Understanding The Risk In The BRICs

When Goldman Sachs economist Jim O'Neil first dubbed the four nations of Brazil, Russia, India and China as theBRICs, back in 2001, he made one of the gutsiest long-term global macroeconomic calls of all time. Featuring the right demographics, vast commodity wealth, growing middle classes and relatively steady fiscal andmonetary policies, O'Neil postulated that these nations would be the biggest drivers for future global growth. So far, the economist's prediction has generally come true. The MSCI BRIC index has risen by more than eight times what the S&P 500 index returned during the past decade, and the BRIC's combined GDP soared to $13.3 trillion last year.

That outperformance has prompted many investors to add the four horsemen of the developing world to their portfolios as a way to cash in on the group's torrid growth. Despite the rosy long-term growth picture for the BRICs, there are plenty of risks, aside from the global macroeconomic pressures in these nations. In the end, these nations aren't called "emerging" for nothing.

With the BRICs continuing to contribute so much to the global economy and with the nations making up a huge portion of emerging market assets, it is critical for investors to understand these risks. Yet, each of the four nations is a completely different animal and comprehending the differences in each of their risk profiles can be a daunting task. Here are some of the internal risks when investing in the BRICs.

A Dragon of Lies
When it comes to emerging market investing as a whole, China remains at the top of many investors' minds. After all, the nation represents the hallmark of the developing market thesis. However, investing in Asia's Dragon economy isn't as easy as buying stock in Germany. 

Perhaps the biggest problem is the lack of GAAP or international accounting standards. That issue has even caught some of the best investors by surprise. For example, billionaire hedge fund manager John Paulson lost a bundle on Toronto-listed Chinese forestry firm Sino-Forest Corp. It was accused of faking land holdings and "cooking the books." Others have been accused of falsifying bank deposits and accounts. That lack of transparency and disclosure of information makes it a lot harder to see the real picture, especially compared with developed market stocks.

That picture gets even muddier when investors are forced to deal with questionable official Chinese data and a heavily regulated/bureaucratic communist government. The majority of the major firms in the nation are in some way owned or controlled by Beijing.

Russia's Corruption Woes Despite the nation's recent entry into the World Trade Organization (WTO), there are still somesignificant investment risks in Russia; corruption and political will are the two biggest. Bribes and organized crime infiltrating legitimate businesses remain standard practices. According to a report by the Information Science for Democracy Foundation, the average amount of petty bribe in the Russian Federation has increased steadily in the last 10 years. Back in 2001, it was roughly 1,817 rubles. By the time 2010 rolled around, it had grown to 5,285 rubles and represented 93% of an average worker's salary.

Then there is the national government to contend with. Voicing an opinion that conflicts with President Vladimir Putin's wishes could lead to your business or investments being seized as well as a potential prison sentence. Just ask Mikhail Khodorovsky, former Chairman and CEO of Russian oil giant Yukos, who was convicted of fraud in 2005 for reasons that are believed to be politically motivated.

LATAM's Commodity King
While outright corruption isn't as big of a problem for Brazil as it is for Russia, the government does have a hand in creating risks for investors that stem from its "protectionist" attitude. The country now has the second-highest number of protectionist measures in Latin America, after Argentina. This includes rules to favor local products, high tariffs on imported goods, tax breaks to encourage domestic production and limiting the access of foreign investors to strategic natural resource assets. For example, investors wanting to tap the nation's vast oil wealth must partner with state-owned energy giant Petrobras. Overall, these policies could derail some investment returns if Brazil decides to go one step further and nationalize various assets.

Asia's Bureaucratic Nightmare
With a democracy as large as India's, you would expect there to be some red tape when it comes to successful investment. However, the nation's bureaucracy has been called the "most stifling in the world." Starting a business in India is incredibly hard, as the local and national governments generally have a hand in the commercial markets. Likewise, enforcing contracts can be impossible, especially when there is a propensity for business partners to enter into undeclared third-party transactions. The Political and Economic Risk Consultancy, a Hong Kong-based think tank, estimates that India's bureaucratic system will prevent it from matching the growth rates of other rival nations.

The Bottom Line
The BRICs offer much in the way of portfolio and economic growth, however, there are some pretty big risks for individual investors as well. Understanding these risks is key to navigating these emerging giants successfully.

The Currency Market Information Edge

The global foreign exchange (forex) market is the largest financial market in the world, and its size and liquidity ensure that new information or news is disseminated within minutes. The forex market has some unique characteristics, however, that distinguish it from other markets. These unique features may give some participants an "information edge" in some situations, resulting in new information being absorbed over a longer period of time. 

Unique Characteristics of the Forex Market Unlike stocks, which trade on a centralized exchange such as the New York Stock Exchange, currency trades are generally settled over the counter (OTC). The OTC nature of the global foreign exchange market means that, rather than a single, centralized exchange (as is the case for stocks and commodities), currencies trade in a number of different geographical locations, most of which are linked to each other by state-of-the-art communications technology. OTC trading also means that at any point in time, there are likely to be a number of marginally different price quotations for a particular currency; a stock, on the other hand, only has one price quoted on an exchange at a particular instant. 

The global forex market is also the only financial market to be open virtually around the clock, except for weekends. Another key distinguishing feature of the currency markets is the differing levels of price access enjoyed by market participants. This is unlike the stock and commodity markets, where all participants have access to a uniform price. 

Market ParticipantsCurrency markets have numerous participants in multiple time zones, ranging from very large banks and financial institutions on one end of the spectrum, to small retail brokers and individuals on the other. Central banks are among the largest and most influential participants in the forex market. On a daily basis, however, large commercial banks are the dominant players in the forex market, on account of their corporate customers and currency trading desks. Large corporations also account for a significant proportion of foreign exchange volume, especially companies that have substantial trade or capital flows. Investment managers and hedge funds are also major participants.

Differing Prices Banks' currency trading desks trade in the interbank market, which is characterized by large deal size, huge volumes and tight bid/ask spreads. These currency trading desks take foreign exchange positions either to cover commercial demand (for example, if a large customer needs a currency such as the euro to pay for a sizable import), or for speculative purposes. Large commercial customers get prices, with a markup embedded in them. from these banks; the markup or margin depends on the size of the customer and the size of the forex transaction. Retail customers who need foreign currency have to contend with bid/ask spreads that are much wider than those in the interbank market. 

Speculative Positions Vs. Commercial TransactionsIn the global foreign exchange market, speculative positions outnumber commercial foreign exchange transactions, which arise due to trade or capital flows, by a huge margin, although the exact extent is difficult to quantify. This makes the forex market very sensitive to new information, since an unexpected development will cause speculators to reassess their original trades and adjust these trades to reflect the new information. For example, if a company has to remit a payment to a foreign supplier, it has a finite window in which to do so. The company may try to time the purchase of the currency so as to obtain a favorable rate, or it may use a hedging strategy to cover its exchange risk; however, the transaction has to occur by a definite date, regardless of conditions in the foreign exchange market. 

On the other hand, a trader with a speculative currency position seeks to maximize his or her trading profit or minimize loss at all times; as such, the trader can choose to retain the position or close it at any point. In the event of new information, the adjustment process for such speculative positions is likely to be almost instantaneous. The proliferation of instant communications technology has caused reaction times to shorten dramatically in all financial markets, not just in the forex market. This knee jerk reaction, however, is generally followed by a more gradual adjustment process, as market participants digest the new information and analyze it in greater depth. 

Information EdgeWhile there are numerous factors that affect exchange rates, from economic and political variables tosupply/demand fundamentals and capital market conditions, the hierarchical structure of the forex market gives the biggest players a slight information edge over the smallest ones. In some situations, therefore, exchange rates take a little longer to adjust to new information. 

For example, consider a case where the central bank of a major nation with a widely-traded currencydecides to support it in the foreign exchange markets, a process known as "intervention." If this intervention is unexpected and covert, the major banks from which the central bank buys the currency have an information edge over other participants, because they know the identity and the intention of the buyer. Other participants, especially those with short positions in the currency, may be surprised to see the currency suddenly strengthen. While they may or may not cover their short positions right away, the fact that the central bank is now intervening to support the currency may cause these participants to reassess the viability and implications of their short strategy. 

Example – Forex Market Reaction to News All financial markets react strongly to unexpected news or developments, and the foreign exchange market is no exception. Consider a situation in which the U.S. economy is weakening, and there is widespread expectation that the Federal Reserve will reduce the benchmark federal funds rate by 25 basis points (0.25%) at its next meeting. Currency exchange rates will factor in this rate reduction in the period leading up to the expected policy announcement. If, however, the Federal Reserve decides at its meeting to leave rates unchanged, the U.S. dollar will in all likelihood react dramatically to this unexpected development. If the Federal Reserve implies in its policy announcement that the U.S. economy\'s prospects are improving, the U.S. dollar may also strengthen against major currencies.

The Bottom LineWhile the massive size and liquidity of the foreign exchange market ensures that new information or news is generally absorbed within minutes, its unique features may result in new information being absorbed over a longer period in some situations. In addition, the hierarchical structure of the forex market can give the biggest players a slight information edge.