II December 2013 GEM Equity Strategy Outlook 2014 Taper versus governance BRICs at most risk of 'classic' EM crisis based on dysfunctional relationship between state and companies Micro structural factors threaten EM economies more than Fed timer There is increasing discussion about the possibility of a financial/economic crisis in one or more emerging markets, based on purely macro considerations, namely the impact of tighter Fed policy on those countries with high external financing requirements. We are sceptical for two reasons. First we believe that the Fed will be extremely cautious in tightening policy, largely because of the potential impact on emerging economies and financial markets which will then feed back into dampening growth prospects in the US. Second, the taper concerns reveal an excessively one-dimensional focus on a single macro- economic aggregate whereas the history of EM shows that more micro related factors around the corporate sector are ultimately the key drivers of EM economies and financial markets. The sudden break in correlation between DM and EM equities at the start of 2013 preceded talk of Fed tapering by several months and was the direct result of investors beginning to discount more favourable structural factors for the US against the bulk of the EM universe. Going forward, the greatest potential for an EM-style financial crisis resides in those countries with the most dysfunctional relationship between the state and the corporate sector. Our conclusion is that at least three of the four BRICs economies, with the possible exception of India, are eventually more liable to a 'classic' EM-type crisis compared to Indonesia, South Africa or Turkey, though we accept that there is a risk with Indonesia in particular that predictions of a crisis, which lead to a rapid run-down in FX reserves, could become self-fulfilling. BRIC economies most vulnerable' because of failure to implement reforms Emerging economies an