Deflation,winners and losers

In sharp contrast,Europes economic recovery appears to be gathering pace. The latest fillip to the markets was Germanys trade data,which showed a 3.8% (month-on-month) rise in exports in June and a trade surplus of almost $19 billion. The Eurozone economy grew just 1% in the second quarter.

The problem is that much of this growth has been driven by exports and it is far from certain that these will hold up given the slowdown in the US. Apart from Germany,most EU economies are struggling to keep their growth in a positive territory. Meanwhile the sovereign debt and banking crisis that continues to unfold in Europe is deflationary as it drives the contraction in bank credit and exacerbates balance sheet restructuring. Overall growth is only likely to be 1.0-1.5% in 2010.

So how will the Brics fare in a global environment characterised by low inflation and anaemic growth in the US and Europe? Deflation will likely drive all Bric markets lower in the near term,reflecting a flight to quality and heightened risk aversion on the part of investors. But the Bric economies should show considerable resilience in adjusting to these developments. Not least because domestic consumption has played a large role in the recovery of the Bricsretail sales have picked up,unemployment has decreased and consumer confidence has improvedand will continue to do so.

Specific country outcomes depend on their exposure to external deflation via exports and commodity prices,which are likely to decline further. By these measures,India stands to benefit while China will be adversely affected,with Brazil and Russia falling somewhere in between.

Chinas exports are concentrated mainly in the developed world and their composition is also concentrated towards manufactures,making China relatively more vulnerable to deflation in the EU and the US. Russias exports are most vulnerable because they are concentrated in Europe and dominated by oil and gas. Brazils exports are somewhat less vulnerable because of broader geographical markets,but they remain highly concentrated in terms of composition with agricultural commodities and iron ore accounting for half of the exports. Indias exports are least vulnerable to deflation because of their diversity.

For China,deflation in the US and Europe and weaker external demand,dramatically increases pressure on policymakers to reduce excess capacity and accelerate long-delayed economic reforms of land and labour market to spur domestic demand drivers. But these take time. Instead,Beijing has started to relax monetary policy to support growth,which continues to slow. In July,industrial production grew just 13.4%,the lowest year-on-year growth in 11 months,imports rose at the lowest pace in nine months,the property market is cooling and retail sales growth is slowing.

Brazil and Russia will see a deterioration in their terms of trade. In Russia,the negative of lower oil prices is balanced by several positives,including a continued fall in domestic inflation and the benefit of lower import prices on the countrys retail sector. In Brazil,strong domestic demand will cushion the drop in external demand. High real interest rates will attract foreign capital into domestic fixed-income instruments and help stabilise the currency,but inflationary pressures remain high.

On balance,external deflation is more positive for India than it is for China. India is less dependent on exports to developed markets than China while lower oil prices will ease the governments fiscal burden associated with subsidies on domestic fuels and fertilisers. External deflation may also reinforce policymakers determination to press on with ambitious goals to sustain rapid growth despite existing high rates of inflation.

Bric growth will continue to be driven by domestic demand,not by developments in developed country markets. This does not imply,however,that we will see an immediate rush of portfolio capital flows into the Brics. This will require confidence among investors that the Bric growth story remains intact and that the policy is on the right track.

In India,the Bric country with the most to gain in the current environment,policymakers must do more to get ahead of the curve on inflation. That may not be an easy task,but is certainly much less difficult than the challenge facing China,the country most at risk,which must now move forward with reforms to rebalance the economy.

The author is a director at Trusted Sources,the Emerging Market research specialist