections might not be realized. Of the BRICs, Brazil has not been growing in line with projections and may have the most immediate obstacles to this kind of growth. It provides a good illustration of the importance of getting the necessary conditions in place.

Research points to a wide range of conditions that are critical to ensuring solid growth performance and increasingly recognizes that getting the right institutions as well as the right policies is important. These are the things that the BRICs must get right (or keep getting right) if the kinds of paths we describe are to be close to the truth. The main ingredients are:

_ Sound macroeconomic policies and a stable macroeconomic background:

Low inflation, supportive government policy, sound public finances and a well-managed exchange rate can all help to promote growth. Each of the BRICs has been through periods of macroeconomic instability in the last few decades and some face significant macroeconomic challenges still. Brazil for instance has suffered greatly from the precariousness of the public finances and the foreign borrowing that it brought about.

_ Strong and stable political institutions:

Political uncertainty and instability discourages investment and damages growth. Each of the BRICs is likely to face considerable (and different) challenges in political development over the next few decades. For some (Russia most obviously), the task of institution-building has been a major issue in recent growth performance.

_ Openness.

Openness to trade and foreign direct investment has generally been an important part of successful development. The openness of the BRICs varies, but India is still relatively closed on many measures.

_ High levels of education.

Higher levels of education are generally helpful in contributing to more rapid growth and catch-up. The LR growth estimates above are based on a strong connection between secondary schooling and growth potential. Of the BRICs, India has the most work to do in expanding education.

Russia
Our well-known BRICs projections imply a rosy long-term future for Russias economy. Not only could it be the largest economy in Europe before the middle of this century but, alone among the BRICs, Russia has a real chance of catching up with living standards of the current G7, increasing its per capita GDP eleven-fold in constant Dollar terms between 2006 and 2050. We believe this is possible despite the dramatic projected population decline (from 142mn people to 109mn in 2050) and despite a steady decline in the average annual real GDP growth rate from 4.3% in 2006-2015 to 1.5% between 2045 and 2050. The BRICs dream is not even a best case Scenario, in fact, Russias recent performance has been considerably better than projected in the original BRICs papers. But it does assume that the necessary conditions for longrun growth are in place, conditions that we have tried to capture in our Growth Environment Scores (GES). Russia scores well above the emerging market mean on education, government

deficit and external debt; marginally above average on openness and life expectancy; lower but still above average on technology (phones, PCs and internet access per capita); and somewhat below average on inflation, which is now in the high single digits. By far Russias worst scores relative to the mean are in political and institutional variables: the rule of law, corruption and political stability. We estimate that if Russia were to move to the .best in class. Among emerging markets on its overall GES score, its growth rate would be 200bp per year higher than today. If it were to move to the .best in class on all the variables except for the political and institutional ones, it would gain only 136bp, forgoing 64bp per year in additional growth, and an amount that over time would compound into a substantial difference. The GES scores highlight the benefits for growth that the country is likely to enjoy thanks to the key achievements of Putins government: restoring the country to solvency, improving macroeconomic management and imposing institutional stability after the chaotic 1990s. But they also make clear that, over the long term, Russias highly centralized political framework is unlikely to be a recipe for the kind of sustained growth that would make the BRICs dreams a reality.

Structural Reforms and Their Limits Russias strong economic performance and financial recovery over the last eight years owes a lot to rising oil prices and the extremely favorable tail-winds from high global growth. But Putins economic policies also deserve some of the credit for proceeding with structural reforms, saving rather than spending the oil windfall, and promoting diversification of the economy through tax policy. Thanks to the backing of a strong legislative majority, the government was able to push through reforms early in Putins administration that under Yeltsin had met with unyielding resistance. Since 2004, however, strong economic growth and high oil revenues have sapped some of the reform momentum of the early Putin years.

After a decade of large budget deficits, the government has run fiscal surpluses every year since 2000, paying down external debt and more recently accumulating a $141bn oil stabilization fund. The budget surpluses were considerably larger than planned, thanks to the unexpectedly rapid rise in oil prices, and government spending is gradually catching up with the higher revenues. But finance minister Kudrin, with the personal backing of the President, deserves credit for fighting off repeated efforts by a range of political forces to spend the surpluses. Kudrin's goals have been economic: first, to repair the countrys balance sheet and enable companies to borrow, later to prevent pro-cyclical spending from driving up inflation, accelerating the real appreciation of the currency and causing the onset of .Dutch Disease... The minister has also been very skeptical of the Russian states ability to spend money effectively. But Putins support for tight fiscal policy appears to be motivated as much by politics as economics: the reduction of debt and the accumulation of fiscal reserves has reduced the country's and by extension, his regimes vulnerability to a possible downturn in oil prices and other potential external shocks. Lastly, after the tumultuous years of political upheaval, macroeconomic volatility and rapidly shifting property ownership in the 1990s, Putins firm grip on power has given the country a degree of stability and predictability, which in turn has stimulated the beginnings of a recovery in investment. Capital investment grew by an average of +11% between 2000 and 2006, compared with -11% annually in the previous seven years. In the first eight months of 2007, it has accelerated further to around +22%yoy. This has come despite the YUKOS case and a handful of other examples of property expropriation and discriminatory tax treatment. Inward foreign direct investment has also risen, from 0.9% of GDP in 1993- 1999 to 1.8% of a much larger GDP in 2000-2006. On the other hand, the current political framework has also ruled out certain other structural reforms. The clearest example is the oil and gas sector. The states desire to retain control over Gazprom has caused it to reject reformers efforts to unbundle transportation from production or to liberalize independent gas producers access to the pipeline system. This is despite inefficiencies in the current system and an imminent shortage of gas on the domestic market.

Since 2004, the state has also expanded its control in the oil sector through asset purchases and renegotiation of earlier contracts (we estimate that more than 65% of the sector remains in private hands, down from 95% in 2003). In our view, the Kremlin wants to maintain control of the oil and gas sector not because it believes that state ownership is more efficient but because it is concerned about the sector falling into the hands of its political opponents. Those hands could be domestic or foreign. Worrying that the west is seeking to subvert Russias political stability, the Kremlin has drafted legislation restricting foreign investment in certain strategic sectors of the economy and in large natural resource deposits. Russia is far from being the only country to restrict foreign investment and insist on a high degree of state ownership in the energy sector; in fact, in recent years that has become the rule rather than the exception, particularly in emerging markets. It should also be understood that the bulk of Russias oil is still produced by private companies, some of them with foreign participation. But the cost of mounting state involvement in the sector has been to discourage investment and to slow the growth in oil and gas sector output, and also to create distortions elsewhere in the economy. The trend towards state control has gone beyond natural resources. The Kremlin has supported the creation of state-sponsored national champions in a number of sectors, including weapons manufacturing, civil aviation and most recently ship-building. From an economic point of view, we see those moves as an example of misguided industrial policy is an effort to use the states abundant resources to resuscitate segments of the Soviet industrial legacy that have not attracted the interest of domestic or international investors rather than part of any grand plan to expand the state management of the economy as a whole. Thus far, the economic costs of state intervention have been concealed by the strong recovery in the private sectors of the economy and high commodity prices, although there has already been a striking slowdown in oil production growth. Over time, however, we believe that state ownership could divert resources from productive areas of the economy to unproductive ones, as it has done in other countries in the past. The inefficiency of the non-tradable sector in turn would be likely to lead to overvaluation of the real exchange rate and a decline in economic competitiveness of the economy as a whole. We believe that if state ownership continues to grow and curbs on foreign investment remain in place, Russia will have considerably more trouble achieving the long-term possibilities outlined

in our BRICs projections. The good news is that we would expect the political elite eventually to respond to declining growth rates by reversing course and returning assets to private hands.

China
Output Growth Forecast Economic growth will be affected by a combination of forces, including the demographic transition, rapidly improving human capital and the further release of surplus labor from the agriculture sector. We show in the following analysis that output growth should hold up well after accounting for the last two factors, as well as a potential easing of the one-child policy. We project real GDP growth in three scenarios:

Scenario 1 is the baseline case and does not account for any human capital acceleration or further reduction of rural-labor migration barriers. It implicitly assumes that China will undergo a modest accumulation of human capital, and sees no change in the urbanization or one-child policy. This estimate is similar to our BRICs projections.

Scenario 2, we take into account the rapid acceleration of education attainment going forward, and allow rural surplus laborers to migrate more freely from 2006. The potential policy environment needed for the second scenario seems to be shaping up well.

Scenario 3 takes into account an improvement in labor quality and the release of surplus labor from the agricultural sector, and assumes a phase-out of the one-child policy beginning in 2010, with details consistent with the proposal discussed above. The extensive review that has been conducted on the one-child policy suggests that the policy will be modified. Hence, we are inclined to think that Scenario 3 is the most likely of the three. Scenarios 2 and 3 take into account both an overall increase in labor supply and a higher quality labor force, suggesting an even more bullish growth prospect than Scenario 1, or our original BRICs estimates. In particular, Scenario 3 demonstrates that the easing of the one child policy will likely further accelerate total GDP growth by 12 basis points and have a limited negative impact on per-capita GDP income. This is because a greater proportion of the added population will be in urban areas and thus will enjoy better educational opportunities. Improvement in average labor quality will ultimately outweigh the burden from the increasing dependent population and help sustain overall growth, especially towards 2050.

Rich but Not Richest

Together, these results suggest that by the time China becomes old, it should be fairly developed, but still not richer than the US or Japan in terms of per-capita income. Richness is usually defined in relative terms, while economic development is both an absolute and relative concept. Generally, an economy is considered to have achieved developed status upon its accession into the OECD. An effective rule of thumb has put per-capita income of $10,000 as the threshold of developed country status. Economies above this line are fairly developed, and are often consistent in sectoral composition of output, urbanization, life expectancy, national wealth, capital stock per labor hour, education and service-sector development, etc. For China, this day may not be too far away. Our analysis shows that by the time China becomes an aged society in 2027; its per-capita GDP should have surpassed $10,000 (in 2005 terms) in all scenarios. However, even by 2030, the most optimistic scenario suggests that per capita GDP could reach nearly $22,000 (2005

prices), but stay well below BRICs estimates of per capita GDP in the US ($61,000), Japan ($60,000) and Germany ($51,000) of that year. In summary, our study on Chinas future labor supply has the following implications: In the medium term, demographic deficits will likely be counterbalanced by an unusually rapid accumulation of human capital and a further release of rural surplus laborers In the longer run, growth will likely hold up well as the country ages. By the time it is old, China will be considered a developed economyalthough it will probably be poorer than many developed countries. Our BRICs projection of real GDP growth may have some further upside, if China adopts a favorable policy mix to address the labor issues. A potential easing of the one-child policy after 2010 would help boost long-term growth, especially towards 2050.

China has a long way to go to accumulate more capital

Despite 27 years of fast growth and a formidable economy in aggregate size, China remains a low-income country on a per capita basis, with many of the countrys 1.3bn people underemployed in rural areas. Therefore, it is not surprising to find that Chinas capital-

to-labor ratio is still a fraction of that in the US and Japan, while the capital-to-output ratio is in line with the US, but significantly below Japan. Further capital deepening will be a crucial part of the development process. Our BRICs research projects that, by 2035, the size of the Chinese economy may be 17 times what it was in 2004 in nominal US Dollar terms (or six times in real CNY terms), and may surpass the US to become the worlds largest economy. Assuming the capital-stock-to-output ratio stays constant until then, China would need to expand its total capital stock by 11 times in US Dollar terms. Moreover, if the capital-stock-to-GDP ratio needs to rise further in the medium term, the investment-to-GDP ratio would need to be even higher.

Chinas Investment Strength Is Sustainable

China still has a big deficit in urbanization-related investment. Notwithstanding fast industrialization, the degree of urbanization is low, with nearly 60% of the population still living in rural areas. Industrialization without urbanization is a unique Chinese phenomenon, the legacy of decades of government policies that segregated urban and rural labor markets. Reforms since 1978 have gradually set the course for urbanization, and its pace has accelerated in the last few years, alongside waves of powerful demand for FAI. Looking forward, we believe that .pent-up. demand for urbanization will not only sustain investment demand for longer, but will also be one of the most important factors affecting the global economy in the next few decades, not least through its impact on industrial and soft commodities. This process will likely involve substantial investment in infrastructure and housing-related projects, such as electricity, water and waste treatment systems, as well as residential property. Most of the FAI in recent years has gone to the non-tradable sectors. This type of investment facilitates urbanization and further increases in consumption as incomes rise. We see substantial scope for this to continue, despite some likely bumps along the road.

Total domestic demand appears to be far from overheated, and can expand further without running into supply constraints. Therefore, the key macro policy challenge has remained the same since early 2003: will China slow excessive growth in its trade surplus, preferably through a currency appreciation.

Brazil
One way to measure Brazils progress is through the prism of our Growth Environment Scores (GES). Among the BRICs, Brazil showed the largest gain in our 2006 GES scores, moving up seven places, to an overall score of 4.15. However, the increase was not large enough to enable Brazil to catch up with its peers in the BRICs, with China and Russia posting increases to 4.9 and 4.35, respectively. While Brazils growth has lagged, the other BRICs have outperformed our estimates of their potential growth rates. We think Brazil falls short relative to the other BRICs in four areas: savings and investments are low; the economy is too closed to trade; the quality of education must improve; and institutional reforms are needed. Since 2003, Brazil has made progress towards putting in place the foundations for growth, with particular emphasis on achieving macroeconomic stability. Stabilization has paid off: inflation has fallen, the external accounts are less vulnerable to external shocks and some progress has been made on reducing the public debt. However, stabilization has come at a high price. Real GDP growth has

averaged only 2.7% since 2003, with the adjustment explaining in part why actual growth rates were lower than the rate of 3.7% used in our BRICs studies. Since 2003, inflation has averaged 7.8%. With inflation declining to 3.0% in 2006, a strong and credible central bank should continue to help Brazil reduce the level and variance of inflation. The success of the inflation-targeting regime should gradually reduce nominal interest rates and develop credit markets; over time, this should stimulate growth. Brazil has also strengthened its external accounts significantly, using its large balance of payments surpluses to reduce its stock of total external debt by one-third, to 18.1% of GDP in 2006, and to bolster its net international reserves almost sevenfold, to US$83bn. In contrast, progress on the fiscal front has been disappointing. Although the Lula administration raised the primary fiscal surplus to 4.25% of GDP, Brazil still has the second-highest nominal fiscal deficit among the BRICs, and the largest stock of total public debt. The bulk of the fiscal adjustment has been achieved by raising taxes, making the tax burden much higher than elsewhere in the BRICs. As the indicators of macroeconomic conditions for growth in Brazil are directly linked to its fiscal performance, they are not as favorable as for the other BRICs. In particular, we note that the investment and savings ratios are extremely low when compared with those in China and India. Although the labor force may continue to grow faster in Brazil than in China and Russia, the secular trend is declining and thus is no longer a strong source of growth for the country. Brazil has broadened its trade platform since the late 1990s. But with its trade share amounting to just less than 25% of GDP, the country is far more closed than China (where trade is almost two-thirds of GDP) or Russia (41% of GDP). Labor productivity has lagged markedly, largely owing to the deficiencies in the quality of education.

If we proxy education by the average number of years of secondary education, Brazil ranks below China and Russia. Brazil has fared relatively better on the technological capabilities front, particularly by increasing internet access and PC access faster than most BRICs other than Russia, and by rapidly expanding telephone access. Brazil has made important progress in developing its political institutions, due to a great extent to its remarkable stability. Even so, political institutions and the nascent democracy are still evolving, and the atomization of power inherent in the complex multi-party political system is a large obstacle to rapid implementation of structural reforms. Corruption has also been a problem, draining budgetary

resources, undermining the quality of public services and leading to frequent stalemates in Congress, which in turn often stalls progress on the reform front. Brazils overall legal framework and judicial system compare reasonably well with its BRICs peers, but we believe that they should be modernized and made more efficient, so as to better suit the needs of an open and free-market-oriented economy. The conclusions from this brief cross-country comparison are clear. In order for Brazil to raise its growth rates and converge towards its peers in the BRICs, the Lula II administration will have to focus on fiscal policy, trade policy, education and modernizing institutions.

REFERENCES

1) www.calloptionputoption.com 2) www.sharetipsinfo.com 3) www.bseindia.com 4) www.indiansharemarket.net 5) www.world-newspapers.com 6) www.stockmarketsreview.com 7) www.bloomberg.com 8) www.wall-street.com 9) www.bmfbovespa.com 10) www.bestbrazil.org