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Transcript of EM Outlook 2012
Global
6 December 2011
Emerging Markets 2012 Outlook
Survival of the Fittest
Deutsche Bank Securities Inc.
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.
Research Team
Marc Balston (+44) 20 754-71484
Robert Burgess (+44) 20 754-71930
Gustavo Cañonero (+1) 212 250-7530
Marcel Cassard (+44) 20 754-55507
Drausio Giacomelli (+1) 212 250-7355
Michael Spencer (+852 ) 2203-8303
G
lob
al M
arke
ts R
esea
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E
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Special ReportsRates in 2012: Identifying Pockets of Value
FX in 2012: The Vehicle to Trade Global Risk Sovereign Credit in 2012: Diminished Returns; Country Selection Key
EM: Survival of the Fittest EM Performance: The Grass is Grayer on the Other Side
EM Technicals in 2012: Structurally Sound; Cyclically Vulnerable A Closer Look at Real-Money Positioning
IMF Financing: Possibilities and Limitations EMEA Domestic Debt: Supply and Demand in Focus
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Key Economic Forecasts
2010F 2011F 2012F 2010F 2011F 2012F 2010F 2011F 2012F 2010F 2011F 2012F
Global 5.0 3.6 3.2 3.7 4.1 3.6 0.5 0.2 0.0 -5.1 -4.5 -3.8
US 3.0 1.8 2.3 1.6 3.3 3.2 -3.2 -3.1 -2.7 -8.8 -8.5 -6.2
Japan 4.1 -0.4 0.5 -0.7 -0.3 -0.3 3.6 2.2 1.9 -8.7 -8.8 -9.1
Euroland 1.8 1.6 -0.5 1.6 2.7 1.9 -0.5 -0.7 -0.3 -6.3 -4.2 -3.6
Germany 3.6 2.9 0.0 1.1 2.5 2.0 5.6 5.4 5.1 -4.3 -1.3 -1.4
France 1.4 1.6 -0.3 1.7 2.2 1.8 -1.8 -2.8 -2.6 -7.1 -6.0 -5.4
Italy 1.3 0.5 -1.1 1.6 2.7 2.3 -3.5 -3.8 -3.0 -4.6 -4.0 -2.5
Spain -0.1 0.6 -0.9 2.0 3.1 1.3 -4.6 -3.9 -3.3 -9.3 -6.8 -6.0
Netherlands 1.6 1.9 -0.5 0.9 2.5 2.0 6.7 7.0 8.0 -5.1 -3.4 -3.5
Belgium 2.3 1.9 -0.6 2.3 3.4 2.0 2.4 2.0 2.0 -4.1 -3.9 -5.0
Austria 2.3 2.8 -0.5 1.7 3.6 2.1 2.9 2.5 2.5 -4.4 -3.2 -3.2
Finland 3.6 2.9 0.0 1.7 3.3 2.3 3.0 2.0 2.0 -2.5 -1.5 -1.5
Greece -3.5 -5.3 -3.0 4.7 3.1 1.3 -11.8 -9.0 -7.0 -10.6 -9.5 -6.6
Portugal 1.4 -1.5 -2.9 1.4 3.6 2.5 -9.8 -8.0 -6.5 -9.8 -6.5 -6.4
Ireland -0.4 1.5 0.2 -1.6 1.2 1.5 -0.7 0.0 0.5 -31.3 -10.5 -9.1
Other Industrial Countries
United Kingdom 1.8 1.1 1.3 3.3 4.5 3.2 -2.5 -2.5 -2.4 -10.3 -8.2 -6.9
Sweden 5.4 4.1 1.3 1.3 2.7 2.0 6.3 6.5 6.0 -0.1 1.9 3.0
Denmark 1.7 1.4 1.2 2.3 2.6 1.9 5.5 5.8 5.6 -5.3 -1.6 -0.8
Norway 0.3 2.2 1.3 2.4 1.6 1.8 12.3 12.8 13.8 10.6 9.1 10.8
Switzerland 2.7 2.0 1.0 0.7 0.7 0.7 15.6 13.8 13.5 0.8 1.0 1.3
Canada 3.2 2.1 2.5 1.8 3.0 2.5 -3.1 -3.2 -3.1 -3.4 -2.1 -1.8
Australia 2.7 1.6 2.9 2.8 3.4 3.0 -2.7 -2.1 -1.6 -4.1 -3.3 -1.4
New Zealand 1.7 2.0 2.6 2.3 4.4 2.5 -3.4 -3.8
Emerging Europe, Middle East & Africa 4.4 4.4 3.3 6.5 6.3 5.8 1.2 1.6 0.7 -3.7 -1.0 -1.3
Czech Republic 2.2 1.8 0.0 2.3 2.0 3.3 -3.3 -4.0 -3.7 -4.8 -4.3 -3.8
Egypt 5.1 1.8 3.0 10.1 8.9 9.0 -2.0 -2.6 -2.4 -8.1 -9.5 -8.5
Hungary 1.2 1.4 -0.8 4.7 4.1 4.7 1.1 0.6 0.3 -4.3 1.9 -3.2
Israel 4.8 4.5 2.8 2.6 2.3 2.3 2.9 -0.4 -1.4 -3.7 -3.3 -3.5
Kazakhstan 7.3 6.6 5.5 7.8 8.0 7.0 3.1 10.4 8.4 1.5 2.0 2.5
Poland 3.9 4.2 2.3 3.1 4.0 2.4 -4.6 -4.5 -4.4 -7.8 -5.5 -4.3
Romania -1.3 1.8 1.9 8.0 3.5 3.2 -4.2 -3.6 -4.1 -6.4 -4.4 -3.1
4.0 4.5 4.6 8.8 7.1 7.0 4.8 5.9 4.1 -3.9 0.2 -0.4
Saudi Arabia 4.1 5.7 3.7 5.4 5.5 4.5 14.9 18.4 14.5 5.2 9.7 7.3
South Africa 2.8 3.1 3.2 3.5 6.4 6.0 -2.8 -3.1 -3.7 -6.6 -5.5 -5.4
Turkey 8.9 7.0 2.3 6.4 9.2 6.4 -6.6 -9.4 -8.4 -3.6 -1.5 -1.5
Ukraine 4.2 4.5 3.9 9.1 6.5 9.0 -2.0 -2.7 -3.1 -5.0 -2.5 -2.5
United Arab Emirates 3.2 3.7 3.5 1.7 1.6 2.4 8.0 10.1 10.3 3.6 8.2 7.4
Asia (ex-Japan) 9.5 7.3 6.9 5.4 4.8 3.7 3.5 2.6 1.9 -2.2 -2.9 -2.9
China 10.3 9.1 8.3 4.6 3.8 2.8 5.2 4.0 3.4 -1.7 -2.0 -2.0
Hong Kong 7.0 5.3 3.0 2.9 6.0 4.3 6.2 5.5 4.8 4.2 1.6 1.2
India 10.0 7.0 7.5 9.4 7.5 6.0 -3.1 -2.9 -3.1 -4.7 -8.1 -7.4
Indonesia 6.1 6.5 6.3 7.0 4.0 6.5 0.8 0.5 -0.2 -0.6 -1.1 -1.4
Korea 6.2 3.7 3.4 3.0 4.1 3.2 2.8 2.3 0.7 -0.2 1.6 0.3
Malaysia 7.2 5.0 4.3 2.1 3.4 2.1 11.5 11.4 9.9 -5.6 -4.2 -5.0
Philippines 7.6 3.5 3.0 3.1 4.7 4.0 4.2 4.5 3.4 -3.5 -2.9 -3.2
Singapore 14.5 5.0 3.0 4.6 5.3 1.2 22.2 19.1 18.5 5.1 8.0 6.6
Sri Lanka 8.0 8.0 7.5 6.8 4.1 7.6 -2.9 -5.6 -4.9 -8.0 -7.0 -7.0
Taiwan 10.9 4.4 3.0 1.2 1.0 0.6 9.2 8.6 7.6 -3.7 -3.2 -3.4
Thailand 7.8 1.8 3.9 3.0 4.1 3.3 4.6 0.0 -1.9 -1.1 -3.7 -4.9
Vietnam 6.8 5.9 5.6 11.7 18.6 10.8 -4.2 -3.8 -5.1 -6.5 -5.3 6.0
Latin America 6.3 4.1 3.6 8.4 8.2 8.2 -0.9 -0.9 -1.3 -2.4 -2.0 -1.8
Argentina 9.2 7.3 3.1 25.2 23.1 25.4 0.8 0.8 -0.5 -1.5 -2.3 -1.5
Brazil 7.5 3.0 3.3 5.9 6.4 5.3 -2.3 -2.2 -2.6 -2.5 -2.1 -1.6
Chile 5.2 6.0 4.2 3.0 3.7 2.9 1.9 -1.1 -1.7 -0.3 0.8 0.2
Colombia 4.3 5.5 5.0 3.2 3.7 3.4 -3.7 -3.2 -2.7 -3.9 -3.3 -3.2
Mexico 5.5 3.9 3.3 4.4 3.4 3.4 -0.6 -0.7 -1.0 -2.8 -2.1 -2.3
Peru 8.8 6.8 5.9 2.1 4.4 3.5 -1.6 -1.4 -1.7 -0.7 0.1 -0.2
Venezuela -1.4 3.9 4.0 27.2 28.0 27.0 4.6 6.9 2.5 -1.9 3.7 -3.7
Memorandum Lines: 2/
G7 2.9 1.5 1.3 1.4 2.6 2.4 -1.0 -1.3 -1.1 -7.7 -7.0 -5.6
Industrial Countries 2.7 1.5 1.2 1.5 2.7 2.3 -0.9 -1.1 -0.9 -7.3 -6.4 -5.1
Emerging Markets 7.7 6.1 5.5 6.2 5.7 5.0 2.2 1.7 1.1 -2.6 -2.3 -2.3
BRICS 9.1 7.3 7.0 6.3 5.3 4.4 2.5 2.0 1.4 -2.7 -3.0 -2.9
Current Account (% GDP) Fiscal balance (% GDP)
1/ CPI (%) forecasts for developed markets are period averages.
2/ Aggregates are PPP-weighted within the aggregate indicated. For instance, EM growth is calculated by taking the sum of each EM country's individual growth rate multiplied it
by its share in global PPP divided by the sum of EM PPP weights.
Real GDP (%) Consumer Prices (%, eop) 1/
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 3
Table of Contents
Emerging Markets and the Global Economy in the Year Ahead
The coming year is clearly going to be a difficult one for the world economy; however, this resilience will not be uniform
across EM. Given the headwinds, 2012 may well prove to be a case of ‘survival of the fittest’. We expect the tug of war
between structural and tactical drivers of 2011 to extend into 2012 – particularly during the first months of the year,
when the future of Europe may be decided. .................................................................................................................... 11
This Month’s Special Reports
Rates in 2012: Identifying Pockets of Value EM receivers performed well after a rocky start. In our 2012 outlook, we analyze those country specific effects using a
model which integrates macro-monetary policy interactions and local curve dynamics. Under our benchmark scenario
the ‚fair‛ curves are relatively close to forward curves. ..................................................................................................... 22
FX in 2012: The Vehicle to Trade Global Risk During 2011, EMFX played the role of shock absorber with a large share of returns attributed to global drivers. External
factors should remain the main drivers of EM currencies in 2012. .................................................................................... 30
Sovereign Credit in 2012: Diminished Returns; Country Selection Key Given the circumstances, 2011 has been another strong year for EM sovereign credit. We highlight how country
selection (as opposed to simple beta-management) has been a key factor in portfolio selection in 2011. With this in mind,
we devote much of this year’s outlook to a thorough examination of specific country factors (pricing, macro and
technical). ............................................................................................................................................................................ 37
EM: Survival of the Fittest We present a framework for assessing relative vulnerabilities across EM using external, fiscal, financial, and growth
sensitivity indicators. EMEA dominates our list of the most vulnerable countries. Other regions look safer though risk
from rapid credit growth (Asia) and commodity dependency (LatAm) bear watching. ................................................. 46
EM Performance: The Grass is Grayer on the Other Side We see the distribution of returns will likely continue to favor fixed income vs. growth-sensitive assets. Though returns
are diminishing, EM still seems too important a source of carry and value to drop from investors’ priority list – either in
risk-on or risk-off modes. In addition, if returns are less appealing in EM, the opportunities in global markets seem even
less so. ................................................................................................................................................................................ 53
EM Technicals Outlook in 2012: Structurally Sound; Cyclically Vulnerable A broad set of metrics suggest that structurally global investors are still under-allocated to EM. However, valuation, lack
of depth, and market access suggest that the pace of strategic inflows will be considerably slower going forward when
compared with 2003-2007. ................................................................................................................................................. 58
A Closer Look at Real-Money Positioning EM local currency funds have grown by a factor of almost 3.5x over the past four years, increasing their impact on the
behaviour of local markets. In this article we examine the rise of these funds and also introduce a new analysis of the
country positioning of such funds. ...................................................................................................................................... 63
IMF Financing: Possibilities and Limitations We review the various options on the table for boosting the financial firepower of the IMF, concluding that an increase
in bilateral loans is the proposal most likely to fly. The need for a bigger IMF is primarily to deal with the euro crisis. We
think the IMF already has enough in its locker to deal with likely EM needs. ..................................................................... 71
EMEA Domestic Debt: Supply and Demand in Focus Since Q32011, forced deleveraging has caused some foreign investors to either cut or hedge their holdings of local
currency government debt. This note presents detailed estimates of the supply/demand dynamics of each EMEA market
in 2012. We flag opportunities and threats from the perspective of technicals. ................................................................ 76
Theme Pieces .................................................................................................................................................................. 184
6 December 2011 EM Monthly
Page 4 Deutsche Bank Securities Inc.
Summary Views – LatAm
Economic Outlook Main Risks Strategy Recommendation
Argentina
Page 84 The government seems to be
ready to combine some fiscal
consolidation with tighter FX and
price controls, and labor union
persuasion aiming at managing a
soft landing to a 5% growth
pace. Nonetheless, inflation
stability together with FX
sustainability will demand an
even weaker economy. The
sooner the government accepts
that reality, the smoother the
expected economic path ahead.
A likely resistance will only
accelerate economic slowdown,
and short term inflation.
Further confirmation of
current policy continuity
could only preserve an on-
going currency run and a
severe capital flight. Lack of
investment amid fiscal
expansion, together with
unfriendly policies, could
maintain high inflation,
reinforcing fears of potential
financial stress. The current
pace of real appreciation is
leading to a rapid and sharp
deterioration of external
accounts, while strong fiscal
spending is adding stretch to
difficult financing.
Remain neutral in the currency, but
the front-end of the NDF curve
offers attractive carry for those
willing to sustain elevated risk.
Continue avoiding the CER curve
which offers unfavorable
FX/inflation breakeven. Badlar-
linked bonds are more attractive
for those seeking local peso
exposure. Stay neutral on external
debt but be conservative on
duration, favor credit to Warrants
and favor global bonds (especially
the Global 17s) over local law
bonds. In addition we recommend
long basis on Global 17s vs. 5Y
CDS.
Brazil
Page 88 The government has showed that
it intends to use all possible
instruments to prevent a strong
economic deceleration by easing
monetary policy aggressively,
revoking some ‚macro-
prudential‛ measures, and
introducing fiscal measures to
stimulate consumption.
Therefore, we expect the
economy to grow slightly above
3% in 2012 despite the bleak
global outlook. Although inflation
is poised to decelerate in the
next months due to the recent
economic slowdown and lower
commodity prices, it will likely
remain above 5% due to high
inertia and aggressive monetary
easing.
The government’s initiative to
aggressively ease monetary
policy to prevent a significant
economic slowdown could
damage its credibility and
lead to permanently higher
inflation, especially if not
accompanied by the
promised fiscal austerity. The
large increase in the
minimum wage and
mounting pressure on the
government to increase
investment in infrastructure
do not bode well for fiscal
restraint in 2012. The BRL
remains vulnerable to lower
commodity prices.
Take profits on long 1M USD/BRL
FVA and enter zero-cost 1M
USD/BRL put spread Take profits
on Jul ’12- Jan ’17 steepener and
enter Jan ’13- Jan15’ flattener.
Stay neutral on external debt and
continue to favor 41s and 40s (to
call) vs. 21s. In addition, we favor
short basis at the 10Y sector as a
tactical trade.
Chile
Page 92 The economy continues to
decelerate along an unbalanced
path, with domestic demand still
growing at a higher pace than
supply. Nevertheless, albeit
some surprises, domestic
inflationary pressures are still
subdued. A weakening CLP and
tight labor markets have so far
had little impact on inflation. The
Central Bank of Chile (BCCh) is
increasingly considering easing
monetary conditions to
counteract negative effects from
the external scenario.
Domestic demand could
adjust faster than expected
due to uncertainty in external
conditions. A slowdown in
global growth and a potential
deceleration in China could
affect copper prices. There
could be some form of
contagion from a credit event
in Europe due to the links
between local and Spanish
banks.
Maintain short EUR/CLP. Shift
from 2Y to 5Y breakeven inflation
and enter 2s5s CLP/CAM
steepener. Underweight sovereign
credit, and buy 5Y CDS vs. Brazil
as a defensive trade.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 5
Summary Views – LatAm
Economic Outlook Main Risks Strategy Recommendation
Colombia
Page 94 Economic activity keeps growing
robustly, while inflation has risen
temporarily, fueled by food
prices. BanRep has begun to hike
the policy rate again, and will
continue to do so in 2012. The
fiscal accounts are improving on
the back of tax collection
outperformance.
Higher inflation because of
stronger commodity prices
and/or domestic demand
pressures. Overheating and
bubbles prompted by a credit
boom. A relapse in the US
economy, destination of
more than one third of the
country’s exports.
Remain on the sidelines waiting for
better entry levels to get exposure to
COP. Close 2s3s COP/IBR steepener
and receive 5Y COP/IBR (or TES Jun
’16) against 5Y USD swap. Stay
overweight external debt and favor
shorter-end of the curve, where we
favor off-the-run 19s and 20s over
the benchmark 21s.
Mexico
Page 98 Headline inflation has accelerated
but core remains well behaved,
very near the medium term target.
Economic activity surprised on the
upside during 3Q11, and will
decelerate very gradually over the
coming months. The negative
output gap will not close until 2012.
Banxico is unlikely to cut the
funding rate unless the currency
appreciates back towards pre-US
downgrade levels.
A relapse in US economic
activity. Higher inflation
because of strong
commodity prices and/or
higher pass-through from
depreciation. Volatility of
political origin ahead of next
year’s presidential elections.
Take profits on long MXN/CZK and
enter short CAD/MXN. Take profits
on 5Y TIIE payer and enter 2s10s
TIIE flattener vs. 2s10s USD swap
steepener. Neutral external debt.
The old 19s remain significantly
rich to the curve.
Peru
Page 102 GDP growth is to be near 7% this
year, slowing down very gradually
towards 6% in 2012. The inflation
spike is likely to be temporary,
but it will prevent monetary
easing for now. Structural excess
demand for dollars is to maintain
the currency well supported.
Higher inflation because of
food prices. Weaker fiscal
and external performance
because of softer mining
prices, if global growth
falters.
Maintain long 3M USD/PEN NDF
and remain neutral on rates.
Increase to overweight external
debt, take profit in the 37s to 19s
switch and now favor the long end
of the curve.
Uruguay
Page 104 Economic growth is decelerating
gradually, converging towards
trend levels, although risk of the
projections is on the upside given
the pipeline of investment
projects. Inflation remains well
above the ceiling of the target
range, preventing any monetary
easing for the time being.
A drop in commodity prices.
A further acceleration in
inflation. Weaker growth in
the country’s main trading
partners.
We favor UYU ’18 as a buy and
hold strategy due to elevated carry
and diversification.
Venezuela
Page 106 Economic activity is picking up
speed, following the contraction
of the past two years and beating
expectations. The recovery should
continue next year on the back of
very expansive fiscal and
monetary policies, ahead of the
presidential elections. Inflation
remains the highest across the
EM universe.
Lower oil prices as a result of
softer global growth or a
financial disruption in Europe.
Further acceleration in
inflation because of food
prices and/or pressures from
very loose fiscal policy.
Volatility of political origin
before next year’s
presidential elections.
Increase to a small overweight,
favoring the Republic over PDVSA.
On Venezuela, 28s look the most
attractive. On PDVSA, we continue
to favor the 13s (for carry-oriented
investors) but also consider moving
to the mid-end of the curve where
we favor the 22s. In addition, while
we continue to recommend long
basis on the sovereign curve (24s
vs. 10Y being the best trade at the
moment), we also like PDVSA 22s
vs. Venezuela 10Y CDS.
6 December 2011 EM Monthly
Page 6 Deutsche Bank Securities Inc.
Summary Views – EMEA
Economic Outlook Main Risks Strategy Recommendation
Czech
Republic
Page 110
The combination of a weak
labour market, ongoing fiscal
austerity and an expected
recession in Euroland leaves a
significant risk of recession in
Czech Republic. But with the
public debt/GDP ratio sub 40%
and C/A deficit financing the
most secure in the region, the
medium-term fundamentals
remain strong.
Germany is by far Czech
Republic’s largest export partner
accounting for 22% of GDP in
exports. A more protracted
recession in Germany leaves
significant downside risk for the
Czech economy and could well
push the CNB into a rate cut.
2s10s IRS set to
steepen.Neutral on rates.
Neutral on EUR/CZK
Egypt
Page 114 The economy is likely to gain
strength in FY2011/12 with
political transition, base effects
and greater access to external
financing.
Occasional setbacks in political
progress and delay in
implementation of a
comprehensive economic plan
in coordination with and funding
from multi-lateral institutions
could lead to a much weaker
growth performance.
Neutral EGP. Political stability
and resumption of talks with
IMF will hold the key.
Hungary
Page 118 We expect Hungary to tip back
into recession in 2012. Fiscal
drag is set to increase in line with
the government’s commitment
to stick to a 2.5% of GDP fiscal
deficit while rate hikes, FX
weakness and rising deleveraging
will all severely constrain growth
for some time ahead. With the
expected recession in Euroland
net trade will be unable to offset
the negative domestic
environment.
Likely policy conflicts between
the authorities and the IMF/EU
risks prolonged program
negotiations which could mean
continued pressure on the
currency, a larger hiking cycle
and further rating downgrades.
It could also mean a very
difficult backdrop to meet
external refinancing needs.
NBH to provide ceiling in
EUR/HUF. Sell vega neutral
3m/6m straddles in EURHUF.
Underweight sovereign credit.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 7
Summary Views – EMEA
Economic Outlook Main Risks Strategy Recommendation
Israel
Page 122 The divergence between strong
domestic absorption and faltering
net exports is set to dwindle,
pointing to a marked loss in
growth momentum. Inflation is
expected to behave benignly,
providing room for further easing
if needed, although housing
dynamics and ILS will also play an
increasingly important role. The
C/A is set to turn negative and
remain in deficit throughout the
forecast horizon, while fiscal
consolidation arrives with a delay.
The geopolitical risk premium is
set to remain elevated given
multiple sources of concern. A
more rapid than needed
deceleration in housing prices
may lead to financial stability
risks and complicate rate
outlook.
Favour tactical shorts in EUR/ILS
above 5.10. Receive 2Y IRS
Kazakhstan
Page 126 Growth is picking up and
inflationary pressures are on the
rise.
The key vulnerability remains in
the banking sector, with
negative implications for
recovery in loan growth.
Maintaining a relative
preference for KZT NDFs vs
their UAH counterparts. Neutral
on sovereign credit (CDS).
Poland
Page 128 A Poland’s larger and less export-
orientated economy compared
with elsewhere in CEE should
outperform again in 2012. While
growth will undoubtedly slow
there is little risk of recession. The
pace of slowdown alongside zloty
performance, the inflation outlook
and the fiscal stance will all
determine the scope for rate cuts
in 2012. We see this as unlikely
before Q3.
Any evidence that the new
government lacks commitment
to fiscal austerity could quickly
put pressure on yields and see
the rating outlook revised to
negative. The discussed
methodology changes to
calculation of the debt rule, if
used as a substitute for fiscal
reform, would be a big negative
in this regard.
We recommend a 1y EUR/PLN
put, with a and strike at 4.25 for
2% of EUR notional.Receive 1Y
XCCY basis as a hedge but
outright purchase of POLGBs
will be attractive in H2 201.
Overweight sovereign credit.
Romania
Page 132 A precautionary IMF/EU SBA in
place until 2013 combined with
the government’s intention to
increasingly tap the Eurobond
market ahead of large external
redemptions in 2013/14 should
help to ensure reform fatigue is
avoided and the structure of
growth continues to improve.
Despite a very difficult external
backdrop we see upside risks to
our growth projection from
stepped up absorption of EU
funding and reform of loss-
making SOEs.
Fiscal slippage in the run up to
the Q4 general election risks
pushing the IMF/EU program off
track and would limit scope for
further monetary easing. It
could also put pressure on the
ratings.
Neutral FX. Overweight
sovereign external debt.
6 December 2011 EM Monthly
Page 8 Deutsche Bank Securities Inc.
Summary Views – EMEA
Economic Outlook Main Risks Strategy Recommendation
Russia
Page 136 Growth accelerating on the back
of high consumption and fixed
investment growth.
Recurring capital outflows and a
drop in oil prices remain key
risks.
Short NOK/RUB, for a move
back down to 51 flat. OFZs
likely to perform in 2012.
Overweight sovereign credit.
South Africa
Page 140 The much weaker growth base in
Q2 and Q3 makes for
encouraging rebound potential in
growth into 2012. We do not
expect a recession locally, as we
estimate this probability between
10-15%. Household demand is
expected to be the main growth
driver in 2012.
Deteriorating global growth,
negative repercussions for
terms of trade could severely
harm corporate profits. From
these risks stem employment
losses, which will offset the
benefit of lower commodity
prices on inflation.
Buy a 1y digital EUR/ZAR put
struck at 10 for roughly 25% of
EUR notional. ZAR curve set to
steepen. Underweight
sovereign credit.
Turkey
Page 144 Rebalancing in the economy
continues with domestic demand
slowing down gradually and
imports losing momentum.
Inflation will continue to rise in
the short term due to FX pass-
through and higher food prices.
A harder landing is on the cards
given the large exposure to
short-term funding from
international banks, balance
sheet effects of a weaker
currency and volatility in capital
inflows.
Having hit the target on long
TRY/HUF, we recommend
playing the range in USD/TRY.
Buy a DnT with strikes at 1.70
and 1.90. Add exposure to Jan-
20 bonds if the economy
responds to the ongoing
tightening. Overweight
sovereign external debt.
Ukraine
Page 148 Growth has been robust but is set
to soften on the back of rising
macroeconomic
Hryvnia weakness on the back
of the deteriorating balance of
payments remains a risk
The negative skew of risks
warrant a bearish position in
NDFs. Underweight sovereign
external debt.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 9
Summary Views – Asia
Economic Outlook Main Risks Strategy Recommendation
China
Page 150
For 2012, we expect the economy
to be featured by 1) disinflation, 2)
initial growth deceleration followed
by a recovery, and 3) policy easing
in 1H followed by a more cautious
stance towards the end of the year.
We maintain our 2012 GDP growth
forecast at 8.3% (down from 9.1%
in 2011), with a qoq trough in Q1
(at 6.4% saar, slightly deeper than
our earlier projection of 6.8%) and
a sequential recovery from Q2. For
2013, we expect GDP growth to
recover to 8.6% largely on stronger
export growth. On policies, we
expect 2-3 more RRR cuts in the
coming 6-9 months, which should
permit average monthly RMB
lending to rebound to RMB800-
900/month in 1H, and annual
lending to reach around RMB8.4tn
in 2012. We expect the fiscal
deficit-to-GDP ratio to remain
largely unchanged at 2-2.2% in
2012. Fiscal priorities in 2012
should include public housing,
completion of on-going
infrastructure projects, SMEs,
services, and consumption.
The two most important shocks
to the economy in the coming
months are property FAI
deceleration and export
slowdown. We expect property
FAI growth to slow from the
current 25 30%yoy to 15%yoy in
the first few months of 2012.
We expect export growth to
decelerate from the current
15%yoy to 8-9% in 1Q 2012.
We favor Repo swap NDIRS/IRS
and Shibor swap 2x5 NDIRS/IRS
steepeners to express our view
that interbank liquidity will ease
markedly in the coming 6-9
months. We retain our bullish
view on the CGB cash bonds.
Expect a slower pace of RMB
appreciation in 2012.
Hong Kong
Page 156
Growth in Hong Kong continues to
follow the lead of the US and EU
economies. This means markedly
slower growth in 2012 but a likely
return to reasonably robust growth
in 2013
A disorderly resolution of the
sovereign debt crisis in Europe
would likely be translated into a
deep recession in Hong Kong.
We see upside risk on Hibor -
Libor basis in Q1 next year
driven by corporate liability
hedging demands.
India
Page 158
Assuming no big collapse in global
financial markets, the Indian
economy ought to grow by 7-7.5%
in 2012, supported by rate cuts
from RBI around mid-2012
Worsening of twin deficits could
prevent inflation from moderating
to mid single-digit levels, which
could complicate RBI’s monetary
policy decision, especially if
growth were to slow sharply at
about the same time
Pay steepeners on the OIS
curve (1Y/2Y) to position for the
turn in the cycle. Risk to INR
gets more digital next year, with
policy intervention a key factor.
Indonesia
Page 164
Building on the momentum built
over the past couple of years,
Indonesia steps into 2012 with
well-anchored consumer and
business confidence, which could
allow the economy to grow by over
6% at a year when global growth
will likely slow sharply.
Inflation could rise sharply on the
back of electricity and fuel price
adjustments, and as demand
remains strong. Rupiah could
come under pressure if global
liquidity crunch and risk aversion
continue. Bond yields could rise
for the same reason.
Increase underweight as 10Y
yields close in on 6%.
6 December 2011 EM Monthly
Page 10 Deutsche Bank Securities Inc.
Summary Views – Asia
Economic Outlook Main Risks Strategy Recommendation
Malaysia
Page 166
Slower export growth will weigh on
investment spending and
consumption cushioned by
continued easy monetary and fiscal
policies.
The main risks lie abroad,
especially the possibility of a
deeper recession in Europe.
Vulnerability to bond market
outflows keeps us cautious on
rates (with a steepening bias)
and neutral on MYR.
Philippines
Page 168
Growth has slowed owing to a
weakening of external demand, but
domestic demand is likely to hold
up as inflation declines, while
consumer and business sentiment
remains resilient.
External demand could be
weaker than expected if the
crisis in Europe deepens further.
Modest overweight on duration
into 2012. Peso to be more
resilient than regional FX.
Singapore
Page 170
Slower global growth means much
slower growth in Singapore in
2012, but sharply lower inflation as
well.
Singapore is Asia’s most export-
sensitive economy, so macro risk
derives mainly from the US and
Europe.
SGS has strong technicals but
rich valuations. Expect the yield
curve to flatten in 2012. Trade
SGD NEER in a range.
South
Korea
Page 172
We see South Korea’s growth to
follow the G2 cycle, reporting a
below trend growth of 3.4% in
2012, followed by a notable
rebound to 4% in 2013.
The sovereign debt crisis in
Euroland pose serious downside
risks to growth.
We look for further steepening
on the KTB curve. Concerns
about lack of reinvestment
demand from offshore fund
investors should reduce, which
is supportive of 2Y-3Y segment.
Sri Lanka
Page 172
Real GDP growth likely to
moderate to 7.5% in 2012 (from
8% in 2011), led by a negative base
and weak external demand.
There is a non-trivial risk that the
ongoing fiscal consolidation
process suffers a setback, in the
event of any external shock, that
threatens to lower growth below
7% in 2012.
Taiwan
Page 178
With exports at 74% of GDP, we
see weak G2 growth of 1% in
2012, vs. 1.7% in 2011, guiding
Taiwan’s growth lower to 3.0%
from 4.4% in the same period.
Risks to our rates outlook remain
to the downside amid the
sovereign debt crisis in Euroland.
We believe TWD interest rate
swap curve is unlikely to break
its recent range in the next three
months unless CBC surprises
the market with cuts in the
policy rates. We recommend to
hold paying the belly in TWD
2x5x10 notional neutral butterfly
position.
Thailand
Page 180
We see GDP growth rebounding to
3.9% in 2012 from 1.8% in 2011,
supported by reconstruction
activities. The latter and weak
exports, however, point to a
current account deficit of 1.9% of
GDP in 2012.
Risks to growth remain to the
downside due to fragile external
conditions and implementation
risks to reconstruction plans.
Bond and swap curves to
steepen driven by valuations,
supply concerns and a more
dovish outlook on monetary
policy.
Vietnam
Page 182
We expect a modest slowdown in
GDP growth, to 5.6% in 2012 from
5.9% in 2011, as lower inflation
and rates counter the negative
impact of weaker external demand.
The banking system remains
under pressure, posing downside
risks to growth and the dong.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 11
Emerging Markets and the Global Economy in the Year Ahead
The coming year is clearly going to be a difficult one
for the world economy. Nevertheless, if, as we
expect, the US economy can continue to tick over at
even a little below trend and China can avoid a hard
landing, this will provide a moderately constructive
backdrop for most of EM. We thus think that EM can
grow at about 5½% in aggregate next year.
However, this resilience will not be uniform across
EM. Whereas we think much of Asia and Latin
America are relatively well placed to weather the
current storm, public and private balance sheets are
generally weaker in EMEA, which is also more
directly exposed to the euro crisis through stronger
economic and financial linkages.
Given the headwinds, 2012 may well prove to be a
case of ‘survival of the fittest’ and with this in mind
we introduce a new framework for assessing relative
vulnerabilities across countries in the EM universe.
We expect the tug of war between structural and
tactical drivers of 2011 to extend into 2012 –
particularly during the first months of the year, when
the future of Europe may be decided. Valuation
supports EM credit, local rates, and FX – particularly
under the risk of some financial repression in the
developed world. Structurally, flows should also
continue to benefit EM, as global investors remain
under-allocated.
In EMFX is most vulnerable to global risk and stands
to benefit more from EU progress. We favor the more
‚US-centric‛ MXN in LatAm, and RUB on persistently
high oil and inflows. Add ZAR tactically only vs. AUD
and HUF while EU uncertainty remains high despite
underperformance. We position for further
appreciation in RMB and PHP.
In rates, value is less than in FX, but fundamentals
support receivers in Mexico, Brazil (for now),
Colombia, Israel, and bonds in Russia, Poland, and
modestly so in the Philippines, but underweight
Indonesia. We favor steepeners in Chile, China,
Korea, and Thailand.
In sovereign credit we expect 2012 to be another
year of modest returns in which country selection
holds the key to outperformance. We recommend
overweight exposure to Venezuela, Colombia, Poland,
Russia, and Turkey; underweight exposure to
Hungary, Ukraine, Chile, and South Africa.
The survival of the fittest
Lower debt tolerance was a trademark of 2011. What
once seemed to be largely an EM trait has become
widespread and likely to constrain the financing of many
DM countries, despite their much deeper credit markets.
Adapting to this new reality will require protracted debt
reduction and thus years of fiscal responsibility, possible
financial repression in some cases, and – as the market
stress even in lower-debt economies such as Spain has
shown – structural reforms to boost potential growth and
improve debt dynamics. The possible outcomes have
become more binary given scarcer financing. But under
our baseline scenario of EU crisis resolution that we
expected to start to be delineated in weeks to come, the
US avoiding recession, China soft-landing, and with EM’s
more vulnerable ‚periphery‛ too small to pose a
significant systemic risk for the asset class, we expect
growth in (the less indebted) EM to outperform by almost
4.5ppts the industrial economies (table).
Summary Growth and Inflation Forecasts
2010F 2011F 2012F 2010F 2011F 2012F
Global 5.0 3.7 3.2 3.7 4.1 3.6
US 3.0 1.8 2.3 1.6 3.3 3.2
Japan 4.1 -0.4 0.5 -0.7 -0.3 -0.3
Euroland 1.8 1.6 -0.5 1.6 2.7 1.9
EEMEA 4.4 4.4 3.3 6.5 6.3 5.8
Russia 4.0 4.5 4.6 8.8 7.1 7.0
Asia (ex-Japan) 9.5 7.6 7.1 5.3 4.5 3.8
China 10.3 9.1 8.3 4.6 3.8 2.8
India 10.0 8.0 8.0 9.5 7.5 6.0
Latin America 6.3 4.1 3.6 8.4 8.2 8.2
Brazil 7.5 3.0 3.3 5.9 6.4 5.3
Memorandum Lines: 2/
G7 2.9 1.5 1.3 1.4 2.6 2.4
Industrial Countries 2.7 1.5 1.2 1.5 2.7 2.3
Emerging Markets 7.7 6.2 5.6 6.2 5.6 5.0
BRICS 9.1 7.5 7.2 6.4 5.3 4.4
1/ CPI (%) forecasts for developed markets are period averages.
2/ Aggregates are PPP-weighted within the aggregate indicated. For instance, EM growth is
calculated by taking the sum of each EM country's individual growth rate multiplied it by its
share in global PPP divided by the sum of EM PPP weights.
Real GDP (%) Consumer Prices (%, eop) 1/
Source: Deutsche Bank
More than a debt crisis year, however, 2011 has
highlighted that – at its very core – this is a governance
crisis. It has been governance and thus capacity to react
that has differentiated performance across the highly
indebted Ireland vs. its peripheral peers, the Fed vs. the
ECB and the also highly indebted US vs. Europe. The
failure of the super-committee has recently reminded us
that we should not underestimate the governance issues
the US faces either, but time is of essence and those are
less pressing and more back-loaded than in the EU. Not
only does the US face better initial growth conditions and
demographics, more flexible markets, a less leveraged
banking sector and a population that largely supports a
6 December 2011 EM Monthly
Page 12 Deutsche Bank Securities Inc.
compromise between the parties, but it has better control
over its monetary policy. Accordingly, despite the
challenges faced by the US and also some emerging
economies, 2012 will be largely driven by EU political
decisions.
Encouragingly, after successive attempts at building
backstops against contagion, we believe that the EU
authorities’ mindset has finally evolved to what we believe
is the fittest policy to resolve this crisis: More integration.
They will face an uphill battle against numerous
institutional constraints – both fiscal and monetary. But
the tolerance for muddling through is now limited and we
believe that the tone of the year will be dictated by the
progress EU authorities make in the first few months of
2012 and a more concerted action seems now underway.
As governance cannot be quickly built, market pressure
seems to us the most credible incentive device and thus
poised to linger. Therefore, this is unlikely to be a bright
year for growth but a year where growth prospects could
brighten somewhat later on as a stronger fiscal pact is
forged in the EU and political (and fiscal) uncertainty is
resolved in the US.
EU: The long and winding road to resolution
We expect material progress toward resolution rather
than dissolution of the EU in 2012. With the crisis deeply
rooted in core countries, widespread recession underway,
and relentless market pressure, EU authorities seem now
committed to tackle the region’s Achilles heel: the lack of
fiscal framework that is consistent with monetary union. It
would be naïve to expect them to take such a task in
stride as treaty changes cannot be delivered fast, but the
EC summit on December 8th-9th should present a positive
blueprint for action. Ideally, the EU should be able to
change national budgets in line with the euro stability, but
DB believes that authorities will pursue a less ambitious
proposal where judicial actions – in addition to financial
sanctions – could be used to enforce a beefed up Stability
and Growth Pact. Whether this would appease markets is
questionable, as the EU would still need to deliver a crisis
resolution framework to deal with the potential offenders.
From a timing perspective, however, it is more important
in preventing the escalation of this crisis that this blueprint
is enough to persuade the ECB to step up its securities
purchases1.
A concerted action from governments and monetary
authorities was instrumental in changing market
sentiment in the post-Lehman debacle and we believe
1 Italy’s response has been impressive in such a short period of time,
although obviously incomplete. The acceleration in pension reform and
expected correction in fiscal accounts underway should encourage the
ECB to help.
that concerted action is needed – and likely – once again.
The coordinated action to ease dollar funding shortages
was a first step in this direction and there have been
indications that more is underway. That France and
Germany endorsed greater fiscal integration is also
welcomed, but this needs to reach critical mass within the
EU (we believe it will). As the risk that the EU crisis goes
global has risen, G-20 economies (and Germany in
particular) seem open to increasing the IMF’s firepower
via bilateral loans, although likely conditional on increased
ECB participation. Judging by the original support
(EUR500bn from EFSF and EFSM, and EUR250bn from
the IMF), DB estimates that the combined IMF/EFSF pool
would have to increase by EUR425-650bn to cover up to
three years of funding needs for Italy, Spain, and Belgium
after discounting for commitments and bank capitalization
contingencies. Assuming the original IMF/EFSF ratio
holds, this would require additional USD825bn. Given the
pending maturities across both banks and sovereigns this
concerted action is needed fast.
What should we expect from the ECB? With European
banks facing EUR450bn in maturities in 1H12, 2Y and 3Y
LTRO extension seem more likely now. But it is important
that the eligibility criteria for collateral are eased. This
could be accomplished via the reopening the facility for
non-euro paper that was discontinued this year.
Alternatively, the ECB could accept lower-rated paper,
although this could face more resistance. Regardless, we
expect the ECB to cut 25bp in December with a risk of a
50bp. Most important is that it accelerates its SMP as
discussed above, although we doubt it would commit to
large amounts a la Fed. In principle, given the risks to the
transmission of monetary policy and price stability it
should be ready to do so, but it will likely await for the
‚green light‛ from fiscal authorities and possibly move
more aggressive during 1Q when maturities peak.
ECB balance sheet to grow further
0
5
10
15
20
25
0
50
100
150
200
250
May-10 Sep-10 Jan-11 May-11 Sep-11
Weekly purchases (rhs)
Cumulative (lhs)
ECB government bond purchases, EURbn
Stage 1:
Greece crisis
Stage 2:
Ireland crisis
Stage 3:
Portugal crisis
Stage 4:
Ita/Spn
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 13
Even if significant progress is made early on it is very
unlikely that the EU could avoid a recession of a least 1ppt
peak-to-through. Fiscal tightening is pervasive, monetary
policy has little room to maneuver, and – with banks
forced to increase their capital ratios – there is less
smoothing in private consumption and investment that
could offset reduced public demand. As a silver lining
when compared with post-Lehman performance, an
already depressed starting point in the cyclical and
stronger external demand could ease the fall
An outright contraction in euro area GDP in 2012
GDP, % yoy
2010 2011F 2012F 2013F
Germany 3.6 2.9 0.0 1.0
France 1.4 1.6 -0.3 1.2
Italy 1.2 0.5 -1.1 0.7
Spain -0.1 0.6 -0.9 0.8
Netherlands 1.6 1.9 -0.5 1.2
Belgium 2.3 1.9 -0.6 1.2
Austria 2.3 2.8 -0.5 1.2
Finland 3.6 2.9 0.0 1.4
Portugal 1.4 -1.5 -2.9 0.4
Greece -4.4 -5.3 -3.0 0.1
Ireland -0.4 1.5 0.2 1.4
EA-17 1.8 1.6 -0.5 1.0 Source: Deutsche Bank
US: Avoiding recession
In the US, 2012 is likely to be another year of sluggish
recovery with growth in the vicinity of 2.5% and with only
modest improvement in the labor market – assuming
authorities control the EU crisis. The recent data have
reinforced the view that the US can decouple from the
likely recession in Europe, with the latest ISM near 53 –
led by new orders at 57. The cyclical components of
demand remain near historical lows thus limiting
downside, but we expect real estate contribution to
growth to accelerate no earlier than in 2013. Home prices
are already nearing the bottom (we see just 4% downside
through 2014), but economic conditions indicate that the
depressed rate of household formation (about half the
historical norm), the overhang of vacant homes and the
still high pace of foreclosures (despite some retrenchment
in recent months) will remain a drag in 2012 2 . The
government’s renewed efforts to ease refinancing (HARP)
will possibly double the participants, but they will remain
marginal. A large-scale program involving principal write-
downs could be a lot more effective, but this is unlikely to
gain much political support ahead of elections.
2 See ‚US Housing Dormant for 2012, Global Economic Perspectives,
December 1st, 2011.
PMIs have decoupled most recently
35
45
55
65
00 01 02 03 04 05 06 07 08 09 10 11
Index, > 50
increasing
35
45
55
65
IndexISM composite index of US (ls)
Euro area PMI: composite output (rs)
Correlation:
Jan'00 - Jul'07 = 0.52
Aug'07 - present = 0.91
Source: Deutsche Bank
The outlook is brighter for consumer durables and
business investment, although less so for the latter as it is
already close to historical average. Altogether, our models
suggest that pent-up consumer and business spending
should more than offset the 1-2% of fiscal drag we pencil
in for the year even under ‚current policies‛ 3 (chart).
Obama’s American Jobs Act (AJA) could offset this drag,
but given the chasm between Democrats and
Republicans we expect the latter to concede on only what
they believe is enough not to be blamed for a double-dip
and this would amount to possibly extending payroll tax
cuts and unemployment benefits. Still, this could reduce
the amount of fiscal drag next year by 1ppt of GDP (to
1%). Inflation is likely to ease a bit from levels that have
been elevated by commodity price increases to remain
relatively subdued – excluding food and energy. But with
US yields already about 100bp depressed vs. what recent
data implies and the outlook for prices far off deflation
territory, Fed actions should continue to be more effective
at attenuating the transmission of EU shocks through the
banking system and easing dollar funding shortage.
3 The CBO’s ‚current law‛ projections assume the expiration of payroll tax
cuts, extended unemployment benefits, AMT patch, and ‚Doc Fix‛ in 2012
and Bush tax cuts in 2013. These account for a substantial part of the
deficit reductions under the CBO ‚current law‛ scenario with the rest
stemming from the winding down of the stimulus package. As no
meaningful tax reform is expected ahead of elections, we expect many of
the Bush tax cuts, the ‚Doc Fix‛, and the AMT patch to be extended (the
‚alternative policy scenario‛), with possible extension also of the payroll
tax reduction and unemployment benefits.
6 December 2011 EM Monthly
Page 14 Deutsche Bank Securities Inc.
No scope for further easing for now
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
10
20
30
40
50
60
70
80
90
100
110
03 04 05 06 07 08 09 10 11
US Surprise Index
UST 10y (LHS)
Source: Deutsche Bank
Although we cannot ignore risks to our scenarios for fiscal
policy and housing it is the EU crisis that poses the most
pressing and potentially most damaging threat. And since
the US is a relatively closed economy – the main risk is
financial contagion. From a pure trade perspective, 1ppt
drop in EU growth would reduce US GDP growth by only
0.1ppt, according to DB estimates. The impact estimated
via simple macro models such as OECD’s is similar, but it
would increase to 0.3ppt if we assume 10% euro
depreciation in line with the 1ppt drop in EU growth – still
far from recession territory.
The financial linkages seem a lot more important. First, the
stock markets are highly correlated and about 15-20% of
S&P500 revenues stem from Europe. Second, consumer
and business confidence surveys correlations have been
very high over the past decade and more so since 2007 –
although we have seen a marked drop since mid-summer.
The same applies to PMIs, although with an even stronger
de-coupling recently. Third, and possibly most damaging,
US banks’ exposure to Europe could be high. BIS and
DTCC data indicates that total claims and other next
exposure to GIIPS amounts to USD230bn – about 40% of
the tier-1 capital of the four largest US banks.
However, DB’s US banks team believes that the actual
exposure could be substantially less than the BIS data
indicates. The Fed survey shows that almost two-thirds of
the respondents reported 0-5% of their C&I loans booked
to Europe and less than 10% had substantial exposure (of
20% of more – see chart).
SLO survey points to lower exposure than BIS data
Exposure of US banks to European economies in their C&I
books
0
10
20
30
40
50
60
70
0-5% 5-10% 10-20% 20-50% 50% - more
%
0
10
20
30
40
50
60
70
%
Source: Deutsche Bank; SLO survey respondent exposure to Europe via C&I loans
China: Soft landing underway
In our assessment, the main risk to Chinese growth is
internal and related to the prospects for the property
market. Chinese property investors have never seen a
bear market for real estate, but they seem to be
responding to lower prices by buying rather than waiting
for even lower prices and recent transaction volumes
appear to be picking up. This is important, because
developers still need to work off the overhang of unsold
properties stemming from hikes in transactions taxes,
credit tightening, and quantity constraints on purchases
during 2011. Also encouraging, inflation is easing on
favorable base effects and also on weaker demand (both
foreign and domestic) and we expect it to drop below 4%
by the end of the month. Accordingly, the 50bp cut in
reserve requirements should be just the beginning of a
cycle with 2 or 3 more cuts over the next 2-3 quarters. An
easing of credit growth restrictions in a heavily bank-
intermediated economy will likely be positive for growth
and reassures us that a "hard landing" scenario -- and that
probably means different things to different people -- is
unlikely.
We forecast that growth will slow to 8.3% in 2012 from
9.1% in 2011, with slight downside risk to that 2012
forecast under our baseline scenario for Europe. The
health of the banking system in China does raise
concerns, especially when regulators concede that 25% -
30% of the loans to local government financing vehicles
are not being serviced by the original borrower (they don't
say whether they are not being serviced at all or just being
covered by someone else). However, as the government
owns the banks and the borrowers the decision to declare
a loan nonperforming boils down to politics. In practice,
the government appears to have decided to absorb most
of the nonperforming local government loans, thus
transferring the losses away from banks. This said, the
post-Lehman massive credit stimulus is now viewed as a
mistake, so that policy expansion should be moderate –
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 15
especially with growth at a robust 8%+ pace. We expect
fiscal stimulus of the order of 1% of GDP or less in the
form of tax cuts and increased social welfare spending.
EM: Policy flexibility and resilience to shocks
The coming year is clearly going to be a difficult one for
the world economy. Nevertheless, if, as we expect, the
US economy can continue to tick over at even a little
below trend and China can avoid a hard landing, this will
provide a moderately constructive backdrop for most of
EM. We thus think that EM can grow at about 5½% in
aggregate next year, well below recent peaks for sure but
substantially above the 2% growth rate registered in 2009
during the last synchronized global recession.
EM’s Favorable Public Debt Dynamics
EM
DM
25
45
65
85
105
125
145
165
185
205
225
2006 2010 2014 2018 2022 2026 2030
(% GDP)
We assume: (i) primary balances are held
constant at this projected 2012 levels; (ii) real
GDP grows at trend rates; and (iii) the
differential between real interest and real
growth rates in each country is 0 until 2015
and 1.0 thereafter.
Source: Haver Analytics, IMF, Eurostat, Deutsche Bank
However, this resilience will not be uniform across EM.
Whereas we think much of Asia and Latin America are
relatively well placed to weather the current storm, public
and private balance sheets are generally weaker in EMEA,
which is also more directly exposed to the euro crisis
through stronger economic and financial linkages.
Reflecting this, we have downgraded our forecasts for
EMEA much more aggressively than for other emerging
regions over the last few months (chart). Within EMEA,
the current crisis is weighing most heavily on the
economies of Central and Eastern Europe: we have
revised down our growth forecast for this region by an
average of 2.5%, even more than our revision for the euro
area, and we expect Hungary to fall back into recession
next year.
Downgrades to DB growth forecasts since July
-2.5
-2
-1.5
-1
-0.5
0
US Eurozone EMEA Asia Latin
America
Change in 2012 GDP growth forecast, ppts
Source: Deutsche Bank
Later in this EMM, we therefore present a new framework
for assessing relative vulnerabilities with a view to
identifying the most likely pressure points within EM over
the coming year. It suggests that EMEA is facing
something of a quadruple whammy. First, while current
account balances have improved in the last few years and
central banks have been able to build bigger buffers of
foreign reserves, the large stock of external debt
accumulated during the middle of the last decade, much
of it in foreign currency still leaves the region with large
external burden. Second, sharply weaker growth in the
last two or three years has taken a heavy toll in the public
finances leaving many with the ‚DM problem‛ of having
to tighten policy into the face of a downturn. Third, the
rapid expansion of western European banks throughout
much of the region has left many countries exposed to
deleveraging by foreign banks as they seek to meet
additional capital requirements. And fourth, the region’s
economies are mostly relatively small and open with high
trade and financial exposures to the euro area, leaving
them relatively more exposed therefore to a recession in
Europe even leaving aside the other vulnerabilities noted
above.
Not surprisingly, therefore, EMEA dominates our list of
the most vulnerable countries. Five countries (Hungary,
Ukraine, Romania, Poland, and Egypt) show up as highly
vulnerable, though for different reasons. Egypt’s
underlying vulnerabilities, for example, are fiscal first and
external second. Ukraine’s risks are mostly external.
Hungary’s vulnerability reflects a combination of risks in all
four areas. Poland’s risk rating is probably a notch too high
according to this mechanical exercise, though it does
underscore that the economy does have macro
imbalances that have yet to be fully addressed. Romania
remains vulnerable but has done a lot of the hard yards in
terms of fiscal adjustment and is poised to move to a
lower risk category.
6 December 2011 EM Monthly
Page 16 Deutsche Bank Securities Inc.
EMEA’s high external debt levels
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
160.0
180.0
LV
AH
UF
ES
TB
UL
CR
OK
ZT
UK
RLTU
RO
NP
LN
ILS
CZK
TR
YR
US
ZA
RE
GY
KO
RM
YS
TH
AID
NTA
IIN
RC
HN
CH
LA
RG
ME
XP
EN
CO
LB
RZ
Short term
Medium and long term
Region median
2010 gross external debt,% GDP
Source: Haver Analytics, BIS, Deutsche Bank
In Asia, years of current account surpluses and sound
fiscal policy have helped to underpin the region’s
resilience. India’s large government deficits are a
persistent worry, though this has to be placed alongside
manageable debt levels (61% of GDP) funded almost
entirely onshore and we think the government will resume
its consolidation efforts once global threats to growth
recede. The main pockets of concern are on the financial
side. Domestic credit expansion has been overly rapid
not only in China in 2009 but also in a many other
economies over the past two or three years. China, Korea,
Malaysia, and Thailand have high credit/GDP ratios
indicating significant potential debt burdens in the private
sector in a slowing growth environment. While the focus
of investors today is, perhaps rightly, on the external risks
to the region, we think domestic debt levels – and
possibly falling asset prices – are a significant risk to some
Asian economies.
Latin America went through a painful and meaningful
external, fiscal, and financial crisis in the 90s and today´s
resilience cannot be understood without that reference.
Forced fiscal adjustments, together with some structural
reforms, and overly conservative financial regulation have
allowed the region to converge to a relatively safe status.
This has permitted growth to become vigorous and
sustained with the helped of steady rise in commodity
prices, the region´s comparative advantage. Lack of
investment and increasing dependency on commodities is
probably the major drawback of this experience.
Increasing complacency regarding long term fiscal
rigidities with spending concentrated in current spending
in cases like Argentina, Brazil, Colombia, even Mexico, are
probably the main yellow light. Strong growth
sustainability and steady alleviation of poverty and social
conflicts remains the main challenge ahead.
Overall vulnerability map
Cu
rre
nt
acco
un
t
FX
re
se
rve
s
Exte
rnal d
eb
t
FX
valu
ati
on
Ove
rall
Ove
rall b
ala
nce
Pu
blic d
eb
t
Matu
rin
g d
eb
t
FX
De
bt
Ove
rall
Lo
an
:de
po
sit
s
Cre
dit
gro
wth
Cre
dit
le
ve
l
Fo
reig
n c
laim
s
Ove
rall
Gro
wth
be
ta
Ov
era
ll
EMEA
Czech Rep
Egypt
Hungary
Israel
Kazakhstan
Poland
Romania
Russia
South Africa
Turkey
Ukraine
Asia
China
India
Indonesia
Korea
Malaysia
Philippines
Thailand
LatAm
Argentina
Brazil
Chile
Colombia
Mexico
Risk ratings as follows: = low = medium = high
External Fiscal Financial
Source: Deutsche Bank
The flexibility that countries have to respond to weaker
global growth by easing policies partly reflects these
relative vulnerabilities. Outside of EMEA, most countries
should have room to at least let their automatic fiscal
stabilizers operate. In EMEA, however, even this room is
constrained in most cases – Russia and Turkey being two
notable exceptions. Pretty much all of Central and Eastern
Europe, for example, is looking to tighten fiscal policy into
a downturn.
Monetary easing is in any event likely to continue to be
the first line of defense for much of EM. Here, we think
reaction functions will continue to vary reflecting central
banks’ differing degrees of tolerance for exchange rate
weakness. At one of the spectrum is Brazil, where the
central bank will likely view recent depreciation as
correcting overvaluation and in that sense acceptable. It
has also cut rates by 150bps since August and we
anticipate a further 150bps in easing to come. Israel is
also in the middle of a mini-easing cycle and we think
there is one more cut to come there. Others are more
constrained by the impact of FX weakness on inflation
and/or domestic balance sheets. Turkey, for example, cut
rates in August in response to global developments but
was forced to change course in late October when the lira
continued to weaken, despite significant FX intervention,
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 17
and this started feeding through into inflation (9.5% in
November). Hungary, which has the largest stock of FX
liabilities in EM, also had to hike last month by 50bps to
prop up investor confidence and will likely have to hike
further. Others, such as Mexico, Poland, and South Africa
are likely to stay on hold for the next few months in this
environment. Inflationary concerns, however, would likely
become secondary if a sharper than anticipated global
slowdown threatens to push some of these countries
towards recession, and we could see a larger group of
countries cutting rates.
Strategy: Facing a binary scenario with a
smaller cushion
Defensive trades outperformed in 2011, boosted by the
drop in global rates. External debt was again the best
vehicle to capture the rally in US Treasury bonds, trailing
UST total returns closely as shown in the table below.
Spreads did widen during the year, but EM external debt
was nevertheless supported by its higher quality (that
benefited from ‚flight to quality‛) and the overall negative
correlation between spreads and UST yields. Hedged local
currency debt also performed well, but the rally in local
rates was hindered by EM central banks need to rein in
inflation after three quarters of solid growth and inflation
pass-through from weaker currencies. Not surprisingly,
equities and currencies lagged on stretched valuations,
higher risk aversion, and lower growth.
Asset performances in the past ten years Year
Return Vol Ret/Vol Return Vol Ret/Vol Return Vol Ret/Vol S&P UST
2003 25.7% 18.0% 1.4 5.5% 2.4% 2.3 10.8% 5.4% 2.0 26.4% 2.3%
2004 11.7% 6.7% 1.8 7.7% 2.9% 2.7 14.2% 6.1% 2.3 9.0% 3.5%
2005 10.7% 2.4% 4.4 7.2% 1.9% 3.8 -0.9% 7.1% -0.1 3.5% 2.8%
2006 9.1% 4.5% 2.0 6.4% 2.6% 2.5 4.5% 7.8% 0.6 10.4% 3.1%
2007 6.1% 7.6% 0.8 4.8% 2.6% 1.8 13.7% 6.5% 2.1 3.9% 9.0%
2008 -10.9% 6.3% -1.7 5.4% 7.1% 0.8 -10.1% 15.5% -0.6 -38.5% 14.1%
2009 28.2% 16.6% 1.7 5.2% 4.2% 1.2 16.0% 12.1% 1.3 23.5% -3.8%
2010 12.0% 5.6% 2.1 8.6% 2.8% 3.1 6.5% 6.9% 0.9 12.8% 5.8%
2011 7.2% 5.2% 1.4 4.3% 3.0% 1.4 -4.4% 8.9% -0.5 -0.8% 8.8%
Average 11.1% 8.1% 1.4 6.1% 3.3% 1.9 5.6% 8.5% 0.7 5.6% 5.1%
Correla- w/ S&P 58% 47% 68%
tion w/ UST 47% 40% -6%
GBI-EM (FX -Hedged) EMFX (spot and ca r ry ) Other assets returnEMBI Globa l
Note: EMFX (spot and carry) is derived from GBI_EM unhedged and hedged returns.
Correlation with S&P and UST returns are calcuated using monthly returns. Source: Deutsche Bank
In contrast with the situation a year ago, EM equities and
EM FX are now a source of value for the year ahead. As
we show in the 2012 outlook pieces for EM rates and
currencies in this publication, there are still some
interesting pockets of value in receivers, but the
weakness of many currencies has already taken them into
overshooting territory. As the table below shows, higher
prospective returns are now skewed towards unhedged
local markets exposure – obviously assuming an eventual
resolution of the crisis in Europe. External debt would
likely avoid losses under less upbeat scenarios, but
returns would be rather diminished and lower than FX-
hedged local debt as the UST cushion is now small.
A simplistic projection of EM FI asset returns under
various scenarios of UST and S&P
Intercept UST S&P Carry*
EMBI Global 448.3 -50.3 0.14 4.36
GBI EM (Hedged) 165.3 -11.5 0.01 1.44
EMFX (spot and carry)** 70.9 1.3 0.06 3.49
Current
Level
10Y UST Yield 2.07
S&P 1247
Fitted Level Return Level Return Level Return
EMBI Global 569 556 -2.2% 578 1.6% 570 0.2%
GBI EM (Hedged) 174 175 0.7% 177 1.7% 175 1.0%
EMFX (spot and carry) 171 158 -7.7% 174 2.1% 182 6.6%
* For EMBI/GBI-EM, a UST-weighted time drift term is used in the regression to capture carry;
For EMFX, a time drift term is used. (Regression is based on 2Y history)
** Proxied by the ratio of GBI-EM Unhedged and GBI-EM Hedged
Bearish
Scenario
Neutral
Scenario
Bullish
Scenario
1.50
1000
2.07
1247
3.00
1350
Source: Deutsche Bank
We expect the tug of war between structural and tactical
drivers of 2011 to extend into 2012 – particularly during
the first months of the year, when the future of Europe is
been decided. Valuation supports EM credit, local rates,
and FX – particularly under the risk of some financial
repression in the developed world. Structurally, flows
should also continue to benefit EM, as global investors
remain under-allocated and EM continued to expand the
‚efficient frontier‛ during both ‚risk on‛ and ‚risk off‛
years 4 . However, EM’s still limited depth has kept it
vulnerable to bouts of deleveraging as we repeatedly saw
throughout 2011 and we expect this weakness to persist
into 2012.
A concerted effort from policymakers a la 2008 could
bring a significant relief rally for EM currencies, equities
and high-yielders. But as the institutional constraints are
more entrenched in Europe, implementation risks are
high. We thus favor trades that would perform well under
a scenario where risks become more EU-centric as more
comprehensive back-stops are built and EU gradually
strengthens its institutional framework. Under this
scenario, we expect LatAm and Asian currencies to
outperform EMEA FX, with more US-centric currencies
such as the MXN to outperform, and – with a soft-landing
in China and no disruption in global flows – the RUB to
benefit from high oil prices. As tail risk is contained, we
see room for flatter curves and favor box trades vs. the
UST, while – in credit – we continue avoid central Europe
and, in RV, favor long basis in Venezuela.
4 See ‚EM Flows: Structurally sound, tactically exposed” included in this
publication.
6 December 2011 EM Monthly
Page 18 Deutsche Bank Securities Inc.
Rates: Concentrating on pockets of value
High interest rate differentials, some additional monetary
accommodation, and contained risk still bode for receiving
(locally-funded) rates in EM, although risk-reward is less
compelling than in 2011. For a good part of the year EM
monetary policy flexibility was limited by robust growth
momentum and residual inflationary pressures stemming
both from the rally in commodities of 1H11 and weaker
currencies later in the year. Since then both growth and
inflation have eased, but FX pass-through risks may
continue to hinder a more dovish monetary stance in
several emerging economies, including most of LatAm
(though less so for Brazil’s CB) and also in Turkey, South
Africa, and Hungary – to name a few. But this should not
last long, as below potential growth settles in as
inflation/pass-through are peaking or close to peak. The
integrated analysis of macroeconomic prospect for the
region and valuation indicates that front-end receivers in
Israel, Colombia, and Poland (where we expect 75bp of
cuts in the year) stand out – although the Polish CB seems
comfortably on hold for now. Valuation is now less
compelling in Brazil, despite the gradual 150-200bp of
easing we expect.
Short-end opportunities to receive and curve trades
Source: Deutsche Bank. Model estimate minus forward curve yields.
FX, technicals and credit risk will continue to weigh on the
shape of EM curves – particularly in EMEA, but we expect
rates to reach lower levels and some term premium to be
priced out. More defensive relative value vs. the US
(where we believe risk is biased to higher yields in the
long end) seems attractive in Mexico and Colombia (and
also Israel – see chart below). Valuation is most
compelling in Mexico’s long-end, where positioning is also
relatively light, and US-related credit risks are lower. The
Turkish curve also stands out as too steep from our
valuation perspective, and technicals are light (we favor
gradually adding to Jan20 bonds). Inflation pressures
seem to be easing, but investors may want to wait for
more clarity on FX policies before building positions. FX
risk remains particularly important for Hungary, where
more bear-flattening seems likely before IMF re-
engagement (or not). In contrast, the Chilean curve should
continue to reflect more closely fundamentals and as such
it is prone to bull-steepen, in our view5. We see room for
rates in the 5-10Y sector in South Africa to drop during the
year, but the reliance on foreign demand to absorb heavy
issuance renders the long-end too sensitive to risk and
thus less attractive for box trades vs. the US for now. We
see better risk-reward in Mexico.
Barring a full-fledged credit crunch as in 2008, bank
deleveraging should in principle take a bigger toll on
EMEA markets. In Poland, adding cross-currency basis as
a hedge could mitigate such risks for long government
bonds (as we recommend). In the less EU-centric Russia,
however, the prospect of Euroclearable OFZs should
benefit these bonds while cross-currency swaps already
price a quite cautious global backdrop.
Searching for RV trades vs. UST: COP, MXN, ILS lead
MXN
CLP
COP
TRY
ZARILS
CZK
HUFPLN
-10-8-6-4-202468
1012
0 0.5 1 1.5
3M 10s receiver carry (bp)
Z-score of 10s differentials to USD curve (6M history)
USD Carry
Source: Deutsche Bank
In Asia, the outlook for rates is less constructive. Curves
across the region are rich and flat. Furthermore, we may
see less support from offshore investors in 2012 on less
compelling currency outlook, and better valuation in other
parts of EM. Although some reversal of the policy
tightening we saw in Asia this year is in order, the longer
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 19
end may underperform. We look for steepening from a
combination of some mean reversion in long end and
more from overshoot in the front end, particularly China,
India, Korea, and Thailand. We still favor receiving Hibor-
Libor basis. On cash bonds, underweight Indonesia,
overweight Philippines, and stay neutral on Malaysia and
Thailand.
As we discuss in more detail in the rates outlook piece,
technicals remain an important potential source of
dislocation and we look for defensive trades via
swaptions. Our search indicates that best risk-reward is
found in Turkey, ZAR, and CZK swaps (chart).
Selected defensive trades in EM swaptions
Source: Deutsche Bank
EMFX: Repository of value, but proxy for global risk
In a year of relentless external shocks, EMFX played its
role as a buffer and performed broadly in line with global
equities and the ebbs and flows of risk (chart). This is
unlikely to change in 2012, in our view. EM carry tended
to be negatively correlated with spot returns and only IDR,
RUB, and the managed ARS delivered a positive
combination of carry and total returns. Regionally, EMEA
currencies did underperform LatAm and Asia FX, but the
worst performer of the year was the rand (the traditional
proxy for global equities and commodities instead of usual
suspects such as CE3 FX). Accordingly, global variables
(such as equities, US yields, and commodities) have
gained considerable importance in explaining EMFX
dynamics more globally since 2008. At this critical
juncture in the crisis we expect EM currencies should
remain broadly a vehicle to trade global risk.
EMFX follows global risk
0.9
1
1.1
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
LatAm
EMEA
Asia
Cumulative Total Return in 2011
Source: Deutsche Bank
Value has been restored, but risks remain asymmetric.
The chart below shows positioning and valuation
(indicated as deviations from long-term ‚fair‛ value
determined by. relative productivity, external prices,
openness, and NFAs) 6 . Most currencies are trailing
fundamentals and positioning is also very light. Since,
inflation targeting has secured mean-reversion in EMFX
with few exceptions (notably Argentina) and positioning is
supportive, there is room for retracement both tactically
and fundamentally. However, as EM currencies have
become a proxy for global factors and they are also
susceptible to non-residents’ hedging of their local
investments, the downside risk should the EU crisis
escalate could easily outweigh their potential to retrace.
If our baseline scenario materializes and the crisis
becomes more EU-centric and contained, we could see a
substantial EMFX recovery in 2012. Accordingly, we favor
currencies where valuation and technicals are favorable,
but the drivers of risk are less EU-centric and more
dependent on the outlook for the US/China and
oil/commodities such as MXN, and RUB. We expect
investors to avoid high current account deficits and thus
expect the TRY to trade in a wide range despite attractive
valuation and would buy ZAR only against some
protection for EU/global risks such as AUD, and HUF. We
also position for PLN undervaluation more defensively via
1Y EUR/PLN 4.25 puts. We expect the BRL to benefit on
relief rallies, but the combination of high inflation and the
central bank’s battle to compress carry limits its
attractiveness. We prefer MXN (and also COP) in the
region.
6 See the FX outlook piece in this publication for an outline of the model
and further discussion.
6 December 2011 EM Monthly
Page 20 Deutsche Bank Securities Inc.
More value and lighter positioning
ARS
BRL
CLP
COPMXN
PEN
HUF
PLN
ILS
RUB
TRY
ZAR
KRWIDR
INR
TWD
SGD
PHP0
1
2
3
4
5
6
-0.15 -0.1 -0.05 0 0.05 0.1
Positioning (+ long USD/ - short USD)
Valuation (+ overvaluation/- undervaluation)
Source: Deutsche Bank
Asia FX valuations and growth differentials are still
supportive (though less so than before), but current
accounts are likely to moderate next year, the policy cycle
is turning, and currencies such IDR remain too exposed to
bond outflows for limited upside. We expect the RMB to
continue to appreciate but at a smaller pace than in 2011,
and will feature early in the sequencing of policy easing in
China. We favor keeping a core long in RMB (via 1Y
NDFs), and remain positive on the low beta currencies
with strong current account support such as PHP. We
favor trading SGD NEER on a range basis, and would look
to add on dips within 100bp of the lower bound of the
corridor. Intra-Asia, we like TWD as the funding currency.
We search for defensive trades across EMFX by favoring
high retracement (over the past 100 business days) and
high long USD or EUR call skews via call spreads. The
chart below highlights the best so defined risk-reward
trades: BRL, HUF, CZK, and KRW.
Selected defensive trades in EMFX options
Source: Deutsche Bank
Credit: Diminished returns; country selection key
Given the circumstances, 2011 has been another strong
year for EM sovereign credit. Although the total return has
not been high, there are very few asset classes which
have produced a better performance. In hindsight, a key
factor behind the overall performance of the asset class
was the diversity of performance within it. Indeed, 2011
was unusual in that alpha dominated beta for EM
sovereign credit as the chart below illustrates7.
Differences in yield and volatility did not explain
relative country performance in 2011
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
2011
YTD
2010200920082007200620052004
Rating change Yield (at start)
Volatility (prev yr) All three combined
Explanatory factors for relative country performance,
R2
Source: Deutsche Bank
In this respect, we expect 2012 to bring more of the same
behavior and so our outlook for the market (discussed in
more depth in the separate special report) is geared
toward trying to identify the potential ‘winners and losers’
for 2012. Overall however, we expect EM sovereigns to
benefit from more upgrades than downgrades in the year
ahead.
7 For each calendar year (and 2011 YTD) we regressed the annual returns
of each country against three different factors: (a) the yield of each
country at the start of the year, (b) the volatility of the country in the
previous year and (c) the net change in rating notches during the year.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 21
We expect 2012 to be another year in which upgrades
dominate for EM sovereigns
40%
30%
20%
10%
0%
10%
20%
30%
40%
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
Proportion of upgrades
Proportion of downgrades
Source: Deutsche Bank
The main exogenous source of risk for EM sovereign
credit remains the crisis in the eurozone. However, while
2011 saw the can being ‘kicked down the road’ (albeit by
progressively shorter distances), we believe that 2012 will
bring greater resolution. Muddling through is unlikely to
be an option for much longer, suggesting a fairly binary
set of possible outcomes with respect to asset price
performance. In the positive scenario (some form of fiscal
union and ECB intervention) risk appetite should be
strong, benefiting EM sovereign debt. However, the likely
continued weakness in the global economy, exacerbated
by ongoing bank deleveraging, will mean that
vulnerabilities will remain for some EM countries. The
negative scenario (the eurozone crisis deepens and fears
of a break up of the currency union and/or sovereign
defaults escalate) would be hugely disruptive for global
markets and for global capital flows. In such a scenario we
would expect all vulnerable EM sovereigns to sell off
substantially. In positioning to defend against such a
scenario, we would argue that it would be better to be
underweight (or short) the more vulnerable credits with
lower yields (e.g. Ukraine and Hungary) than the traditional
highest beta credits (Argentina and Venezuela). This
approach towards defending against the crisis scenario
results in a rough barbell approach to risk allocation.
In terms of the overall return outlook for the asset class
we are not optimistic that we will see much better than
mid-single digit returns in 2012. The only scenario which
could bring an upside to this would be one in which
spreads compress, but UST yields remain anchored at
their current low levels. Ultimately however, we see an
environment in which very few asset classes offer a
compelling value/risk proposition and in this environment
EM sovereign credit may well prove to be the least ugly
sister.
For 2012, our strategic country recommendations are
to be overweight exposure to Venezuela, Colombia,
Poland, Russia, and Turkey; underweight exposure to
Hungary, Ukraine, and South Africa.
We also recommend buying Chile 5Y CDS vs. Brazil
as a defensive trade.
In terms of relative value we recommend Venezuela
24s vs.10Y CDS, PDVSA 22s vs. Venezuela 10Y CDS.
Argentina Global 17s vs. 10Y CDS
Drausio Giacomelli, New York, +1 212 250 7355
Robert Burgess, London, +44 20 7547 1930
Marc Balston, London, +44 20 7547 1484
6 December 2011 EM Monthly
Page 22 Deutsche Bank Securities Inc.
Rates in 2012: Identifying Pockets of Value
EM receivers performed well after a rocky start.
Country specifics have remained the dominant driver
of returns, but the importance of global factors
increased in 2011.
In our 2012 outlook, we analyze those country
specifics effects using a model which integrates
macro-monetary policy interactions and local curve
dynamics. We restrict our analysis to two potential
scenarios: the benchmark given by our country
forecasts and a more pessimistic alternative due to
potential events in Europe.
Under our benchmark scenario the ‚fair‛ curves are
relatively close to forward curves. Nevertheless, we
identify some interesting opportunities. The short-
dated tenors of Colombia, Poland, and the long-end
of Mexico and Israel stand out as opportunities to
receive, steepeners seem most attractive in Chile and
Poland, while Peru yields seem too low and the
Turkish curve poised to bear-flatten.
Interestingly, while the analysis under the more
pessimistic scenario produces some changes in
valuation, the most attractive opportunities seem to
be robust to a greater slowdown in economic activity.
Nevertheless, under the bearish scenario technical
issues could pose a greater risk. In analyzing real
money exposure for specific countries we find that
EMEA in general appears more vulnerable than
LatAm. South Africa and Hungary stand out in EMEA,
while Brazil appears more vulnerable in LatAm.
Turkey, Peru, and –to lesser extent – Colombia and
Mexico, could benefit from lean positioning.
Taking Stock of Recent Performance
EM receivers had a relatively good performance despite
the rocky start of 2011, when US growth expectations
were revised up and UST yields sold off sharply. With the
exception of HUF, cumulative returns for EM receivers
(which we compute by rolling 1M10Y forward-starting
swap) turn marginally positive already in February. It still
took a few months for receivers to renter positive
territory, with LatAm outperforming primarily on to closer
connection with the more accommodating Fed, while, in
EMEA, CZK outperformed on its closer linkages with
Bunds. Overall, the initial level of yields had little to do
with total return, with low yielders benefiting from the
dramatic repricing of yields across the US and EU.
EM receivers: Back-loaded returns
-100
-50
0
50
100
150
200
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
USD LatAm EMEA
Accumulative Total Return in 2011
Source: Deutsche Bank
Country specifics have remained the dominant source of
returns, but the share of EM rates returns that can be
attributed to the performance in DM assets increased in
2011 vs. recent years. After controlling for EMFX, weekly
returns of long duration strategies were highly correlated
with global assets such as UST, S&P500 and CRY on a
disaggregated level. For buy-and-hold 10Y receiver swaps
strategies, global factors account for approximately 20%
of the weekly non-overlapping returns, compared to 14%
for the year of 2008, and 10% for the last 5 years (with
PLN and ZAR the exceptions). The results above also carry
on to relative curve trades such as buy-and-hold 2s10s
flatteners. As the chart above suggests, this increased
correlation probably owes to the wide swings in core
rates that seem more likely to repeat under a scenario of
more rapid resolution of the crisis in Europe
Diminishing importance of carry
* Negative Carry are not shown
** Crisis Period: from Sep 2008 to Dec 2009
0%
100%
200%
300%
400%
USD BRL MXN CLP TRY ZAR ILS CZK HUF PLN
crisis 2011 5Y
Carry Return/Absolute Spot Variation
Source: Deutsche Bank
In contrast with EMFX and equities, EM rates
performance remains largely driven by domestic factors,
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 23
with cross-country residuals displaying a low degree of
correlation. Over the past five years, the first principal
component of the individual returns -after controlling for
global macro drivers- is responsible for only 30% of the
total variation, indicating a low degree of cross country co-
movement. In order to assess the outlook for EM local
rates, we thus look in more depth into individual drivers of
curve valuation for hints about potential performance
during next year.
EM rates performance mainly idiosyncratic
* Crisis Period: from Sep 2008 to Dec 2009
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
USD EUR JPY GBP BRL MXN CLP TRY ZAR ILS CZK HUF PLN
crisis
2011
5Y
Source: Deutsche Bank. Percentage of co movement of first component of PCA.
Outlook for 2012
The front-loaded sell-off of 2011 seems unlike to repeat in
2012 unless EU authorities move fast toward fiscal
integration. Although we expect progress toward a
stronger fiscal pact and crisis containment, EU authorities
have rather moved reactively and slowly. It seems too late
to avoid recession in the region and it would be naïve to
expect major breakthroughs on US fiscal policy and
housing overhang ahead of elections. Although progress
seems in order with a more concerted and focal action,
economic growth seems poised to decline. The US could
still avoid recession, while China experiences a soft
landing, but EM will continue to decelerate. The possible
outcomes of this crisis have become more binary,
however, and we consider an alternative scenario where
another credit crunch materializes, China slows down
more than expected, and EM central banks are forced to
act more aggressively amid heightened risk aversion.
Assessing valuation in binary scenarios
We build on a model which integrates macro-monetary
policy interactions and local curve dynamics. The
methodological discussion is summarized in the box at the
end of this piece and the results are presented in the
charts below. The chart shows the difference between
our estimated curves under two different scenarios for
several LatAm and EMEA countries and their respective
forward curves. The baseline scenario is given by our
economists’ forecasts presented in the respective country
sections of this publication. The alternative, more
pessimistic, scenario assumes a larger slowdown in
activity triggered by credit crunch, contagion and the
associated reduction in inflation.8
We find that under our benchmark scenario the simulated
curves are relatively close to forward curves.
Nevertheless, we identify some interesting opportunities
across both short and long tenors.
The short end:
We find little value on the front-end (1Y) of most
curves (see chart); in particular the forward valuation
in the short tenors of the local curves in Mexico,
Brazil, South Africa or Czech Republic are broadly
consistent with our own forecasts. The market has
already discounted enough monetary easing in Brazil
(-150bp), and it seems difficult that the Bank of
Mexico would engage in an aggressive monetary
easing by cutting much more than the 25bp already
discounted by the market. In EMEA, the SARB has
already signaled it will remain on hold.
The short-dated tenors of Colombia, Poland, and to
lesser extent Israel, seem more attractive. In
Colombia, this is consistent with our view that the
market has been too aggressive in pricing potential
tightening of monetary conditions. Although we
believe that the central bank will continue its recently
initiated hiking cycle, it should pursue a more gradual
path than currently discounted by the market. In
Poland, the NBP is pointing to 2H cuts (75bp, in our
view), but these could be advanced depending on
extent of the slowdown in the EU and PLN
weakness. We are more constructive in Israel, where
the latest minutes and inflation numbers pave the
way for two more cuts.
In Peru and Turkey pricing is relatively tight in short
tenors, suggesting a bias to pay in these countries. In
the case of Peru, a managed exchange rate, local
pension system support and foreign sponsorship
have helped the local curve to remain immune to
increasing volatility in external markets. In Turkey, the
corridor blurred the policy rate as the instrument of
monetary policy and we prefer to focus on the longer
end of the curve.
8 In particular, we assume a departure from our forecasts of -2% and -1%
for the output gap and inflation respectively.
6 December 2011 EM Monthly
Page 24 Deutsche Bank Securities Inc.
Simulated curves vs. forwards
Source: Deutsche Bank
The long end:
We find more value at longer tenors (10Y) of some
curves under our benchmark scenario. The best
opportunities appear in Mexico and Israel, where
premium seems to have overshot fundamentals the
most. In contrast, there are some curves which have
not incorporated enough risk premia, in our view,
such as in Brazil, Chile, Peru, Poland, and Czech
Republic. Accordingly, while steepeners appear as
attractive in Chile and Poland (swaps), and to lesser
extent, Brazil and Russia, flatteners seem most
attractive in Mexico and Israel.
Interestingly, while the analysis under the more
pessimistic scenario produces some changes in valuation,
the most attractive opportunities seem to be robust to a
greater slowdown in economic activity. The front-end of
the Colombian curve stands out in terms of offering value
to receive under that scenario, while the Mexican and
Israeli curves continue to be the best options in the long
end. Steepeners in Chile also become more attractive
under a sharper slowdown – in line with typically
aggressive central bank responses.
Positioning: A lingering source of risk
Following two years of steady inflows, EM Local Debt
saw significant outflows starting last September (although
moderate as a percentage of assets under management).
Still, positioning bodes for caution as it looks elevated in
several markets -in some cases near historical highs. The
chart below shows the latest figures and the distribution
of foreign holdings of domestic debt.
Encouragingly, the past year’s tame investor reaction to
rising risk has revealed remarkable resilience to repeated
bouts of global deleveraging. Fundamentals such as low
growth, controlled inflation, and high interest rate
differentials likely played an important role, with local debt
flows showing considerable more stability than EM
equities flows. That central banks have been ready to
provide plentiful liquidity should also remain reassuring for
local investors. Accordingly, foreigners remained
committed even throughout the most serious episode of
risk aversion (September), when disruptions to USD
funding of European banks acted as a channel of
contagion to EM. It appears that most funds chose to
hedge their exposure to FX via NDFs rather than unwind
their bond positions. This should stay the norm barring a
major setback in Europe.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 25
Inflows have been on an exponential trend (USD bn)
TH
ZA
TR
RU
PL
MY
MX
KR
ID
HU
CZ
BR
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0% 5% 10% 15% 20% 25% 30% 35% 40%
Foreign Holdings of Domestic Government Debt (latest data)
Foreign Holdings of Domestic Government Debt on 31-Aug-08
Source: Deutsche Bank
In our view, fundamentals and the binary risks we foresee
continue to support long rates and inflows into bonds at
the expense of equities – the pattern of the past years
that we doubt will change at least while growth is
depressed in the US and the EU is in recession. However,
local markets inflows have been sensitive to bouts to risk
aversion (proxied by the VIX) despite the structural forces
discussed above.
The exposure z-score indicates how ‘over-/under-
weight’ funds are at present
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
BR ZA MY TH KR HU MX CO RU CZ ID PL EG RO PE IL TR
Oct 11
Prev. Mth
Exposure Z-score*
*-Avg exposure vs benchmark, relative to 12mth MA, divided by StDev of monthly
change in exposure
Source: Deutsche Bank
In order to assess which curves seem more exposed to
short-term disruptions, we have developed an approach
that allow us to monitor these funds average exposure
relative to the country’s weight in the benchmark as well
as the relative strength of these funds appetite for a
specific country.9 In our assessment, we find that EMEA
in general appears as more vulnerable than LatAm.
South Africa and Hungary stand out in EMEA as most
vulnerable, while Brazil more vulnerable in the LatAm. In
the case of South Africa – where the curve was most
obviously dependent on external factors – the local
investor base seems to be persistently underweight when
yields for back-end bonds fall below (8.5-9%), leaving the
role of supporting the market to foreign investors. In a
scenario, where foreign inflows are more timid next year,
the curve would steepen and ASW will widen.
In the case of Hungary, we are concerned that non-
resident holdings have not adjusted enough in line with
the riskier profile as it falls into economic recession in
2012 (our base case scenario). Non-resident holding are
only 7% below their recent peak, despite a downgrade to
sub-investment grade by one rating agency. More
negative news, such as disappointments in IMF
negotiations could accelerate foreigner’s exit from that
market. Brazil stands out in terms of positioning in the
LatAm region and it could be contrasted with the situation
in Mexico. While appetite in Brazil should remain strong
amid easing, the outlook could change should the
currency weaken substantially (not our baseline scenario).
At the other end of the scale, we believe that Turkey
benefits from a high carry and low positioning, and
therefore an improvement in fundamentals is likely to be
met with strong inflows. Peru and, to lesser extent,
Colombia and Mexico, could benefit from lean positions.
The buyers v sellers index gives an impression of the
relative strength of appetite for different countries
-0.5
-0.4
-0.3
-0.2
-0.1
0
+0.1
+0.2
+0.3
+0.4
+0.5
ZA TH RU BR KR CO CZ HU RO MX MY TR PL PE IL ID EG
Oct 11
Prev. Mth
Buyers v sellers index, 3m MA*
*-Number of funds actively increasing exposure minus number of funds actively
decreasing exposure, divided by the total number of funds
Source: Deutsche Bank
9 For details on the methodology: please see “A Closer Look at Real-
Money Positioning”, inside this publication
6 December 2011 EM Monthly
Page 26 Deutsche Bank Securities Inc.
Defensive trades in swaptions
As protection for potential bouts of deleveraging we look
for high payout ratios in put spreads after normalizing for
the different degrees of responses during the 2008 crisis.
The chart below shows the resulting ‚normalized‛
ranking: ZAR, CZK and TRY offer a combination of steep
skew and significant upside move in the underlying rate
making those curves the most desirable ones to place
defensive trades in the back end. We build these curves
by fixing the difference between high and low strike at
25bp. The payout ratio monotonically increases with the
volatility skew, but to make these positions we take the
2008 as the benchmark year for a shock. We thus
normalize the move in rates by the realized standard
deviation (a 5bp move in ILS would correspond to a 10 bp
move in TRY, for instance).
TRY, ZAR, and CZK stand out as defensive trades
Source: Deutsche Bank
Conclusion and recommendations:
The situation remains fluid, but while valuation is not
particularly appealing fundamentals and the risk bias
favors receivers in EM. In this piece we look at valuation
in more detail and highlight the most attractive pockets of
value. Interestingly, these opportunities seem to be
robust to our more pessimistic scenario characterized by
lower economic growth and inflation. Our top
recommendations in LatAm and EMEA are:
LatAm: In Argentina, stay out of local curves but
favor Badlar linkers in relative terms. In Brazil, take
profits on July ’12-Jan ’17 DI steepener and enter Jan
’13-Jan ’15 flattener. Enter a 2s5s CLP/CAM
steepener in Chile. In Colombia close 2s3s IBR/COP
steepener and enter a 5Y receiver, either in IBR/COP
or TES Jun ’16, against 5Y USD swap payer. Take
profits on 5Y TIIE payer in Mexico, and enter a box
trade of 2s10s TIIE flattener against 2s10s USD swap
steepener
EMEA: In Israel receive 2Y IRS. In Poland receive 1Y
XCCY basis as a hedge. Receive 1Y EURPLN cross-
currency basis. In Czech Republic take profit on
2s10s
Drausio Giacomelli, New York, +1 (212) 250 7355
Mauro Roca, New York, +1 (212) 250 8609
Guilherme Marone, New York, +1 (212) 250 8640
Lamine Bougueroa, London, +44 (20) 7545 2402
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 27
Appendix: Modeling local curves
To determine how the different curves could behave in
these distinct scenarios we use a dynamic model of the
term structure of interest rates based on macroeconomic
fundamentals (see “EM Rates: Modeling Curve Dynamics
under Macroeconomic Shocks,” EM Special Publication,
November 18th 2011). Our methodology can be
characterized by a series of steps.
First, we parameterize the yield curve using a Nelson-
Siegel decomposition. This approach consists in
projecting the entire yield curve on three latent factors,
which could be associated with the level, slope, and
curvature, respectively (see chart). One of the advantages
of this approach is that the relationship between the
different tenors of the yield curve and these latent factors
has a closed form representation which can be used to
reconstruct the entire yield curve from these three factors
at any point in time.
Since we are ultimately interested in exploring the
behavior of the yield curve under different
macroeconomic conditions, in a second step we estimate
an econometric model (Vector Auto-Regression, VAR) of
the latent factors and some selected macroeconomic
variables). Following a basic New Keynesian
representation we characterize the economy by a
measure of prices (YoY consumer price inflation), a
measure of activity (the deviation of GDP or IP from its
trend), and the stance of monetary policy (the policy
interest rate).
Finally, from the estimated relationships between the
variables in the VAR, we can forecast the interest rate
curves under certain assumptions regarding the future
evolution of the macroeconomic variables or determine
what would be the dynamic response of each of these
variables –or the entire term structure of interest rates- to
a shock in any other variable (that is, we obtain the
corresponding impulse response functions). We can then
compare the simulated curves with forward curves to
assess if there is some value under our assumptions.
In summary, our methodology allows analyzing the
behavior of the term structure of interest rates by
exploiting the dynamic feedback mechanism between the
latent factors, -representing the yield curve- and some key
macroeconomic variables. The latter influence the position
and shape of the curve, but the curve also influences the
evolution of the macro variables.
What Nelson-Siegel factors capture
4
5
6
7
8
4
5
6
7
8
Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11
NS LEVEL CLP/CAM 10Y, lhs%
-4
-2
1
3
5
7
-100
0
100
200
300
Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11
CLP/CAM 2s10s, lhs NS SLOPEbp
-5
-3
-1
1
3
5
7
9
-20
0
20
40
60
80
Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11
CLP/CAM 2s5s10s NS CURVATUREbp
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 28 Deutsche Bank Securities Inc.
Appendix: Rates Strategy Summary
Country View Strategy Risks
China We believe the risk of an RRR cut before the year-
end is rising to 30% from 0% and we expect short-
term rates to fall towards 3% over the next two
months.
We take profit on the 2Y/5Y steepeners Upside surprises on CPI which could delay
monetary easing
Hong Kong Hibor - Libor basis to remain stable towards the
year-end
Looking to receive Hibor-Libor basis position USD strengthens against EM currencies
India Concerns about further fiscal slippages to add to
issuance will keep cash bonds under pressure,
unless we see RBI easing liquidity through OMOs
or a cut in CRR. That might not come till the CB
gets more evidence of a sharp growth slowdown,
or at least an easing in inflation because of base
effects into end year. Timing is critical in receiving
the front end of OIS curve, given the steep
negative carry.
Neutral A very weak Q3 (calendar 2011) growth number.
Indonesia Mostly a tail risk trade at these levels. The
fundamentals of the Indonesia story have not
changed, but we don’t like the timing of the rate
cut by BI, or indeed that the CB has been the only
significant buyer of duration in the last couple of
months.
Stay underweight Squeeze on under allocated investors if risk tone
improves, especially as supply winds down into
end year
Malaysia The policy outlook could arguably turn more dovish
in the coming months, but with a large supply
calendar in 2012, the markets would need strong
appetite again from offshore investors, in the
absence of interest from local players.
Neutral. Return of appetite for EM exposure among global
investor portfolios.
Philippines Except for its traditional EM like character
because of shallow markets, there is little to fault
the rates backdrop in Philippines - comfortable
inflation outlook, improving fiscal picture, strong
BOP and low concentration of risk with offshore
investors.
Modest overweight. Spike in food inflation because of spillover from the
Thai flood situation.
Singapore With the MAS not having eased as aggressively as
expected, richness in front end of the curve could
persist for a while on weak macro conditions.
Neutral Upside surprise to economic data.
South Korea Steepening bias on KTB curve driven by rolling over
pressure from the concentration of KTB
redemption in December. Modest steepening view
on KRW 2Y-5Y IRS curve.
DV01 neutral 3Y/10Y KTB steepener through 3Y
and 10Y KTB futures at 36bp with a target of 50bp.
An early monetary easing tends to flatten the IRS
curve.
Thailand The flood situation is likely to remain a drag on the
supply outlook for this market. Any dovish turn in
the policy outlook could end up impacting belly of
the curve more, given the low level of yields in the
front end.
Pay 5Y/10Y steepeners, target 60bp. BOT cuts rates sharply in response to a
worsening flood situation.
Taiwan The front-end of the IRS curve likely will remain
anchored but 5Y/10Y has room to flatten.
Maintain 2Y/5Y/10Y butterfly spread paid position
at -7bp
Deterioration in exports and growth causing CBC
to turn dovish.
Czech Czech economy to be impacted by the Eurozone
slowdown. Central bank to remain dovish
Neutral at current levels A reversal in risk appetite that would hurt the
Krona
Egypt Significant deterioration in the political outlook
since the reinstatement of emergency rule.
Balance of payment difficulties likely to persist
causing pressure on the level of FX reserves
We do not favour being invested in EGP or T-bills
until we see more clarity on the political situation
Resumption of demonstrations asking for a faster
pace of reforms, leading to capital outflows
Israel Disinflation trend to persist due to macro and
micro elements. BoI likely to continue monetary
easing policy
Receive 2Y IRS. Expect curve to bull steepen Middle East political uncertainty
Poland Our and market expectations Cuts have been
pushed back to Q3 2011. Growth to decelerate but
remain positive in 2012. Inflation to start slowing
after Q1 2012
Receive 1Y XCCY basis as a hedge. Outright
purchase of POLGBs will be attractive in H2 2012
The negative impact of the Eurozone crisis on
banks operating in Poland (liquidity risk)
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 29
Appendix: Rates Strategy Summary Cont’d
Country View Strategy Risks
Russia Strong fiscal performance. Year-end inflation
target (7%) likely to be met, but capital outflows
maintaining rates at a high level
Neutral in rates. Bullish bias on OFZ market A sudden fall-out in global growth would have
negative consequences for oil
South Africa SARB to stay on hold for a prolonged period.
Inflation outlook dependent on ZAR
Expect rates to trade in range consistent with
5y5y in (8.40-9%). Front-end rates are well
anchored, while the back-end is dependent on ZAR
performance. 2s10s set to steepen
Large scale foreign outflows from bond and
equities, caused by global risk aversion
Turkey CBT trying to juggle multiple goals, but with
inflation being its top priority at this stage. De
facto tightening of monetary policy to help
rebalancing the economy
Receiver bias at the back-end Roll-over risks for local banks short term external
debt
Argentina With real yields in low double digits CER-linked
bonds do not offer an attractive return for foreign
investors.
In relative terms, we continue to favour Badlar
linkers, which benefit from nominal instability.
Liquidity could dry very rapidly
Brazil The market is widely expecting that BCB will
continue reducing rates aggressively during 1Q12
(150bp to 9.5%).
We recommend taking profits on our July ’12-Jan
’17 DI steepener recommendation and position for
a setback in short-term rates with a Jan ’13-
Jan’15 DI flattener.
With domestic and external activities trending
lower, the risks to this scenario are still biased to
the downside due to BCB’s increasing focus on
growth.
Chile As the economy continues to decelerate, the
BCCh seems closer to ease monetary conditions.
As a consequence, we recommend shifting the 2Y
breakeven inflation position to the 5Y sector and
entering a 2s5s CLP/CAM steepener.
The cuts could help to build up additional risk and
inflation premium in the belly of the curve.
Colombia The local curve has been anticipating the on-going
tightening cycle for some weeks.
Closing 2s3s IBR/COP steepener and entering a 5Y
receiver, either in IBR/COP or TES Jun ’16, against
5Y USD swap payer .
Risks are biased to the downside for short-term
rates, as the slowdown in global growth may drag
on domestic activity and reduce some inflationary
pressures.
Mexico Local rates have been following the movements in
the exchange rate.
We take profits in our 5Y TIIE payer
recommendation and switch to a box trade of
2s10s TIIE flattener against 2s10s USD swap
steepener .
The reduction of risk appetite.
Peru The local curve, supported by favorable technicals
and a stable currency, has shown extraordinary
resilience to external events.
With the curve now trading at relatively low levels,
the risk/reward of the position looks less
attractive, even at shorter tenors.
Higher than expected inflation might force the
Central Bank to rise rates.
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 30 Deutsche Bank Securities Inc.
FX in 2012: The Vehicle to Trade Global Risk
During 2011, EMFX played the role of shock absorber
with a large share of returns attributed to global
drivers. It ended the year as one of the worst
performer across the major global asset classes. In
line with increased risk aversion, ex-ante carry tended
to be a poor indicator of ex-post performance.
External factors should remain the main drivers of EM
currencies in 2012. More attractive valuation will have
to overcome the ebbs and flows of external prices,
portfolio flows, and risk appetite. For its liquidity and
role as a shock absorber, EMFX should continue to be
the preferred vehicle EM investors have to express
their views on the global economy and the prospect
for the EU crisis.
Global risks could be amplified by domestic
weaknesses. Even if global risks do not escalate but
linger, the market may start to focus on EM’s
‚periphery‛.
In LatAm we recommend entering zero-cost 1x2
USD/BRL put spreads and short CAD/MXN, while
maintaining short EUR/CLP and long USD/PEN. In
EMEA, we favor shorting EUR/ILS and oil sensitive
NOK/RUB, and entering long PLN/HUF and long ZAR
versus an equally weighted basket of similarly high
betas AUD and HUF.
Taking Stock of Recent Performance
EMFX –after EM equities– ended the year as one of the
worst performer across the major global asset classes10.
In line with perceptions on global growth, EM currencies
performed reasonably well until mid-year, when the EU
crisis and worsened economic data in developed markets
prevailed (chart). In terms of leaders and laggards,
idiosyncratic currencies such as PEN and (the managed)
ARS outperformed their peers while currencies most
linked to global drivers (such as ZAR) lagged – although
country-specifics also amplified external shocks in
currencies such as TRY and INR.
10 See ‚EM performance: The grass is greyer on the other side‛ in this
publication.
EMFX performs in line with global growth and risk
0.9
1
1.1
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
LatAm
EMEA
Asia
Cumulative Total Return in 2011
Source: Deutsche Bank
In line with increased risk aversion, ex-ante carry tended
to be a poor indicator of ex-post performance with
positive carry normally incurring in negative P&L as shown
in the chart below. Except for the IDR, only managed or
dirty floating currencies such as the RUB, ARS and PEN
delivered positive total return and carry, with only the low
carry PEN posting total return in excess of carry.
Under heightened risk aversion, carry anticipated loss
Source: Deutsche Bank
EMFX played the role of shock absorber and, accordingly,
a large share of the returns could be attributed to global
drivers in 2011. Cross-country did matter with heavy
positioning, stretched valuations, or lack of central bank
support associated with underperformance. But simple
regressions of spot EMFX weekly changes on the
equivalent changes in some relevant global variables (SPX,
UST and CRY) shows that ex-carry, total returns indeed
traded as a global asset in 2011. As the chart below
shows, and as we have highlighted in several reports,
EMFX has become more of a proxy of global risks since
the outset of the 2008 crisis. Except for more tightly
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 31
managed RUB, the best performers were the low r-square
currencies (ARS and PEN) while the worst performers
(ZAR, TRY and MXN) were the high r-square pairs.
EMFX as a proxy for global risks
0%
10%
20%
30%
40%
50%
60%
70%
ARS BRL CLP COP MXN PEN CZK HUF PLN ILS RUB TRY ZAR KRW IDR INR THB TWD SGD PHP
crisis 2011 5Y
Source: Deutsche Bank
Outlook for 2012
External fundamentals and technicals should remain the
main drivers of EM currencies in 2012. In contrast with
rates where fundamentals and –to a lesser extent
valuation– are aligned, in the case of EMFX more
attractive valuation will have to overcome the ebbs and
flows of external prices, portfolio flows, and risk appetite.
For its liquidity and role as a shock absorber, EMFX should
continue to be the preferred vehicle EM investors have to
express their views on the global economy and the
prospect for the EU crisis. This and the fact that real
money investors have hedged their local markets
exposure at moments of stress should continue to amplify
external shocks even if speculative positioning is light.
From a tactical perspective, the most pressing issue is
whether the steps to fiscal integration to be announced
later in the week will suffice for the ECB to step up its
purchases. We believe that it will – even if backloaded to
1Q12 –and that additional firepower will be added by the
IMF– conditional on EU’s increased commitment to
resolution of the crisis.
Our scenario thus bodes well for near-term retracement in
EMFX under the view that a more concerted action by
authorities will succeed in containing the escalation of this
crisis and hopefully render it more EU-centric. But as
many parts need to fall in place implementation risk will
run high and we favor trades that could benefit from less
policy-sensitive risks as US growth and China’s soft-
landing supporting commodity prices.
The degree of underperformance vs. financial drivers
presented in the table below provides an indication of
potential retracement and sensitivity to each driver (not
shown) 11. PLN and HUF naturally feature among the most
‚undervalued‛ after the recent correction, but we’d rather
avoid their sensitivity to EU developments. Although the
table below also points to laggards such as the ZAR and
TRY as the pairs that have most room to catch up under
retracement, we would be long ZAR only vs. an equally-
weighted basket of crisis-sensitive HUF and AUD and
avoid currencies with large current account deficits such
as TRY.
We favor currencies such as MXN (vs. USD or CAD), COP,
and RUB (vs. NOK) that are more exposed to US and
commodities (oil) instead. Tactically we would be long
BRL, although – from a longer-term perspective – we find
it less appealing than MXN.
EMFX overshoots drivers, but heterogeneity matters
Source: Deutsche Bank
From a strategic perspective, growth prospects and EM
fundamentals in particular are most relevant and we focus
on macro – rather than financial – variables to asses value.
Accordingly, we estimate ‚fair‛ value using an
econometric model of real effective exchange rates vs.
selected macroeconomic fundamentals such as
productivity, terms of trade, net foreign assets, and trade
openness (see Appendix for further details). Although this
11 The table shows EMFX misalignments vs. a benchmark of financial
drivers such as S&P500 (or VIX), CRY (or the more appropriate metric for
external prices a country faces), EUR/USD and UST or credit risk. The
regressions are specified according to each currency pair
6 December 2011 EM Monthly
Page 32 Deutsche Bank Securities Inc.
model has more of a medium to long term appeal, and misalignment tends to correct only gradually, the equilibrium values are more representative of EMFX’s true value as currencies do tend to revert to this moving “mean”12.
The results point to some similarities across fundamentals- and financials-based models. This is not surprising when floating currencies trade more closely to fundamentals so that dislocations show in both types of models. But in currencies such as the BRL very high rates and an elevated pace of foreign direct and portfolio investment could set a wedge between financials and fundamentals approaches. Indeed, the BRL appears undervalued according to the short-term financial drivers perspective, but it remains one of the most overvalued EM currencies from a fundamentals standpoint (see chart below). Moreover, as the level of inflation the central bank now accepts combined with its urgency to depress carry suggest that the BRL has become a less appealing currency to hold strategically while policies are not corrected. Currencies such as MXN, ZAR, PLN and TRY appear as undervalued in both set of estimates, but MXN poses the best BoP situation. PLN vulnerability is less than HUF and valuation is more attractive, but we prefer to add more cautious bullish trades via EUR/PLN put spreads.
Undervaluation vs. fundamentals is becoming the
norm
Source: Deutsche Bank
While higher inflation is a long-term concern for the BRL and also for TRY, it is the main concern for the Argentine peso because of the higher rate of inflation in Argentina (about 5 times higher than in Brazil) and lower reserves (less than 1/7th Brazil’s). But with forwards already pricing 20-30% devaluation and FX being an important nominal anchor for the country, this is already in excess of the
12 Inflation targets and batter balance sheets have anchored inflation and rendered nominal EMFX mean-reverting across most emerging countries.
devaluation we foresee. Most countries have accepted some depreciation to reflect worse fundamentals, but in Peru more forceful intervention has already pushed the currency into slight overvaluation territory. The less interventionist and more EU-sensitive EMEA FX naturally concentrates the most undervalued currencies in our sample. From a risk perspective, the chart below shows that the most overvalued currency in our sample (the BRL) has moved closer to fair, but the degree of undervaluation in MXN, PLN or TRY has increased further despite already hovering around depressed levels.
EMFX valuation: Corrections and exaggerations
Source: Deutsche Bank
How risky are EM currencies? Although global risks are dominant they could be amplifying by domestic weaknesses. Moreover, even if global risks do not escalate but linger, the market may start to focus on EM’s “periphery”. The following tables present a set of scores to gauge external and fiscal vulnerabilities across EM countries. Not surprisingly Hungary stands out, although Poland’s and Turkey’s wide current account deficit also raises concerns, although market financing seems a lot more robust than in Hungary. In LatAm, the current account deficits are wider in Brazil and Colombia, but the capital account is expected to provide enough financing. Argentina is the only country in the region where international reserves could begin to matter, particularly if the government insists in using the Central Bank as a financing source to service the debt.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 33
EMEA appears more vulnerable than LatAm
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FX
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Fo
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laim
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EMEA
Czech Rep
Hungary
Israel
Poland
Russia
South Africa
Turkey
LatAm
Argentina
Brazil
Chile
Colombia
Mexico
External FinancialFiscal
Source: Deutsche Bank
When observing positioning, valuation, and carry/risk
indicators for EMFX, we find that there is ample
heterogeneity (see Table below). Some currencies like
ARS, BRL or TRY continue to offer relatively high carry but
as a compensation for different types of risks. Valuation is
becoming attractive in several currencies, but BRL and
PEN are clearly overvalued. Risk reversals are relatively
high across EM FX, but those of BRL and MXN are
relatively low with respect with recent history. Positioning
is relatively lean across all EMFX, with PEN, MXN and TRY
standing out in terms of long USD bets.
EM FX Scorecard: An heterogeneous landscape
Technical
ST LT 3M Carry 3M Carry/Vol 3M IV/HV 3M 25D RR* Positioning**
ARS - 2% 28.9% 1.9 4.3 1.5 1.0
BRL -7% 5% 7.6% 0.4 0.8 0.6 2.5
CLP 0% 0% 4.3% 0.2 1.0 1.1 3.5
COP -10% 0% 0.2% 0.0 1.4 1.3 4.0
MXN -7% -10% 2.8% 0.2 0.8 0.5 4.5
PEN 0% 6% 3.1% 0.5 1.6 1.1 5.0
CZK -1% - -0.3% 0.0 1.1 2.4 1.0
HUF -5% -4% 4.3% 0.3 1.0 2.0 0.5
PLN -6% -15% 3.7% 0.3 0.9 1.4 1.0
ILS -3% 3% 0.8% 0.1 1.1 2.5 0.5
RUB -2% -2% 5.4% 0.3 1.0 1.5 1.5
TRY -10% -13% 7.6% 0.5 1.0 1.5 4.0
ZAR -12% -14% 5.4% 0.2 0.9 1.2 2.5
KRW - 4% 2.1% 0.1 1.1 0.8 0.5
IDR - 9% 8.9% 0.6 1.1 1.7 0.5
INR - -4% 7.2% 0.6 1.1 1.8 0.5
THB - 3% 3.4% 0.5 1.0 1.7 -
TWD - -2% -3.0% -0.4 1.1 1.2 2.0
SGD - -4% -0.2% 0.0 0.8 0.8 1.0
PHP - -2% 1.2% 0.1 1.0 1.2 0.5
ST: Short-term valuation model based on financial drivers
LT: Long-term valuation model based on macroeconomic fundamentals
Carry/vol: Ratio of expected carry and implied volatility
IV/HV: Ratio of implied and historical volatility
25D RR: 1-year z-score of 25D risk reversal
Positioning: Latam, z-score of official data; EMEA and Asia, dbSelect Positioning Indicator
Valuation Return Risk
Source: Deutsche Bank
Considering all the potential risks and the heterogeneity of
the asset class, it is worth asking which currencies offer
the best defensive trades. To answer this question we
look at those liquid pairs with higher USD call spread
payout ratios and which have retraced the most during the
last 100 days (see chart). We find that BRL, KWR and CZK
stands out.
Top trade recommendations:
LatAm: Enter zero-cost 1x2 USD/BRL put spreads, and
maintain short EUR/CLP and long USD/PEN. Take profits
on long MXN/CZK and switch to short CAD/MXN.
EMEA: Short EUR/ILS and oil sensitive NOK/RUB. Enter
long ZAR versus an equally weighted basket of similarly
high betas AUD and HUF and long PLN/HUF.
6 December 2011 EM Monthly
Page 34 Deutsche Bank Securities Inc.
Identifying defensive trades
Source: Deutsche Bank
Drausio Giacomelli, New York, +1 (212) 250 3755
Mauro Roca, New York, +1 (212) 250 8609
Guilherme Marone, New York, +1 (212) 250 8640
Appendix: Our Model of Equilibrium REER
We base our assessment of fundamental valuation of EM
FX in an econometric model of the real effective exchange
rates (REER). More specifically, our model can be framed
into the class of Behavioral Effective Exchange Rate
(BEER) models.
Following the extensive literature on exchange rate
valuationi, the value of the exchange rate is determined in
this model by a few relevant macroeconomic variables.
We choose these variables with the aim of both capturing
the main determinants of exchange rate valuation and
maintaining a parsimonious model for tractability
purposes. In particular we use the following variables:
- Productivity differential (ratio between domestic and
foreign total factor productivities). This is a proxy for
relative productivities of the tradable and non-tradable
sectors, capturing the well known Balassa-Samuelson
effect (a higher productivity differential produces a relative
appreciation of the currency). ii
- Net Foreign Assets (ratio between net foreign assets
and GDP). This variable captures the potential inter-
temporally financing of the current account with net
holdings of foreign assets. iii
- Terms of trade. This variable captures the positive
income and wealth effects resulting from an improvement
in the relative price of exports.
- Openness, (ratio of the sum of imports and exports and
GDP). This variable not only captures the sensitivity of the
exchange rate to disequilibrium in the domestic economy
and its external sector but also is very sensitive to
structural breaks resulting from regime changes or crisis.
To estimate the model we follow a cointegration
approach, following and Granger and Engle.iv We apply it
to a panel covering more than a decade of monthly data –
from January 2000 to October 2011- for 20 EM countries.
The panel approach allows us to exploit the information in
the cross-section of countries to overcome the relative
short duration of macroeconomic time series of EM
countries. However, this forces all countries in the panel
to share regression coefficients, neglecting some relevant
diverse characteristics. We chose a balanced approach by
estimating regional panels for LatAm, EMEA and EM Asia;
this allows us to exploit intra-regional similarities without
being subject to inter-regional differences. Moreover, we
allow the coefficient of openness to be country specific as
this variable –as explained above- captures several
idiosyncratic effects.
iMacDonald, Ronald, 1998."What determines real exchange
rates?: The long and the short of it," Journal of International
Financial Markets, Institutions and Money, Elsevier, vol. 8(2), pp.
117-153, June; Obstfeld, Maurice & Rogoff, Kenneth, 1995.
"Exchange Rate Dynamics Redux," Journal of Political Economy,
University of Chicago Press, vol. 103(3), pages 624-60, June;
Sebastian Edwards & Miguel A. Savastano, 1999. "Exchange
Rates in Emerging Economies: What Do We Know? What Do We
Need to Know?," NBER Working Papers 7228, National Bureau of
Economic Research, Inc.i ii Bela Balassa, 1964."The Purchasing-Power Parity Doctrine: A
Reappraisal," Journal of Political Economy, University of Chicago
Press, vol. 72, pp. 584. iii
Philip R. Lane & Gian Maria Milesi-Ferretti, 2006."The External
Wealth of Nations Mark II: Revised and Extended Estimates of
Foreign Assets and Liabilities,1970-2004," The Institute for
International Integration Studies Discussion Paper Series 126. iv Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and
Error Correction: Representation, Estimation, and Testing,"
Econometrica, Econometric Society, vol. 55(2), pp. 251-76,
March.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 35
Appendix: FX Strategy Summary
Country View Strategy Risks
China Authorities have yet to signal worries of a slow
down in economic activity. Monetary policy
remains focus on stabilizing inflation and
authorities are allowing gradual appreciation of the
RMB.
Sell 1Y USD/CNY NDF with trailing stop-loss of
1.5%.
Positioning unwind extends; authorities pushing
spot higher in retaliation to US protectionists
measures
Hong Kong We do not think HKMA will change its USD peg in
the near-term. HKD has been trading in line with H-
shares, and we suggest watching signs of policy
easing in China, which would be a catalyst for a
renewed rally in H-shares and HKD.
Neutral HKMA surprises with a policy change
India India runs a huge C/A deficits and is dependent on
foreign inflows to fund its deficits. Weak market
sentiment limits portfolio inflows, while RBI is not
showing effort to stabilize its currency through FX
intervention.
Bearish. Negative risk sentiment due to external factors or
domestic corporate governance issues.
Indonesia Recent move by the central bank to cut interest
rates, as well as hints of more cuts ahead, could
dampen foreign bond inflows somewhat. However
FDI and C/A inflows remain strong and should
provide support for the IDR.
Neutral Sharp acceleration in inflation or global risk
aversion causing heavier bond outflows.
Malaysia The MYR has a high beta to global sentiments. A
bullish mid-term view is still warranted given the
strong C/A and growing FDI inflows, though a
stabilization in risk sentiment is needed before the
MYR resumes its uptrend.
Neutral Weak growth environment causing BNM to be
more defensive on FX.
Philippines BoP underpinned by steady growth in remittances
and outsourcing inflows. Seasonals are turning
favourable for the peso and remittances are likely
to pick up ahead of the year-end festive period.
Positive, with a 3M target of 42.5 Oil / food price shocks dragging down the BoP.
Singapore With SGD NEER spot and forwards still trading
below the mid-band, there remains scope for SGD
to appreciate vs. the basket. However, the beta of
SGD to external drivers is exceptionally high and
SGD is thus vulnerable to swings in the euro and
global risk.
Neutral A sharp slowdown in economic growth leading
MAS to shift to a neutral policy
South Korea Positive on valuations and strong C/A surplus.
External contagion and a tightening of USD funding
remains a key risk, but BoK is likely to intervene
more actively if spot attempts to break the 1200
level.
Neutral Heightening of geopolitical tensions, tightening of
USD funding and capital controls.
Thailand Recent severe flooding in Thailand is likely to
dampen economic activity and investor sentiment.
BoT may not cut rates in the near-term, but is
likely to prevent outperformance of the THB
relative to regional currencies to provide some
support for exporters.
Neutral A more severe slowdown in global demand leading
to weaker demand for Thai exports.
Taiwan The beta of Taiwan's growth to G2 demand is
high. CBC is likely to limit TWD appreciation to
support exports in a weak growth environment.
Prefer to use TWD as a funding currency for intra-
Asia carry trades.
A sharp slowdown in exports growth leading CBC
to intervene more aggressively.
Czech Few catalysts for downside in EUR/CZK. CZK has
become a cheap hedge against Euro woes - this is
unlikely to change in the short term. Sidelined for
now.
Neutral Significant slowdown in the key German export
market and continued euro related risk aversion
will hurt the koruna.
Egypt Political stability and resumption of talks with IMF
will hold the key.
Neutral on USD/EGP. Political risk after the planned election due to end
in Jan '12 and swings in global risk appetite. Source: Deutsche Bank
6 December 2011 EM Monthly
Page 36 Deutsche Bank Securities Inc.
Appendix: FX Strategy Summary Cont’d
Country View Strategy Risks
Israel Escalation of the ongoing conflict with Iran,
continued social unease over living costs as well
as a further deterioration in the trade balance, we
do not find risk-rewards in being long ILS spot quite
as attractive anymore.
Tactical sellers of EUR/ILS at levels above 5.10. Increased geo-political tensions in the Middle East
and expectations for further rate cuts will
undermine ILS.
Kazakhstan Domestic backdrop improving. Neutral but should outperform neighbouring UAH
NDFs
Sharp correction oil prices and sustained risk
aversion.
Poland Cautiously constructive. This is based on strong
economic momentum, sticky inflation and
commentary towards the hawkish side from NBP
and positive developments on the fiscal front.
Longer term valuation is attractive.
Long PLN/HUF (target around 72). Long 1y vanilla
EUR/PLN put at 2% of EUR notional.
Emergency hikes from NBH and the fact that PLN
has to some degree become a hostage of the
Eurozone crisis.
Romania Despite an improving macro backdrop, we do not
see meaningful catalysts for a significant sell off in
EUR/RON in a risk positive scenario. Upside in
EUR/RON should be limited by NBR intervention.
Neutral. Generalised risk aversion and lower oil prices.
South Africa Remains default risk-on/off choice, regardless of
fundamentals (limited gross external financing
requirements and attractive LT valuation). Fate of
the rand will be determined by European rather
than domestic factors.
Our preference remains to express constructive
ZAR views through relative value trades. We
recommend long ZAR versus an equally weighted
basket of similarly high betas AUD and HUF.
Otherwise, buy a 1y digital EUR/ZAR put struck at
10 for 25% of EUR notional.
ZAR currently has one of the highest EUR/USD
betas, meaning it might suffer more in any risk led
sell off.
Turkey Is one of the worst performing EM currencies,
having lost 19% vs USD and 21% vs EUR. Going
forward, we expect the lira to stay rangebound
between 1.75-1.90.
Trade ranges, or alternatively, but a short dated
DnT with strikes at 1.70 and 1.90.
Global recession fears and the consequential
drying up of financing flows would hurt the lira.
Ukraine The three most important factors for the UAH are
gas price negotiations with Russia, risk appetite in
macro markets and domestic economic and
political developments. The risks to all three are
negative in our view.
Bearish NDFs. One positive that could emerge is reduction in gas
price charged by Russia. Press reports that this
could be up to 40% (i.e. to $225/mcm from
$355/mcm in 3Q '11) - saving Ukraine $500m/y.
Argentina The government will find it increasingly difficult to
avoid any meaningful depreciation due to the
combination of worrisome levels of capital flight
and double digit inflation.
We recommend avoiding exposure to the NFD
curve, but some investors may find attractive the
elevated carry in the front-end.
Elevated risks and low liquidity
Brazil The BRL –as other liquid EM currencies- has
suffered from increased volatility on the back of
developments in core markets.
Positioning for potential short-term retracement
with zero-cost 1x2 USD/BRL put spreads.
Carry is expected to decrease further as the
central bank continues easing monetary conditions
aggressively with a focus on economic activity.
Chile During next year, the CLP will continue to be
affected by the continuous revisions of
expectations regarding global growth and copper
prices.
Maintain a short EUR/CLP position The main short-term risks are related to the direct
and indirect effects of a potential escalation in the
European crisis.
Colombia Fundamentals keeps improving the medium-term
prospects for the COP.
We remain on the sidelines, waiting for better
entry levels at the beginning of next year.
The currency could also suffer from a more
challenging global environment.
Mexico MXN was one of the currencies which suffered
the most from recent market volatility.
Taking profits in our long MXN/CZK
recommendation and switching to short
CAD/MXN.
Swings in risk aversion originating from the
external enviroment.
Peru The successful Central Bank intervention in the FX
market has shielded the PEN from the recent
volatility in global financial markets.
We recommend maintaining 3M USD/PEN NDF. The risks, in our view, are biased toward
depreciation.
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 37
Sovereign Credit in 2012: Diminished Returns; Country Selection Key
Given the circumstances, 2011 has been another
strong year for EM sovereign credit. Although the
total return has not been high, there are very few
asset classes which have produced a better
performance.
In this article we highlight how country selection (as
opposed to simple beta-management) has been a key
factor in portfolio selection in 2011. With this in
mind, we devote much of this year’s outlook to a
thorough examination of specific country factors
(pricing, macro and technical).
For 2012 our strategic recommendations are to be
overweight exposure to Venezuela, Colombia, Poland,
Russia, and Turkey; underweight exposure to
Hungary, Ukraine, Chile and South Africa.
Given the circumstances, 2011 has been another strong
year for EM sovereign credit. Although the total return has
not been high, there are very few asset classes which
have produced a better performance. In hindsight, a key
factor behind the overall performance of the asset class
was the diversity of performance within it. Indeed, 2011
was very much a year in which alpha dominated beta for
EM sovereign credit.
In this respect, we expect 2012 to bring more of the same
behaviour and so we devote much of this outlook toward
trying to identify the potential ‘winners and losers’ for
2012. We examine a variety of factors in determining the
appropriate country selection. These factors cover market
pricing, macro fundamentals and technicals (supply,
demand and positioning).
The main exogenous source of risk for EM sovereign
credit remains the crisis in the eurozone. However, while
2011 saw the can being ‘kicked down the road’ (albeit by
progressively shorter distances), we believe that 2012 will
bring greater resolution. Muddling through is unlikely to
be an option for much longer, suggesting a fairly binary
set of possible outcomes with respect to asset price
performance. In the positive scenario (some form of fiscal
union and ECB intervention) risk appetite should be
strong, benefiting EM sovereign debt. However, the likely
continued weakness in the global economy, exacerbated
by ongoing bank deleveraging, will mean that
vulnerabilities will remain for some EM countries. The
negative scenario (the eurozone crisis deepens and fears
of a break up of the currency union and/or sovereign
defaults escalate) would be hugely disruptive for global
markets and for global capital flows. In such a scenario we
would expect all vulnerable EM sovereigns to sell off
substantially. In positioning to defend against such a
scenario, we would argue that it would be better to be
underweight (or short) the more vulnerable credits with
lower yields (e.g. Ukraine and Hungary) than the traditional
highest betas (Argentina and Venezuela). This approach
towards defending against the crisis scenario results in a
rough barbell approach to risk allocation.
In terms of the overall return outlook for the asset class
we are not optimistic that we will see much better than
mid-single digit returns in 2012. The only scenario which
could bring an upside to this would be one in which
spreads compress, but UST yields remain anchored at
their current low levels. Ultimately however, we see an
environment in which very few asset classes offer a
compelling value/risk proposition and in this environment
EM sovereign credit may well prove to be the least ugly.
Taking Stock of 2011
Sovereign credit has outperformed yet again in 2011…
As we discuss in EM Performance: grass is greyer on the
other side, 2011 has been another year of outperformance
of EM assets and, in particular, sovereign credit. The total
return of the EMBI Global is higher than US IG (despite
EM having a lower average rating) and only slightly lower
than that of USTs (see the graph below).
During a year of heightened risk aversion, EM Sovereign
Credit seems fairly close to being a ‘safe-haven’.
2011 YTD performances of major asset classes
Source: Deutsche Bank
…but it can’t be ignored that yet again USTs were a
significant contributor to performance
Clearly, EM credit once again benefited from lower US
yields. The graphs below show the UST rally has
6 December 2011 EM Monthly
Page 38 Deutsche Bank Securities Inc.
accounted for most of the positive total returns of DB-
EMSI constituents. With the notable exceptions of
Ukraine, Egypt, and Argentina, the stellar performance of
USTs has more than offset the widening in spreads. The
best performers have been, not surprisingly, low-beta,
high-quality LatAm credits. Only in Venezuela were yields
(and carry) high enough to more than compensate for the
widening in spread seen in 2011.
Sovereign credit: UST more than offsets wider
spreads
-5%
0%
5%
10%
15%
20%
EC UY PE PA MX CO VE BR PH ID EM ZA CL LB RU SV HU TR PL BG UA EG AR
Total Return UST Contribution
YTD Total Return and UST Contributions
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
VE QA MX CO PE BR PH PA LV ZA IL KZ MY RU ID CZ RO HU PL TR BG UA AR HR SK
5Y CDS Total Returns, YTD
Source: Deutsche Bank
However, this simple picture of a year dominated by
lower UST yields and wider credit spreads is misleading.
The reality was more complex. 2011 was very much a
year of two halves as the chart below illustrates. For the
first seven months of the year, spreads were tightly
range-bound, while USTs rallied. Then, in late July,
spreads dramatically broke out of that range as the
combination of fiscal concerns in the US and financing
concerns in Europe both lead to a sharp increase in risk
aversion.
The chart below highlights that the level of spreads for
EM sovereigns has remained closely in-line with the level
of spreads for equivalently rated US corporates for much
of the past two years. Does this mean that EM
sovereigns are at fair value and hence offer little upside
vs. corporate credit? We think not, for two reasons.
First, credit markets are currently pricing two fairly distinct
markets: corporates and financials, with the latter priced
significantly wider than the former, at the same rating.
While the chart above represents the blend of these two
markets, we believe that it is more appropriate to
compare EM to the corporate market alone, since the
majority of EM sovereigns do not suffer from the same
pressures that have led to the re-pricing of financials
(excess leverage and uncertain funding costs).
The second reason for us to believe that EM sovereigns
continue to offer value over and above US corporates is
because we continue to see an underlying positive rating
migration in the asset class. As we discuss later, we
expect upgrades to continue to outpace downgrades by a
significant degree during 2012. Such migration leads EM
to outperform, even if the relative level of spreads at a
given rating remains constant.
2011 has been a year in which ‘alpha’ has dominated
inter-country returns
Historically, EM sovereign credit has been a market
dominated by ‘beta’. During most calendar years, a large
degree of the variation in the returns of different countries
can be explained simply by market ‘beta’. This beta can
be reflected in the yield and volatility of the individual
components.
However, 2011 has been far from the norm in this respect
as the chart below shows. For each calendar year (and
2011 YTD) we regressed the annual returns of each
country against three different factors: (a) the yield of
each country at the start of the year, (b) the volatility of
the country in the previous year and (c) the net change in
rating notches during the year.
EM Sovereign spreads have been highly correlated
with the US corporate credit market
200
250
300
350
400
450
Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11
Median for US/EU corporates* EM Sovereigns
Libor spread, bp
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 39
Differences in yield and volatility did not explain
relative country performance in 2011
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
2011
YTD
2010200920082007200620052004
Rating change Yield (at start)
Volatility (prev yr) All three combined
Explanatory factors for relative country performance,
R2
Source: Deutsche Bank
It is clear that in most years the beta factors alone (yield
and volatility) can explain a large degree of the variation in
inter-country returns. However, in 2011 (just as in 2006)
these factors have explained virtually none of the
variation. On the other hand, the ratings changes which
have occurred explain a significant proportion of the
variation. Indeed, with the exception of the years in which
beta dominates, ratings are a consistently significant
factor in explaining the return variation.
It may seem to be stating the obvious that changes in
credit ratings can explain return variation. However, given
the scepticism regarding the value of the ratings and
given that the agencies certainly have a tendency to lag
the market, it is nevertheless an interesting result which
justifies examining possible rating changes for the year
ahead.
We expect 2012 to be another year in which upgrades
dominate for EM sovereigns
2011 was again a year in which upgrades outpaced
downgrades – particularly during the second quarter when
the pace of sovereign upgrades in EM reached its highest
level in almost four years. More recently the actions have
been more balanced, with Egypt, Hungary and Venezuela
all suffering downgrades, but we remain optimistic for
2012.
Looking across the major EM sovereign credits, we
believe that upgrades could be expected for Argentina,
Brazil, Colombia, Peru, Russia, Turkey and Indonesia. On
the other hand we believe that Hungary and Ukraine are
both likely to suffer further downgrades.
Most countries face higher than usual external debt
payments in 2012
Since the 2008 financial crisis, external issuance by EM
governments and private sector entities has been
extremely strong, breaking the records set pre-crisis. For
governments, the increased issuance has been to finance
looser fiscal positions and has arisen due to many new
borrowers tapping the market for the first time. For
corporates the increase in bond issues as been in part to
substitute for the contraction in bank lending as
developed market banks have reduced their balance
sheets. We expect both the factors to continue to
influence issuance and hence we expect the pipeline of
issuance to remain robust.
An additional reason to expect issuance to remain high in
2012 is that the majority of EM sovereigns are facing
higher than usual external debt payments (principal and
interest) in 2012. As the chart below shows, for some
countries the repayments in 2012 are up to 2-4 times the
average amount in the prior three years. Upgrades have generally outpaced downgrade, but it
is clear that the agencies remain very active
0%
5%
10%
15%
20%
25%
05 06 07 08 09 10 11 12
Downgrades
Upgrades
Rolling 3-mth ratings changes (as a % of number of rated sovereign
EM issuers)
Source: Deutsche Bank
We expect 2012 to be another year in which upgrades
dominate for EM sovereigns
40%
30%
20%
10%
0%
10%
20%
30%
40%
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
Proportion of upgrades
Proportion of downgrades
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 40 Deutsche Bank Securities Inc.
These payments (approx. USD60bn in total for 2012) can
be seen as both positive and negative. For the market as
a whole they should be a positive factor, as we would
expect a large proportion to be recycled. However, for
the individual countries facing higher gross external
financing needs, they are potentially a negative factor.
Those countries which have deep, flexible domestic
markets should be less susceptible to this pressure, since
they should be able to be more flexible in the external
borrowing plans.
Ultimately, whether it is a positive or negative factor likely
comes down to the net issuance by individual countries.
We illustrate this indirectly in the chart below. The chart
shows (a) the estimated gross borrowing per country
assuming that the net issuance is the same as the
average of the past three years, and (b) our own estimates
of gross issuance. The difference between the two bars
is effectively the difference in the net issuance between
what we expect (or what has been stated by officials) and
what has been the average outcome over the past three
years.
The chart highlights that many of the larger EM borrowers
are cutting back on net issuance, while there is expected
to be a substantial increase in net issuance by the smaller
countries and less frequent borrowers.
Notable exceptions to this are Hungary, Ukraine, UAE (in
which we include both Abu Dhabi and Dubai) and Russia.
For the former two the financing needs which drive the
issuance expectations are more pressing. If the market is
not conducive to the significant amount of issuance
implied for Hungary and Ukraine then they will need to
find alternative sources or make further fiscal
adjustments.
If all countries in the chart below were to issue the gross
amounts indicated in the chart, the total amount of
issuance would be USD75-85bn (75bn based on the blue
bars, 85bn based on the grey bars)
Most countries face higher than usual external debt
payments in 2012, some as much as 2-4x higher
VN
VE
UY
UA
AE
TR
LK
KR
ZASI
SK
CS
RU
RO
QA
PL
PHPE
PA
PK
MA
MX
MY
LT LB
JM
IL
IQ
ID
HU
GHGA
SV
EG
EC
DO
CZ
HR
CO
CN
CL
KY
BG
BR
BH
AR
8bn
4bn
2bn
1bn
500mm
250mm
125mm
50mm
8bn4bn2bn1bn500mm250mm125mm50mm
2012 Payments = 3Y Avg
2012 Payments 2x/0.5x Avg
2012 Payments 4x/0.25x Avg
External debt payments in 2012 (principal and interest), USD
Average annual external debt payments (2009-11), USD
Source: Deutsche Bank
Despite the market turmoil in recent months, EM
issuance in 2011 has been close to last year’s record
0
20
40
60
80
100
120
140
2004 2005 2006 2007 2008 2009 2010 2011
Corporate
Financial
Sovereign
Gross external issuance, USD equivalent bn
Jan-Nov (Full year outcome is indicated by error bars)
Source: Deutsche Bank
Gross borrowing in 2012 projections vs. estimates
based on past 3Y average
* The estimated gross issuance is compiled from a variety of sources (official
statements, budgets, comments from government officials and, in some cases
conjecture based on our assessment of needs). Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 41
Dedicated investors have cut exposure to the ‘high
betas’
According to the latest data on investor positioning (end-
Oct), investors have cut back on exposure to the higher
yielding sovereign credits in EM. In another article in this
report13 we introduce a new approach to analyzing data on
dedicated fund exposures. In this approach we have two
measures to assess the potential impact of dedicated
funds: (a) Positioning (evidenced by a z-score measure of
the fund exposure relative to the reference benchmark,
and (b) An ‘appetite’ index which measures the relative
proportion of funds in the sample which have been
actively adding to their exposure to a given country,
versus those that have been reducing.
The chart below illustrates the positioning score. Note
that exposure to Argentina, Hungary, Ukraine and
Venezuela are all at the far right, with z-scores in the -1
to -3 range14, indicating that the exposure of dedicated
funds is well below the average level of the past two
years. Meanwhile, funds have increased exposure to a
number of the smaller, less-liquid credits.
Understanding how dedicated funds are positioned with
respect to individual countries can help to shed light on
how the bonds of those countries might react to a shock
(positive of negative). If positioning is biased toward over-
or under-weight then we would expect the response to a
shock to be similarly biased (overweight leading to a
negative bias and vice versa). In addition to this indicator
of current positioning, we also like to understand whether
13 A Closer Look at Real-Money Positioning
14 A z-score of 1 implies that for exposure to return to the 2Y average level
(relative to the benchmark) then the required change in exposure would be
1 standard deviation of the historical monthly changes.
investors have been actively15 adding/reducing exposure
to a given country. In order to do this we construct an
index which represents the net proportion of funds in the
sample which have added exposure. This index is
computed for each country, for each month. The chart
below shows the three month moving average for each
country.
Appetite has recently been strong for core IG
sovereign credits
-0 .3
-0 .2
-0 .1
0
+ 0 .1
+ 0 .2
+ 0 .3
+ 0 .4
Z A :
R S
:
:
M X
B R :
P L
:
:
T R
C L :
C O
:
:
T N
M Y :
R U
:
:
V N
P K :
P H
:
:
A R
U Y :
K R
:
:
P E
E G :
B G
:
:
V E
P A :
G H
:
:
H U
S V :
U A
:
:
ID
O c t 1 1
P re v . M th
B u y e rs v s e lle rs in d e x , 3 m M A *
* -N u m b e r o f fu n d s a c t iv e ly in c re a s in g e x p o s u re m in u s n u m b e r o f fu n d s a c t iv e ly
d e c re a s in g e x p o s u re , d iv id e d b y th e to ta l n u m b e r o f fu n d s
Source: Deutsche Bank
The chart indicates that fund managers have been adding
exposure to the core investment grade credits (BR, MX,
ZA, PL) along with Serbia (which issued a Eurobond in late
September). At the other end of the spectrum, funds
have been actively reducing exposure to Indonesia,
Ukraine and El Salvador.
For further detail on these exposure indicators – along
with time series of both indicators for all countries –
please see the companion article in this report.
Survival of the Fittest
The headline theme of this 2012 outlook has been
‘Survival of the Fittest’, a theme on which we elaborate in
another of the special reports16 in this publication. In this
special report we introduce a set of indicators to capture
the relative vulnerability of each country to four key risks:
external risks, fiscal risks, financial risks and exogenous
risks. Given that the avoidance of risks is central to asset
allocation within a credit portfolio, such indicators should
be very relevant for our assessment of relative country
exposures.
15 We distinguish between active changes in exposure and passive
changes, the latter arising from relative price movements. See the
accompanying article for further discussion of this distinction. 16
See: EM: Survival of the Fittest
Dedicated funds have reduced exposure to high beta
credits
-4 .0
-3 .0
-2 .0
-1 .0
0 .0
1 .0
2 .0
3 .0
4 .0
R S :
C L
:
:
P K
V N :
P E
:
:
P A
B G :
S V
:
:
P L
M X :
B R
:
:
C O
T R :
P H
:
:
Z A
M Y :
U Y
:
:
T N
G H :
R U
:
:
V E
E G :
U A
:
:
ID
H U :
K R
:
:
A R
O c t 1 1
P re v . M th
E x p o s u re Z -s c o re *
* -A v g e x p o s u re v s b e n c h m a rk , re la t iv e to 1 2 m th M A , d iv id e d b y S tD e v o f m o n th ly
c h a n g e in e x p o s u re
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 42 Deutsche Bank Securities Inc.
Unsurprisingly, EMEA dominates the list of the most
vulnerable countries. Five countries (Hungary, Ukraine,
Romania, Poland, and Egypt) show up as highly
vulnerable, though for different reasons. Egypt’s
underlying vulnerabilities, for example, are fiscal first and
external second. Ukraine’s risks are mostly external.
Hungary’s vulnerability reflects a combination of risks in all
four areas. Poland’s risk rating is probably a notch too high
according to this mechanical exercise, though it does
underscore that the economy does have macro
imbalances that have yet to be fully addressed. Romania
remains vulnerable but has done a lot of the hard yards in
terms of fiscal adjustment and is poised to move to a
lower risk category.
Outside of EMEA, only Malaysia makes it on to our list of
countries with medium risk ratings mainly reflecting the
high level of foreign bank claims on the country (which
may be overstated) and moderate concerns about the
country’s public finances.
Forced fiscal adjustments, together with some structural
reforms, and overly conservative financial regulation in
response to a severe external crisis in the 90s have
allowed LatAm to converge to a relatively safe status.
Increasing dependency on commodities is probably the
major short term vulnerability. Complacency regarding
long term fiscal rigidities with spending concentrated in
current spending is probably the main yellow light for the
medium term.
Strategy Recommendations
As discussed in the introduction, we expect country
selection rather than simple beta-management to be key
to portfolio outperformance in 2012. To help identify the
potential ‘winners and losers’ for 2012, we compare a
variety of factors, based largely on the preceding
discussion. These factors cover market pricing, macro
fundamentals and technicals (supply, demand and
positioning).
On the following page we present a simple scorecard of
the factors which influence our views. We divide these
factors into three groups:
Market Factors
Yield and Spread. As discussed earlier, in most years
yield differences alone can explain a large degree of
the variation in country returns. While we do not
expect 2012 to be such a ‘beta’ year, but
nevertheless yield remains an important factor in our
selection.
Market-implied rating (z-score). While the ‘yield’ is a
useful static, absolute measure of the value offered
by a credit, it conveys little in the way of relative
value, either to other credits, or relative to itself over
time. To address this we also look at the market-
implied rating of the credit (as a deviation from the
actual rating) and also a z-score of this market-implied
rating deviation. For example, in the scorecard below,
Turkey has a market-implied rating deviation of -0.7
(meaning that the market prices-in an average 0.7
notch rating improvement across the three agencies).
However, the z-score of this deviation is +1.8,
meaning that the current deviation represents a much
smaller deviation than the past 1-year average.
Macro fundamentals
Vulnerability indicators. As discussed, we present the
four vulnerability indicators which are described in the
article ‘EM: Survival of the Fittest’.
Forecast rating changes: We present forecasts of
likely rating changes over the coming year, based on
the expectations of our economics team. A value of
one indicates a one-notch change by all three
agencies. A value of 1/3 would indicate a one notch
change by a single agency.
Technicals
Real-money positioning and appetite. As discussed
previously, we look at two indicators based on the
exposures of dedicated real-money funds. The
positioning indicator is a z-score of the current
average exposure deviation, versus the average
deviation of the past two years. The ‘appetite’
indicator is a measure of the net proportion of funds
in the sample which have been actively adding (or
reducing) exposure to the country.
Supply/demand (gross payments and expected net
issuance). We show the gross payments due from
each credit; what this amount represents as a
multiple of the average payments from the past three
years and also the expected net issuance by the
country.
To highlight the positive and negative factors we highlight
appropriate values in the score card. For most indicators
we highlight the top and bottom four values in each
column. For rating changes we highlight all values. For
the vulnerability indicators we highlight the values
corresponding to ‘medium risk’ and ‘high risk’ according
to the methodology discussed in the accompanying
report.
On the basis of these indicators, and also considering
additional subjective factors (such as political risk etc.) we
arrive at the following investment recommendations.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 43
Strategic overweights
Venezuela
Though Venezuela presents a clear case of credit
deterioration and features some of the worst
technical conditions due to large amount of net
issuances, valuation looks extremely attractive, and in
our view, has not sufficiently priced in the chance for
a relatively peaceful transition of power to the
opposition in 2012 (meaningfully large than 50% in
our view), which will likely lead to a significant (albeit
gradual) shift of political and economic policy down
the road. The main risk is the potential volatility during
the election process and doubt on whether the
transition of power will be done peacefully. For this
reason, we would keep only a small overweight in the
near terms.
Colombia
Colombia presented a prominent case of ascension in
the credit standing in 2011, with significantly
improvement of the country’s political and economic
environment over the past few years reaping benefits
as it joined the investment grade club. It remains
marginally more risky in comparison with its regional
high grade peers according to our vulnerability
indicators, but the positive trend and marginally better
valuation are keys to our strategic overweight
recommendation on Colombia in 2012.
Russia
On all the ‘domestic’ vulnerability indicators, Russia is
clearly one of the least vulnerable countries in EMEA.
External vulnerability is however significant, a
consequence of its heavy reliance on oil exports.
Valuation, rating outlook and fund positioning are all
favourable and although net issuance may be
substantial, this would only take place in the context
of a very supportive market. 2012 is an important
year for Russia with likely WTO accession and the
passage of elections. While we are not very
optimistic that the return of Putin to the Kremlin will
spur reform, we believe that the market currently
prices an excessive risk premium.
Turkey
While we remain concerned about the direction of
monetary policy and the risks of a hard landing for the
economy, from a sovereign credit perspective Turkey
looks fairly positive. Given the healthy primary
surplus, moderate debt stock and low real rates, the
credit spreads on bonds of well above 300bp seems
incongruous. Certainly some premium is warranted
given the aforementioned risks, but Turkey’s debt
dynamics are considerably less vulnerable than in the
past. Relative to the EM sovereign market as a whole
Turkey credit is cheap on a historical basis.
Poland
On the scorecard, the picture for Poland is mixed. It
is rated as high risk on the vulnerability indicators,
real-money investors are modestly overweight and
repayments are high. On the flip side, we expect net
issuance to be negative, which would be a substantial
change from prior years and, perhaps most
importantly, it has cheapened considerably in recent
months. In fact, the extent of the change in the
market-implied rating is similar to that of Ukraine,
Hungary and Argentina, which we think is wholly
unjustified. Furthermore, as we discuss in ‘EM:
Country Scorecard Market Factors Macro fundamentals Technicals Recommendation
DB F'cst
Yield Z-Spd Market-Implied Vulnerability Rating Chg Real-Money Funds Supply Exp.
% bp Rating Z-Score Ext. Fisc. Fin. Exo. Up Dwn Pos'n App. Pmts Net Iss.
Latin America
Argentina 11.8 1037 +3.0 +2.4 0.15 0.13 0.25 0.20 0.7 -3 -2 4.2 0.9x -4.2 Neutral Argentina
Brazil 3.5 162 -3.5 +0.0 0.15 0.38 0.25 0.58 0.7 +1 +22 5.6 1.2x -2.6 Neutral Brazil
Chile 2.3 68 -3.9 -2.5 0.15 0.00 0.50 0.70 +4 +13 0.8 3.6x -0.8 U/W Chile
Colombia 3.6 174 -3.4 -1.0 0.15 0.25 0.25 0.66 0.3 +1 +12 1.9 1.4x +0.1 O/W Colombia
Mexico 3.6 168 -3.0 -1.4 0.00 0.13 0.13 0.85 +1 +27 3.4 0.7x +0.1 Neutral Mexico
Peru 4.5 222 -1.8 -0.2 n.a. n.a. n.a. n.a. 0.3 +2 -7 1.4 1.9x +0.6 Neutral Peru
Uruguay 4.6 221 -3.2 -1.2 n.a. n.a. n.a. n.a. -0 -4 0.4 0.8x -0.4 Uruguay
Venezuela 14.0 1219 +5.4 -1.3 n.a. n.a. n.a. n.a. -1 -9 2.5 0.9x +4.0 O/W Venezuela
EMEA
Egypt 7.2 509 +0.5 +0.5 0.50 1.00 0.00 0.26 -7 0.1 0.3x +1.9 Neutral Egypt
Hungary 7.5 566 +4.5 +2.1 0.30 0.75 0.63 1.31 0.3 -2 -10 3.2 1.3x +1.8 U/W Hungary
Poland 4.3 282 +3.3 +2.4 0.60 0.63 0.38 0.62 +1 +19 6.6 2.2x -0.6 O/W Poland
Russia 4.4 260 +0.8 +0.6 0.00 0.00 0.13 1.75 1.0 -1 +4 3.8 0.7x +3.2 O/W Russia
South Africa 3.8 197 -0.2 +0.7 0.45 0.25 0.25 0.59 +0 +34 1.5 2.4x +0.5 Neutral South Africa
Turkey 5.2 340 -0.7 +1.8 0.45 0.13 0.25 1.49 0.3 +0 +13 5.3 1.0x -0.8 O/W Turkey
Ukraine 9.6 814 +2.9 +2.6 0.75 0.25 0.38 3.36 1.0 -2 -20 1.1 1.0x +1.9 U/W Ukraine
Asia
Indonesia 4.2 244 -2.7 -0.1 0.00 0.00 0.00 0.07 0.7 -2 -22 1.6 1.2x +1.7 Neutral Indonesia
Malaysia 3.3 172 -0.5 +0.6 0.15 0.25 0.50 1.22 +0 +6 0.1 0.1x -0.1 Neutral Malaysia
Philippines 4.1 209 -4.5 -0.8 0.00 0.63 0.00 0.64 +0 -1 1.7 0.5x +0.6 Neutral Philippines Source: Deutsche Bank
6 December 2011 EM Monthly
Page 44 Deutsche Bank Securities Inc.
Survival of the Fittest’ we feel that the vulnerability
indicators are overly harsh on Poland as they do not
take account of some key offsetting features.
Strategic underweights
Hungary
Hungary appears as the most vulnerable of all EM
countries on the vulnerability indicators and while
valuation and positioning are supportive, we do not
believe they are sufficient to offset the risks. 2012 is
set to be particularly challenging given the
government’s need to raise a substantial amount on
the external bond market. If this is not forthcoming,
then an agreement with the IMF seems critical.
However, to secure such an agreement would likely
require a radical change of approach from the
government and we are not convinced that this
government would be willing to stomach such a
change.
Ukraine
Unsurprisingly, Ukraine comes out poorly on the
vulnerability indicators, but valuation and positioning
are supportive. Our primary concern is the tightness
of financing conditions raising the risk of credit
problems in the coming year. The treasury continues
to struggle to execute its domestic borrowing plan
and is reliant on the NBU for financing. Net claims of
the NBU on the central government have more than
doubled since the end of May, reaching approx.
USD8bn. A deal with Russia on gas prices would
certainly be positive, but we are not convinced that it
would be sufficient to mitigate the risks and reverse
sentiment.
South Africa
The combination of increased gross issuance ahead,
coupled with the fact that dedicated investors are
already relatively overweight the credit persuades us
to be cautious. Furthermore, as our vulnerability
indicators highlight, SA is not entirely immune to the
risks which characterise much of EMEA.
Chile
Despite its solid fundamentals, the tight credit
spread, financial risk (albeit moderate) as shown in
our vulnerability indicators, and the likely lack of
support from the USTs in 2012 mean risk is biased
towards lower returns. In addition, real money
investors have been significantly overweight Chile,
creating a non-supportive technical condition. We
look to buy Chile CDS as a defensive trade.
Further, we note that while the scorecard as a very useful
reference that influences our views, it does not capture all
the aspects we need to consider in order to make a
comprehensive decision on our country positioning
recommendations, especially those that are qualitative in
nature. We take exceptions to what the scorecard
suggests to us regarding:
Argentina
Strategically, we recommend a neutral position on
Argentina in 2012 even though the scorecard
suggests overweight. In our view, Argentina’s main
vulnerability lies in the erosion of investors’
confidence (caused by the risk of medium term
economic crisis in the absence of policy change)
coupled with significant capital flight. In addition, in
terms of technicals, Argentina’s large negative net
issuance is more indicative of lack of a conventional
market based means of financing (for well
documented reasons) rather than presenting good
technicals.
Indonesia and the Philippines
Even though the vulnerability indicators look positive
for Indonesia, its underperformance in September
and October suggests that Indonesia remains very
sensitive to a weakening of risk sentiment due to the
lack of a strong local bid (unlike in the Philippines). In
our view, this lack of defensive prevents us from
holding a strategic overweight recommendation on
Indonesia, despite its solid and improving macro
fundamentals. In fact, we have recently been
underweight Indonesia. However, we would now
take the opportunity of Indonesia’s underperformance
to cover underweight and move to neutral tactically.
In terms of the Philippines, while we acknowledge
the weakness apparent in its fiscal vulnerability
indicators, the strong investor sponsorship for its
external debt more than compensate this shortfall.
We hence recommend a strategically neutral
exposure to the Philippines.
Marc Balston, London, 44 207 547 1484
Hongtao Jiang, New York, 1 212 250 2524
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 45
Appendix: Credit Strategy Summary
Country View Strategy Risks
Hungary Clearly one of the most vulnerable credits in CEE.
External financing could be challenging in 2012
absent a new IMF program.
Underweight cash A short position is likely to be costly in a general
market rally, but the risk-reward still justifies the
position.
Kazakhstan With plenty of opportunities in the Russian
sovereign/quasi-sovereign space there is little
reason to take exposure in Kazakhstan at present
Neutral.
Poland Recent underperformance provides the potential
for outperformance should the new government
deliver a credible fiscal plan. Poland is one of the
few EM credits with the potential to deliver a
positive catalyst.
Overweight. The newly re-elected government fails to deliver a
credible fiscal adjustment.
Romania Risks to economic performance are mounting, but
the government’s commitment to fiscal
adjustment and its good relationship with the IMF
should stand the country in good stead to weather
potential storms ahead.
Overweight Renewed pressure on eurozone sovereigns.
Russia Valuation, rating outlook and fund positioning are all
favourable and although net issuance may be
substantial, this would only take place in the
context of a very supportive market.
Overweight With the budget assumption for oil now raised to
$93bbl (Urals), the risk from a drop in oil prices
has risen.
South Africa Increased gross issuance ahead, coupled with the
fact that dedicated investors are already relatively
overweight the credit persuades us to be cautious.
Underweight Increase issuance, to the extent that it leads to a
higher benchmark weight, could limit the
downside.
Turkey Turkey sovereign credit is the cheapest it has been
in three years, relative to EM. Concerns over
monetary policy have diverted attention from
strong fiscal performance.
Overweight. Shorten duration to capitalize on the
very flat cash curve. 2015s represent the 'sweet
spot'.
Turkey weathered the 2008-09 crisis well, but the
current unconventional policy mix risks sacrificing
those gains.
Ukraine Sources of financing are diminishing, Little
likelihood of IMF disbursement; eurobond issuance
is hard to imagine and even domestic issuance is
proving challenging.
Remain underweight. A volte-face on domestic gas prices and/or some
leeway from Russia on the Gazprom contract
could ease the pressure,
Argentina The external risk environment in 2012 is unlikely to
be supportive for Argentina, and we remain
doubtful there will be any meaningful policy
changes. But attractive valuation looks attractive.
Stay neutral, favor global bonds (especially the
Global 17s) over local law bonds. Long basis on
Global 17s vs. 5Y CDS.
A surprise shift to market friendly policies takes
place and renders our conservative approach a
losing proposition.
Brazil Though fiscal performance appears to be on track
in 2011, we project it to underperform budget in
2012.
Stay neutral and continue to favor 41s and 40s (to
call) vs. 21s. Sell basis (10Y vs. 21s).
Notional Treasury does not resume buying back
legacy bonds, causing 5Y sector to underperform;
Brazil taps long end of the curve, causing further
steepening.
Chile Despite its solid fundamentals, its tight spread and
the likely lack of support from the USTs in 2012
mean risk is biased towards lower returns.
Underweight and look to buy CDS as a defensive
trade.
Colombia Macro momentum remains strong and valuation is
still marginally more attractive valuation relative to
its LatAm low beta peers.
Stay overweight and favor shorter-end of the
curve
Historically, a higher beta credit than regional
peers - whether this has changed is yet to be
tested
Mexico Valuation does not look attractive, but Mexico is
among the credits having the lowest risk on our
vulnerability indicators. Improving US economic
activity is also supportive.
Neutral. The old 19s remain significantly rich to the
curve.
Sharper than expected slowdown in the US and
lower oil prices.
Peru While we value Peru’s stability drawn from its
fundamental strength, valuation also looks
marginally more attractive in comparison with
Brazil and Mexico.
Increase to overweight, take profit in the 37s to
19s switch and now favor the long end of the
curve.
Policy risk remains given President Humala’s
political background, though it will unlikely be a
serious concern in the near term.
Venezuela Attractive yields, high oil prices, and medium-term
prospects for political change will continue to play
in Venezuela' favor relative to its high-yielding
peers.
Increase to a small overweight, favoring Republic
over PDVSA. Stay long basis on the sovereign
curve (24s vs. 10Y), and also long PDVSA 22s vs.
Venezuela 10Y CDS.
Volatility of political origin
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 46 Deutsche Bank Securities Inc.
EM: Survival of the Fittest
We present a new framework for assessing relative
vulnerabilities across EM in a systematic manner
using external, fiscal, financial, and growth sensitivity
indicators.
EMEA dominates our list of the most vulnerable
countries. Five countries (Hungary, Ukraine, Romania,
Poland, and Egypt) show up as highly vulnerable,
though for different reasons. Egypt’s underlying
vulnerabilities, for example, are fiscal first and external
second. Ukraine’s risks are mostly external. Hungary’s
vulnerability reflects a combination of risks in all four
areas.
Poland’s risk rating is probably a notch too high
according to this mechanical exercise, though it does
underscore that the economy does have macro
imbalances that have yet to be fully addressed.
Romania remains vulnerable but has done a lot of the
hard yards in terms of fiscal adjustment and is poised
to move to a lower risk category.
Outside of EMEA, only Malaysia makes it on to our
list of countries with medium risk ratings mainly
reflecting the high level of foreign bank claims on the
country (which may be overstated) and moderate
concerns about the country’s public finances.
Forced fiscal adjustments, together with some
structural reforms, and overly conservative financial
regulation in response to a severe external crisis in
the 90s have allowed LatAm to converge to a
relatively safe status. Increasing dependency on
commodities is probably the major short term
vulnerability. Complacency regarding long term fiscal
rigidities with spending concentrated in current
spending is probably the main yellow light for the
medium term.
EM resilience faces a stern test
The coming year is going to be a difficult one for the
world economy. Much of Europe will likely be in recession
and the US will do well to grow at anywhere close to
trend. Together, Europe and the US are now expected to
grow by 0.9% in 2012 compared with our forecast of
2.6% back in July. Reflecting this, we have downgraded
our forecasts for EM over the last few months, primarily in
EMEA, whereas we continue to think Asia and Latin
America will be less severely affected. Within EMEA, the
current crisis is weighing most heavily on the economies
of central and eastern Europe: we have downgraded our
growth forecast for this region by an average of 2.5%,
even more than our revision for the euro area, and we
expect Hungary to fall back into recession next year.
Downgrades to DB growth forecasts since July
-2.5
-2
-1.5
-1
-0.5
0
US Eurozone EMEA Asia Latin
America
Change in 2012 GDP growth forecast, ppts
Source: Deutsche Bank
EM resilience is clearly being tested, though we continue
to think that growth will remain well above that in DM at
an aggregate level. EM and DM cycles have become
increasingly correlated over the last 10-20 years as EM
economies have become more integrated with global
economic and financial markets – i.e. cyclical coupling.
Once we strip out the cycle, however, trend growth rates
have moved firmly in favour of EM and we would expect
this positive differential to remain intact next year. This is
illustrated in the chart below – if there is one chart that we
have got more mileage out of than any other it is this one,
so we repeat it here for one last time this year.17
Cyclical coupling and trend decoupling
EM ex. China
trend
DM Trend
EM ex. China
cycle
DM cycle
-6
-4
-2
0
2
4
6
1980 1985 1990 1995 2000 2005 2010
Growth (%)
Source: IMF, Deutsche Bank
The reasons for this EM resilience have been widely
discussed elsewhere. We think a big factor has been
improved economic policies, which have in turn allowed
17 See also ‚EM: Trend Decoupling but Cyclical Coupling‛ in our July
EMM.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 47
many EM economies to reduce debt and accumulate
substantial foreign reserves. This is most clearly visible in
the public finances (see chart below) where a combination
of more prudent fiscal management and rapid growth –
helped in some cases by financial repression and very low
domestic real interest rates – have brought government
debt levels down to comfortably sustainable levels across
much of EM. These stronger public and private balance
sheets should leave much of EM relatively well placed to
weather the current economic storm.
Simulated public debt paths
EM
DM
25
45
65
85
105
125
145
165
185
205
225
2006 2010 2014 2018 2022 2026 2030
(% GDP)
We assume: (i) primary balances are held
constant at this projected 2012 levels; (ii) real
GDP grows at trend rates; and (iii) the
differential between real interest and real
growth rates in each country is 0 until 2015
and 1.0 thereafter.
Source: Haver Analytics, IMF, Eurostat, Deutsche Bank
This resilience is not uniform, however, across EM
regions or countries. Public and private balance sheets are
generally weaker in EMEA, for example, which is also
more directly exposed to the euro crisis through stronger
economic and financial linkages. Growth in Latin America
has remained more robust but the region remains heavily
reliant on commodities and would suffer if commodity
prices fell sharply in response to slower global growth.
Asia has for some time been the star performer within EM
and we would expect this to continue into 2012.
Nonetheless, very rapid credit growth and rising property
prices could quickly turn and present problems in a lower
growth environment.
We have highlighted each of these and other potential
weaknesses several times in our research throughout the
year. Here we assess them in a more systematic manner
with a view to identifying the most likely pressure points
within EM. We present a new framework for assessing
relative vulnerabilities across EM and then draw some
conclusion for each emerging region.
Assessing Vulnerability
We provide a structured and objective assessment of the
underlying vulnerabilities of EM economies. Our
assessment is based on a range of measures that we
think capture a country’s susceptibility to an economic
crisis. Specifically, we look at the following indicators:
External sector: current account balance in percent
of GDP, external debt in percent of GDP, exchange
rate valuation (REER vs HP trend), and foreign
reserves as a percent of risk-weighted liabilities. The
latter is our preferred measure of reserve adequacy
(see Reserve Adequacy in EMEA in our November
EM Monthly for more details).
Fiscal sector: overall fiscal balance, public debt, debt
maturing in the next year (to capture rollover risk), and
foreign currency denominated debt (to capture
exchange rate risk) – all measured in percent of GDP.
Financial sector: loan-to-deposit ratios, the pace of
private credit growth (average over the last two
years), and the level of private credit in percent of
GDP. We also include a measure of foreign bank
claims on the economy (in percent GDP), using the
BIS consolidated banking statistics, which includes
exposure through local subsidiaries. Our aim here is
to capture the potential risk from deleveraging by
stressed banks in core markets.
Exogenous shocks: we include our growth betas, i.e.
the elasticity of economic growth with respect to
growth in the US and Europe.
These indicators are then given a risk rating – low,
medium, or high – depending on whether or not they
exceed certain thresholds. Our thresholds are relative
rather than absolute insofar as they are based on the
distribution of observations for each indicator across our
EM universe over the last five years. Taking external debt
as an example, the 60th and 80th percentiles of the
distribution correspond with 38.3% of GDP and 52.8% of
GDP. Countries with external debt above these levels are
assigned medium and high risk ratings respectively for
this indicator.
We then aggregate the scores within each sector to come
up with vulnerability ratings for each of one (i.e. external,
fiscal, financial, and exogenous). These sector ratings are
in turn then combined to result in a single overall
vulnerability rating. In doing so, we attach a higher weight
(40%) to the external sector, followed by the fiscal sector
(30%), financial sector (20%), and exogenous sector
(10%) reflecting our judgment on the relative importance
of these variables in precipitating an economic crisis in an
EM context.
Below we summarize the main results, our current overall
vulnerability rankings, and the evolution of these overall
rankings over the last five years.
External vulnerabilities
Our external vulnerability indicators immediately point to
relatively greater risks in EMEA, with only Israel and
Russia within the region ranking as low risk overall on this
metric. This is driven primarily by the region’s relatively
6 December 2011 EM Monthly
Page 48 Deutsche Bank Securities Inc.
high external debt levels, which in some cases are higher
now than they were going into the last crisis because of
deep recessions and currency depreciations resulting in
an increase in the valued of foreign-currency denominated
debt.
Current account balances in EMEA have strengthened as
a result of import compression but remain elevated in
Poland and, especially, Turkey. Reserve cover has also
improved in recent years but remains low relative to our
preferred risk-weighted measure of liabilities in South
Africa and Ukraine. Egypt’s reserves are also very low
halving more than halved since the start of the year. Egypt
is also the only county where we see hints of exchange
rate overvaluation.
Overall, the high risk countries according to this metric are
Egypt, Poland, and Ukraine. This may perhaps overstate
the risks in Poland somewhat, where the current account
is moderately high but comfortably financed by EU funds
and FDI. Similarly, the risks posed by Hungary’s extremely
large external debt level and Turkey’s very large and
largely short-term financed current account deficit are
probably not fully captured by these metrics.
Outside of EMEA, the picture is more comfortable with no
countries in LatAm or Asia rated as having high overall
external risks. There are a few pockets of vulnerability,
such as India’s current account deficit, relatively low
reserve coverage in Malaysia, and a moderately high
external debt level in Chile and relatively large (by regional
standards) current account deficit in Colombia although
fully financed by FDI. Chile´s external debt is, however,
largely compensated by high value of exports and one of
the most solid fiscal fundamentals globally as we will note
in the following section.
Fiscal vulnerabilities
Public finance risks are a little more evenly distributed
across the three regions but again EMEA emerges as
most vulnerable. Egypt’s chronic fiscal problems come
out quite clearly, with its double-digit deficit, public debt,
and rollover risks the highest in our EM universe. Despite
its relatively moderate deficit, Hungary is also highly
vulnerable because of its high debt, rollover risks, and
large FX exposure. Poland is again perhaps rate too
harshly on our metric – it is close to the edge of some of
our thresholds, and we would expect it to move to a
lower risk category should fiscal consolidation proceed
along the lines outlined by Prime Minister Donald Tusk
last month.
External vulnerabilities Overa ll
% GDP Risk % Risk % GDP Risk % Risk Risk
EMEA
Czech -3.1 Med. 132.3 Med. 48.2 Med. -1.4% Low Med.
Egypt -2.6 Med. 92.6 High 14.9 Low 1.6% Med. High
Hungary 0.6 Low 163.2 Low 146.0 High -2.1% Low Med.
Israel 1.0 Low 182.0 Low 46.8 Med. -2.2% Low Low
Kazakh 8.1 Low 125.1 Med. 83.8 High -2.6% Low Med.
Poland -5.0 High 146.8 Low 63.5 High -3.2% Low High
Romania -3.7 Med. 229.3 Low 75.2 High 0.5% Low Med.
Russia 5.9 Low 221.3 Low 27.3 Low -2.0% Low Low
South Africa -2.8 Med. 111.6 High 20.8 Low -2.5% Low Med.
Turkey -9.1 High 131.0 Med. 36.4 Low -10.0% Low Med.
Ukraine -2.7 Med. 97.0 High 81.1 High 0.2% Low High
Asia
China 4.4 Low 198.0 Low 4.4 Low 0.3% Low Low
India -3.4 Med. 338.3 Low 13.7 Low -0.6% Low Low
Indonesia 0.4 Low 189.7 Low 23.7 Low -0.3% Low Low
Korea 1.1 Low 146.7 Low 32.1 Low 5.4% High Low
Malaysia 9.4 Low 129.0 Med. 28.7 Low -1.1% Low Low
Philippines 4.5 Low 431.2 Low 32.2 Low -1.3% Low Low
Thailand 3.5 Low 349.4 Low 21.8 Low -1.6% Low Low
LatAm
Argentina 0.8 Low 138.2 Med. 30.9 Low -0.3% Low Low
Brazil -2.2 Med. 243.5 Low 17.1 Low -1.7% Low Low
Chile -1.1 Low 149.1 Low 43.1 Med. -0.5% Low Low
Colombia -3.2 Med. 188.0 Low 22.4 Low -1.9% Low Low
Mexico -0.7 Low 146.5 Low 19.8 Low -1.1% Low Low
Med. threshold -2.0 142.1 38.3 1.1%
High threshold -3.7 120.7 52.8 3.1%
Current account Reserve cover Ex terna l Debt FX Valuation
Source: Haver Analytics, Deutsche Bank
In Asia, the risks are highest in the Philippines reflecting
its moderately large public debt, over half of which is
denominated in foreign currency, with relatively significant
amount (12% of GDP) falling due in the next year. Aside
from Egypt, India’s fiscal deficit is the largest in EM at
about 8% of GDP although this has so far been
comfortably financed domestically.
In LatAm, there are a couple of amber warnings in Brazil
given it high rollover needs and moderately large debt
stock, and in Colombia reflecting its moderate deficit and
relatively high FX exposure. Brazil´s relatively large primary
surplus (3.2% of GDP estimated for this year and 2.5%
projected for 2012) together with full dominance of local
market-local currency debt significantly mollifies the fiscal
risk although short term duration is still meaningful. A
balanced primary result in Colombia also helps to
moderate its fiscal risk but the combination of medium
size deficit and debt makes the country the most
vulnerable among the largest economies in the region
from a fiscal stand point.
Financial sector vulnerabilities
The picture in the financial sector is even more varied.
Loan-to-deposit ratios are typically higher in EMEA,
especially in Hungary and Ukraine, reflecting the
wholesale and external funding model of many banks in
the region. Loans are typically more than fully covered by
deposits in Asia and LatAm, however, with the notable
exceptions of Korea, Chile, and Colombia.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 49
Fiscal vulnerabilities Overall
% GDP Risk % Risk % GDP Risk % Risk Risk
EMEA
Czech -4.3 Med. 39.9 Low 6.5 Low 6.0 Low Low
Egypt -9.5 High 76.2 High 18.6 High 18.5 High High
Hungary -2.9 Low 75.9 High 13.7 High 32.3 High High
Israel -2.8 Low 71.1 High 8.6 Med. 13.8 Med. Med.
Kazakh 2.7 Low 12.9 Low 0.9 Low 1.0 Low Low
Poland -5.5 High 56.7 Med. 8.4 Med. 12.7 Med. High
Romania -4.4 Med. 34.0 Low 9.2 Med. 21.8 High Med.
Russia 0.2 Low 11.7 Low 1.1 Low 2.7 Low Low
South Africa -5.5 High 36.1 Low 0.9 Low 3.3 Low Med.
Turkey -1.5 Low 39.7 Low 9.5 Med. 10.7 Low Low
Ukraine -2.5 Low 39.3 Low 5.1 Low 26.1 High Med.0.0 Low 0.0 Low
Asia
China -1.5 Low 19.6 Low 6.1 Low 0.1 Low Low
India -8.1 High 61.2 Med. 3.2 Low 4.2 Low Med.
Indonesia -1.1 Low 26.0 Low 1.2 Low 10.9 Low Low
Korea 0.0 Low 34.4 Low 2.2 Low ... Low Low
Malaysia -4.9 Med. 55.2 Med. 2.9 Low 2.0 Low Med.
Philippines -2.8 Low 58.2 Med. 11.5 High 32.9 High High
Thailand -3.3 Low 36.0 Low 6.5 Low 6.3 Low Low
LatAm
Argentina -2.3 Low 21.8 Low 6.0 Low ... Low Low
Brazil -2.1 Low 56.6 Med. 16.8 High ... Low Med.
Chile 0.8 Low 7.4 Low 2.4 Low 2.2 Low Low
Colombia -3.3 Low 39.3 Low 3.9 Low 14.0 Med. Low
Mexico -2.1 Low 35.2 Low 8.7 Med. 9.2 Low Low
Med. threshold -3.4 41.5 7.4 12.0
High threshold -5.5 62.2 10.3 17.7
Overall balance Public debt Maturing debt FX debt
Source: Haver Analytics, IMF, Bloomberg LLP, Deutsche Bank
Many emerging European economies are still recovering
from the collapse of earlier credit booms and this is reflect
in low credit growth across much of the region. Turkey is
an exception where credit has been growing at an annual
average rate of 35% over the past two year, albeit from a
relatively low base. Credit is growing more rapidly in Asia
and LatAm, especially in Argentina, Brazil, and China. The
stock of outstanding credit is also quite high in China, now
at well over 100% of GDP.
One particular concern right now is that European banks
might look to reduce their exposures to EM as part of
efforts to meet capital requirements. The total risk
exposure of foreign banks is about 45% of GDP on
average in EMEA and about 26% of GDP in Asia,
reflecting the relatively greater role of European bank
subsidiaries in central and eastern Europe. Outside of
Europe, Malaysia (inflated a little bit by the offshore
banking business in Labuan), South Korea, Thailand, and
Chile have moderately high ratios of international bank
claims to GDP.
Overall, this metric suggests that the biggest risks lie in
Chile, Malaysia, Korea, and Hungary, though there are
moderate vulnerabilities in almost all countries. One
indicator that we did not include here was non-performing
loans because we think they way these are measured
varies greatly from country to country, making
comparisons difficult. If we had included a measure,
however, this would have bumped up our risk ratings for
Ukraine and, especially, Kazakhstan. Likewise, it is
questionable that high foreign claims make Chile
vulnerable as long as any other economic fundamentals
remain rock solid.
Financial vulnerabilities:
Overa ll
% Risk % Risk % GDP Risk % GDP Risk Risk
EMEA
Czech 0.81 Low 4.2 Low 73.2 Med. 105.9 High Med.
Egypt 0.48 Low 3.7 Low 30.8 Low 18.3 Low Low
Hungary 1.45 High -0.8 Low 78.1 Med. 101.4 Med. High
Israel 1.05 Low 6.1 Low 130.2 High 11.7 High Med.
Kazakh 1.25 Med. 0.0 Low 47.5 Low 18.7 Low Low
Poland 1.17 Med. 7.7 Low 51.9 Low 64.3 Low Med.
Romania 1.20 Med. 3.1 Low 56.3 Low 71.6 Low Med.
Russia 1.14 Med. 6.3 Low 0.0 Low 13.1 Low Low
South Africa 1.13 Low 3.2 Low 75.3 Med. 33.5 Med. Med.
Turkey 0.97 Low 35.3 High 41.9 Low 28.6 Low Med.
Ukraine 1.56 High 1.5 Low 62.9 Med. 25.5 Med. Med.0.0 Low 0.0
Asia
China 0.77 Low 19.5 Med. 117.7 High 10.1 High Med.
India 0.00 Low 18.1 Med. 56.9 Low 17.5 Low Low
Indonesia 0.72 Low 17.3 Low 27.8 Low 14.7 Low Low
Korea 1.36 Med. 3.9 Low 121.2 High 34.7 High High
Malaysia 0.90 Low 11.9 Low 116.6 High 59.1 High High
Philippines 0.61 Low 10.4 Low 33.7 Low 17.9 Low Low
Thailand 1.03 Low 10.5 Low 102.1 High 28.0 High Med.
LatAm
Argentina 0.72 Low 29.5 High 15.2 Low 10.7 Low Med.
Brazil 0.70 Low 22.2 Med. 71.8 Med. 24.1 Med. Med.
Chile 1.41 High 3.7 Low 66.7 Med. 56.6 Med. High
Colombia 1.70 High 14.6 Low 31.8 Low 12.6 Low Med.
Mexico 0.74 Low 6.1 Low 38.1 Low 35.8 Low Low
Med. threshold 1.1 17.8 59.4 30.3
High threshold 1.4 25.5 94.3 56.8
Loan/deposit Cred it g rowth Cred it Level
Foreign bank
c la ims
Source: Haver Analytics, BIS, Deutsche Bank
Exogenous shocks
We next assess the exposure of countries to an
exogenous shock in the form of a drop in external demand
in developed markets. Our measure for this is the growth
elasticity of each EM economy with respect to growth in
the US and Euro area. These ‚growth betas‛ are derived
as the coefficient estimates of regressions of a country’s
GDP on PPP-weighted US and Euro area GDP growth.
Within EMEA, five countries (Ukraine, Russia, Romania,
Turkey, and Hungary) have growth betas in excess of one,
pushing for above one regional average. Worth noting, the
impact of a synchronized global slowdown could be
higher than our growth betas – which capture the average
relationship over the last decade or so – would suggest.
During the last crisis, for example, the average drop in
output in EMEA was about 8-9%, compared with 5.4% in
the Euro area and 5.0% in the US.
In Asia, not surprisingly the growth betas are highest in
the economies with the largest export sectors. So
Singapore and Hong Kong – not included in this study
because their roles as financial centers exaggerate their
apparent vulnerability to financial shocks – have growth
betas in excess of 1.5. Taiwan also has a beta of around
1.5. So in the chart below the economies that appear
highly sensitive in a pan-EM perspective -- namely
Malaysia, Thailand, and South Korea – are actually in the
middle of the pack in Asia in terms of concerns about
imported growth shocks. Growth betas for three of the
region’s largest economies, China, India, and Indonesia,
are small as their large populations and relatively smaller
penetration of export sectors into the economy insulate
them to a considerable extent. We reckon these countries
are less sensitive to European growth than the US is
6 December 2011 EM Monthly
Page 50 Deutsche Bank Securities Inc.
despite the fact that in China exports to Europe comprise
about one-third of total exports.
In Latin America, in addition to the well known case of
Mexico, there is also relatively high dependence on US/EU
growth in Chile and Colombia, as expected given their
openness, but also because of the importance of the
commodity complex in their economies. This
notwithstanding, the region is becoming increasingly
dependent on Asia flows and commodity prices. This is
today the most important channel of contamination from a
global problem for Latin America. In Argentina, domestic
policies during the last eight years or so have allowed a
fairly independent performance of its economy relative to
the global scenario, something that is unlikely to continue
now that most of the financing buffers it initially had are
almost fully utilized.
EM Growth Betas
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
UK
R
RU
S
RO
M
TU
R
HU
N
MYS
TH
A
KO
R
KA
Z
CZ
E
ME
X
ISR
CH
L
CO
L
PH
L
PO
L
ZA
F
BR
A
CH
N
EG
Y
AR
G
IND
IDN
Betas to 1pp change in US/Eurozone growth
Source: Deutsche Bank
Overall vulnerability ratings
Combining each of these sectors, and attaching relatively
more weight to the external and fiscal sectors, we
construct an overall vulnerability score or rating for each
country. This is shown in the chart below together with
the contributions from each particular sector. Based on
the discussion above, it will come as no surprise to find
that EMEA dominates our list of most vulnerable
countries. Five countries (Hungary, Ukraine, Romania,
Poland, and Egypt) show up as highly vulnerable, though
for different reasons. Egypt’s underlying vulnerabilities, for
example, are fiscal first and external second. Ukraine’s
risks are mostly external. Hungary’s vulnerability reflects a
combination of risks in all four areas. As we noted above,
our sense is that Poland’s risk rating is probably a notch
too high according to this mechanical exercise, though it
does underscore that the economy does have macro
imbalances that have yet to be fully addressed.
Outside of EMEA, only Malaysia makes it on to our list of
countries with medium risk ratings mainly reflecting the
high level of foreign bank claims on the country (which
may be overstated) and moderate concerns about the
country’s public finances.
Overall vulnerability scores
Medium risk
threshold
High risk
threshold
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
HU
N
UK
R
RO
M
PO
L
EG
Y
TU
R
CZ
E
ZA
F
MY
S
ISR
KA
Z
BR
A
IND
KO
R
PH
L
CO
L
CH
L
AR
G
RU
S
TH
A
CH
N
ME
X
IDN
Growth Fin Fisc Ext
Overall vulnerability score
Source: Deutsche Bank
The graphic below summarizes these findings with a more
visual map, including every single indicator used for an
easier and comprehensive comparative analysis
Overall vulnerability map C
urr
ent
acco
unt
FX
re
se
rve
s
Exte
rnal d
eb
t
FX
valu
ati
on
Ove
rall
Ove
rall
bala
nce
Pub
lic d
eb
t
Matu
ring
de
bt
FX
De
bt
Ove
rall
Lo
an:d
ep
osit
s
Cre
dit
gro
wth
Cre
dit
le
ve
l
Fo
reig
n c
laim
s
Ove
rall
Gro
wth
be
ta
Ove
rall
EMEA
Czech Rep
Egypt
Hungary
Israel
Kazakhstan
Poland
Romania
Russia
South Africa
Turkey
Ukraine
Asia
China
India
Indonesia
Korea
Malaysia
Philippines
Thailand
LatAm
Argentina
Brazil
Chile
Colombia
Mexico
Risk ratings as follows: = low = medium = high
External Fiscal Financial
Source: Deutsche Bank
Having constructed our vulnerability measures, we can
also track how these have evolved over time. Below we
show the evolution of the overall ratings for each sector
and for the overall (cross-sector) rating from 2007-11.
Three things emerge clearly from this graphic:
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 51
While EMEA is currently clearly the most vulnerable
region, these vulnerabilities were actually even higher
prior to the last crisis in most cases – i.e. it was no
accident that many EMEA economies suffered their
own crisis in 2008-09
Some countries, however, have become more
vulnerable recently, at least in some respects. Egypt
is the obvious example, primarily reflecting its much
weaker reserve position but also some deterioration
in the current account. Fiscal risks have also become
greater in Poland and South Africa as fiscal deficits
have widened sharply; and also in Ukraine as debt
levels increased sharply.
The relatively high financial exposure of countries in
Asia (China, Korea, Malaysia) or LatAm (Brazil, Chile,
Colombia) seems to have persisted over time despite
relatively strong external and fiscal fundamentals,
which should moderate the potential relative risk in
this regards. This notwithstanding, we feel domestic
debt levels – and possibly falling asset prices – are a
significant risk to some economies in Asia.
Evolution of vulnerability ratings (2007-2011)
20
07
20
08
20
09
20
10
20
11
20
07
20
08
20
09
20
10
20
11
20
07
20
08
20
09
20
10
20
11
20
07
20
08
20
09
20
10
20
11
EMEA
Czech Rep
Egypt
Hungary
Israel
Kazakhstan
Poland
Romania
Russia
South Africa
Turkey
Ukraine
Asia
China
India
Indonesia
Korea
Malaysia
Philippines
Thailand
LatAm
Argentina
Brazil
Chile
Colombia
Mexico
Risk ratings as follows: = low = medium = high
External Fiscal Financial Overall
Source: Deutsche Bank
Conclusions
EMEA: facing a quadruple whammy
We have consistently highlighted the relatively greater
vulnerability of EMEA among emerging regions to a
renewed downturn in core developed markets. Indeed the
region faces something of a quadruple whammy right
now with significant weakness across each of the areas
that we have looked at.
First, current account balances have improved in the last
few years and central banks have been able to build
bigger buffers of foreign reserves. But the large stock of
external debt accumulated during the middle of the last
decade still leaves the region with large external burden.
Much of this borrowing took place in foreign currencies –
Swiss franc mortgages in Hungary (20% of GDP) being
just one example – the local currency burden of which is
now being inflated as those currencies come under
pressure. With these debts needing to be serviced on an
ongoing basis, many countries still face large external
financing needs even as their current account positions
have improved. This is particularly true of Hungary and
Ukraine, which have gross external financing needs of
30% of GDP or above in 2012 despite a moderate current
account deficit in Ukraine and a small surplus in Hungary.
If the difficulties facing Hungary and Ukraine are partly a
reflection of past external deficits, Turkey’s external
vulnerabilities are largely a reflection of the large current
account deficit (9% of GP) it is running now. Much of this
is financed through short term flows. Egypt’s problems
are different again with political uncertainty precipitating a
withdrawal of capital from the country and foreign reserve
coverage to fall to the lowest level in EM.
Three of these countries may well need to tap the IMF for
financial support next year. Ukraine already has an IMF
program (of which USD 12bn or 6.5% of GDP is
potentially still available) but is currently looking first to
Russia for cheaper gas prices to reduce its external
financing needs. Hungary is seeking the reassurance of a
precautionary IMF program although negotiation on the
policy condition has not yet started and could well be
difficult. Egypt had reached agreement in principle on a
USD 3bn (1.2% of GDP) arrangement with the IMF but
has yet to proceed with the deal for political reasons. We
don’t think Turkey will need to turn to the IMF but the risk
there is that a squeeze on capital inflows would
precipitate a sharp slowdown in domestic growth and a
weaker lira.
Second, as in many developed countries, sharply weaker
growth in the last two or three years has taken a heavy toll
in the public finances. In some cases, such as Egypt and
Hungary, fiscal positions were relatively weak to begin
with. Elsewhere, they are almost entirely a reflection of
the fiscal response to the crisis. Poland and South Africa,
for example, enjoyed strong budget positions going into
the last crisis and were therefore able to ease fiscal policy
aggressively. They have, perhaps understandably, been
slow to unwind this easing but may now find themselves
having to either tighten policy into a downturn (as Poland
6 December 2011 EM Monthly
Page 52 Deutsche Bank Securities Inc.
plans to do) or at least unable this time around to ease
policy to prop up growth.
Third, the buildup of foreign currency debt was probably
largely a reflection of relatively high and volatile inflation in
some cases, leading to a large spread between domestic
and foreign interest rates. But the availability of foreign
currency loans was also facilitated by the rapid expansion
of western European banks throughout much of the
region. This has left many countries exposed to
deleveraging by foreign banks as they seek to meet
additional capital requirements imposed by the European
Banking Authority. These requirements are largest for
Greek, Italian, and Spanish banks, which may be a
concern for Romania and Hungary (as well as Croatia,
Serbia, and Bulgaria outside our sample) where Greek and
Italian banks are most active. But other banks may also be
reluctant to maintain their exposures in the region.
Germany’s Commerzbank, for example, has indicated that
it will temporarily suspend new lending outside of
Germany and Poland. Austria’s central bank has also
imposed limits on new lending in CEE by the subsidiaries
of Austrian banks. And countries without strong parent-
subsidiary ownership linkages are also unlikely to be
immune. Turkish banks, for example, have substantially
increased their short term external borrowing in the last
couple of years (from foreign banks) and may face some
difficulties in rolling these loans.
Fourth, EMEA’s economies are mostly relatively small and
open markets with high trade and financial exposures to
the euro area and US. Even leaving aside the
vulnerabilities discussed above, it would leave countries
such as Hungary and Czech Republic – where exports to
the euro area account for about 40% of GDP - relatively
more exposed therefore to a recession in Europe.
There are, however, some pockets of resilience within
EMEA. With its current account surplus, large stock of
reserves, and low debt levels, Russia faces few of the
macro vulnerabilities of the rest of the region. Its
weaknesses are largely structural in nature though, as the
experience in 2008-09 reminds us, growth and the rouble
would come under pressure in the event of a significant
weakening of oil prices. The same is also true of
Kazakhstan, though the banking sector remains a potential
source of weakness. Israel’s macroeconomic
fundamentals are also generally strong and the main risks
are geopolitical in nature.
Asia: risks from rapid credit growth bear watching
Years of current account surpluses and sound fiscal policy
contribute to a picture of a region that is relatively less
vulnerable than EMEA for example. With the exception of
Korea’s real exchange rate – the apparent overvaluation of
which has likely been eliminated with the 6% depreciation
since September – Asia’s external vulnerabilities are
modest. Even India’s current account deficits – usually
3% of GDP or less – raise only an amber warning. Once
upon a time it was considered normal for emerging
economies to import capital.
And while India’s chronic large government deficits –
often more than 7% of GDP for the state and central
governments combined – are a persistent worry it has to
be placed alongside the manageable debt/ GDP ratio of
about 61% of GDP funded almost entirely onshore. We
don’t think policymakers are complacent, but deficit
reduction has been difficult over the past few years and
we expect that as global threats to growth recede in 2013
and beyond, the government will return to its pre-global
financial crisis trend of falling deficits.
Where this vulnerability exercise raises worries for Asia –
concerns which we have raised before – is on the financial
side. Domestic credit expansion has been overly rapid
not only in China in 2009 but also in a many other
economies over the past two or three years. The
economies of China, Korea, Malaysia, and Thailand have
high credit/GDP ratios indicating significant potential debt
burdens in the private sector in a slowing growth
environment. While the focus of investors today is,
perhaps rightly, on the external risks to the region, we
think domestic debt levels – and possibly falling asset
prices – are a significant risk to some Asian economies.
LatAm: Commodity dependency remains the main risk
Latin America went through a painful and meaningful
external, fiscal, and financial crisis in the 90s and today´s
resilience cannot be understood without that reference.
Forced fiscal adjustments, together with some structural
reforms, and overly conservative financial regulation have
allowed the region to converge to a relatively safe status.
This has permitted growth to become vigorous and
sustained with the helped of steady rise in commodity
prices, the region´s comparative advantage. Lack of
investment and increasing dependency on commodities is
probably the major drawback of this experience.
Increasing complacency regarding long term fiscal
rigidities with spending concentrated in current spending
in cases like Argentina, Brazil, Colombia, even Mexico, are
probably the main yellow light. Strong growth
sustainability and steady alleviation of poverty and social
conflicts remains the main challenge ahead.
Robert Burgess, London, (44) 20 7547 1930
Gustavo Canonero, New York, (1) 212 250 7530
Michael Spencer, Hong Kong, (852) 2203 8305
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 53
EM Performance: The Grass is Grayer on the Other Side
The year 2011 was marked by relentless crises in the
EU, damaged confidence, and faltering political
leadership that kept the global economy flirting with
recession for most of the year. Looking across all
asset classes, the most growth-sensitive ones have
underperformed fixed income in 2011 – a trend we
expect to extend into 2012.
EM Credit benefitted from lower US yields, but we
believe UST is unlikely to repeat its contribution to the
total returns in 2012.
EM rates have benefited from easier monetary
policies, but depreciation of the currencies has offset
gains. So the prospect for local markets hinges on
EM currencies and thus, on the resolution of the EU
crisis – the sooner the better.
We see three main takeaways from recent history
that are relevant for the year ahead: 1) the distribution
of returns will likely continue to favor fixed income vs.
growth-sensitive assets such as equities and EMFX –
especially in Q1 or H1; 2) returns are diminishing; 3)
EM still seems too important a source of carry and
value to drop from investors priority list – either in
risk-on or risk-off modes.
That said, if returns are less appealing in EM as they
used to be, the opportunities in global markets seem
even less so. Looking beyond bouts of deleveraging
and flight-to-quality, developed markets may set an
even-lower bar for EM in the years ahead.
Taking Stock: Lessons from 2011
The year 2011 was marked by relentless crises in the EU,
damaged confidence, and faltering political leadership that
kept the global economy flirting with recession for most
of the year. Backward-looking performance has often
times been a very poor predictor of future returns, but as
we write, the shocks that buffeted global markets in 2011
seem very likely to persist well into 2012. In particular, we
see three main takeaways from recent history that are
relevant for the year ahead: 1) the distribution of returns
will likely continue to favor fixed income vs. growth-
sensitive assets such as equities and EMFX – especially in
Q1 or H1; 2) returns are diminishing; 3) EM still seems too
important a source of carry and value to drop from
investors priority list – either in risk-on or risk-off modes.
In the sections below we shed more light on these.
The outperformance of the defensive
Not surprisingly, the chart below shows that the most
growth-sensitive assets underperformed fixed income – a
trend we expect to extend into 2012. Total returns were in
single digits, except for EM equities, which dropped about
17%. We have highlighted in recent Monthly publications
that EM FX has become more of a proxy for global risks
than EM specifics. This has weighed significantly on local
markets performance, and it seems unlikely to change
soon. In contrast, credit has benefited from the rally in
UST, but this is unlikely to repeat. Altogether, the stage
seems set for fixed income to outperform once more – at
least in the beginning of the year, but total returns seem
poised to shrink for long-only defensive investors.
2011 YTD performances of major asset classes
-20% -15% -10% -5% 0% 5% 10%
UST
EMBI-G
IG
GBI-EM (hedged)
HY
GBI-EM
G10 FX Carry Basket
S&P
EM FX (Spot & carry)
Com'dty
FX Carry Basket
EMFX Spot
EM Eq
YTD returns of various asset classes
Source: Deutsche Bank; MSCI EM, JPMorgan, Bloomberg Finance LP
EM credit benefitted not only from lower US yields but
also from the negative correlation between spreads and
yields during a good part of 2011, which compressed total
return volatility and boosted Sharpe ratios. How much did
the rally in UST contribute to total returns? The chart
below shows that the UST rally has accounted for most of
DB-EMSI constituents’ positive total returns year-to-date.
With the notable exceptions of Ukraine, Egypt, and
Argentina, the stellar performance of the USTs have more
than offset the widening in spreads.
The best performers have been, not surprisingly, low-
beta, high-quality LatAm credits. Only in Venezuela, yields
(and carry) were high enough to more-than-compensate
for the widening in spread seen in 2011. Looking ahead,
the good news is that spreads are higher and thus, offer
an additional buffer for shocks. The bad news is that UST
is unlikely to repeat its contribution to total returns in
2012. All in all, it seems more likely that EM hard currency
returns will be reduced going forward either by the limited
room for yield compression or potential re-pricing up of
UST as developed markets deal with their debt crises.
6 December 2011 EM Monthly
Sovereign credit: UST more than offsets wider
spreads
-5%
0%
5%
10%
15%
20%
EC UY PE PA MX CO VE BR PH ID EM ZA CL LB RU SV HU TR PL BG UA EG AR
Total Return UST Contribution
YTD Total Return and UST Contributions
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
VE QA MX CO PE BR PH PA LV ZA IL KZ MY RU ID CZ RO HU PL TR BG UA AR HR SK
5Y CDS Total Returns, YTD
Source: Deutsche Bank
EM rates have also benefited from easier monetary
policies, but depreciated currencies have offset gains
(chart below). The chart above shows that hedged returns
held up well near 5%, while EMFX returns (with carry)
were in line with the poor SP500, but outperformed
Deutsche Bank’s global FX (dynamic) carry basket,
commodities, and EM equities. EMFX will likely remain a
drag while the global economy flirts with recession and
EM rates are already relatively low. In fact, real rates are
negative in Asia, near zero in EMEA, and still positive in
LatAm – but relatively low. EM central banks are still
dealing with residual inflation (from FX pass-through and
commodities), but the inflation outlook is brightening. Still,
only in LatAm we see room for easing – though not
aggressive. Altogether, the prospect for local markets
hinges on EM currencies and thus on the resolution of the
EU crisis – the sooner the better.
EMFX: The major drag for local currency debt
85
90
95
100
105
110
90
95
100
105
110
Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11
GBI-EM
DBI-EM (FX-hedged)
EMFX (Spot and Carry)
YTD Returns
Source: Deutsche Bank
Diminished returns
The performance in 2011 was driven by adverse market
conditions but also by years of re-pricing of EM risk. As
the chart below suggests, double-digit returns in external
debt seem now confined to post-crisis recovery years.
After years of re-rating, EM investment-grade sovereigns
account for half of Deutsche Bank’s external debt index.
This, relatively low spreads and real rates in the US near
zero point to lower returns ahead. In the case of local
markets, the downtrend in total returns (FX + rates) still
seems less pronounced, but this is overshadowed by FX
volatility. In fact, FX-hedged returns have been remarkably
stable around 5% over the past decade, with fluctuations
mildly tracking global policy rates.
Asset performances of past ten years Year
Return Vol Ret/Vol Return Vol Ret/Vol Return Vol Ret/Vol S&P UST
2003 25.7% 18.0% 1.4 5.5% 2.4% 2.3 10.8% 5.4% 2.0 26.4% 2.3%
2004 11.7% 6.7% 1.8 7.7% 2.9% 2.7 14.2% 6.1% 2.3 9.0% 3.5%
2005 10.7% 2.4% 4.4 7.2% 1.9% 3.8 -0.9% 7.1% -0.1 3.5% 2.8%
2006 9.1% 4.5% 2.0 6.4% 2.6% 2.5 4.5% 7.8% 0.6 10.4% 3.1%
2007 6.1% 7.6% 0.8 4.8% 2.6% 1.8 13.7% 6.5% 2.1 3.9% 9.0%
2008 -10.9% 6.3% -1.7 5.4% 7.1% 0.8 -10.1% 15.5% -0.6 -38.5% 14.1%
2009 28.2% 16.6% 1.7 5.2% 4.2% 1.2 16.0% 12.1% 1.3 23.5% -3.8%
2010 12.0% 5.6% 2.1 8.6% 2.8% 3.1 6.5% 6.9% 0.9 12.8% 5.8%
2011 7.2% 5.2% 1.4 4.3% 3.0% 1.4 -4.4% 8.9% -0.5 -0.8% 8.8%
Average 11.1% 8.1% 1.4 6.1% 3.3% 1.9 5.6% 8.5% 0.7 5.6% 5.1%
Correla- w/ S&P 58% 47% 68%
tion w/ UST 47% 40% -6%
GBI-EM (FX -Hedged) EMFX (spot and ca r ry ) Other assets returnEMBI Globa l
Note: EMFX (spot and carry) is derived from GBI_EM unhedged and hedged returns.
Correlation with S&P and UST returns are calcuated using monthly returns.
-20%
-10%
0%
10%
20%
30%
2003 2004 2005 2006 2007 2008 2009 2010 2011
EMBI Global
GBI-EM (FX-Hedged)
EMFX (spot and carry)
EM asset returns, past 10Y
Source: Deutsche Bank, Bloomberg Finance LP
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 55
FX-hedged returns have provided higher Sharpe ratios
than hard currency, but total returns in external debt have
been almost twice as high since 2003. Returns in external
debt are matched only by unhedged local markets returns
in this period, but at a cost of higher volatility. Deciding
whether to allocate more to external debt or local markets
naturally depends on the prospects for US equities and
rates. From a valuation perspective, EMFX has more to
offer as it has lagged other assets. However, with global
growth likely to pick up only in 2013, FX will more likely
weigh on returns into 2012.
In order to provide some insight to the prospective and
constraints to the performance of sovereign credit and
local markets (and the relative performances between
them), we run a multiple regression of the asset
performances on S&P and UST for last two years, and
project their returns in 2012 based on three scenarios:
a bearish scenario under which 10Y UST yield
tightens to 1.5% and S&P drops to 1000
a neutral scenario where both UST and S&P remains
around the current levels
a bullish scenario under which 10Y UST yield rises to
3% and S&P rises to 1350
A simplistic projection of EM FI asset returns under
various scenarios of UST and S&P
Intercept UST S&P Carry*
EMBI Global 448.3 -50.3 0.14 4.36
GBI EM (Hedged) 165.3 -11.5 0.01 1.44
EMFX (spot and carry)** 70.9 1.3 0.06 3.49
Current
Level
10Y UST Yield 2.07
S&P 1247
Fitted Level Return Level Return Level Return
EMBI Global 569 556 -2.2% 578 1.6% 570 0.2%
GBI EM (Hedged) 174 175 0.7% 177 1.7% 175 1.0%
EMFX (spot and carry) 171 158 -7.7% 174 2.1% 182 6.6%
* For EMBI/GBI-EM, a UST-weighted time drift term is used in the regression to capture carry;
For EMFX, a time drift term is used. (Regression is based on 2Y history)
** Proxied by the ratio of GBI-EM Unhedged and GBI-EM Hedged
Bearish
Scenario
Neutral
Scenario
Bullish
Scenario
1.50
1000
2.07
1247
3.00
1350
Source: Deutsche Bank
The table above shows that both credit and FX-hedged
local markets would perform poorly under both the
bearish scenario (suffering from lower growth and higher
risk aversion) and the bullish scenario (suffering from
higher rates). Not surprisingly, EMFX (spot and carry) will
perform the best under the bullish – and even the neutral
scenario – given that they have sold off the most and
hence will have more to offer if there is a bounce in the
market. On the flip side, given its high beta to equities,
EMFX would take a big hit if S&P sold off 20% from
current level. That said, we note that the approach we
take here is very simplistic. Our aim here is to provide a
simple perspective, rather than deriving precise
quantitative implication from this exercise.
Nevertheless, the main point is that it will be hard for
credit to perform well without the support of USTs, and
likewise for local market without the contributions of FX
exposure.
The grass is greyer on the other side
Despite overall solid balance sheets and increased
investor interest18, EM performance has been hostage to
bouts of de-leveraging typical of riskier assets. This and
the prospect of diminished returns cast doubt on whether
EM could still expand the investment frontier. Despite its
obvious limitations, we rely on standard portfolio
optimization to shed some light on asset allocation, as it
remains the workhorse in the industry19. We obviously
avoid deriving precise quantitative implications from such
an exercise, as this would be futile under so much
uncertainty and data limitations. Instead, we look at
different periods and asset sets that could help identify
performance patterns. A subset of our results is
presented in the charts below and in the appendix.
The past decade has seen extreme bull and bear markets,
but throughout these adverse and pro-risky markets EM
assets have most often participated in the optimal
portfolios and in shares that tended to exceed by a large
margin those reported by global asset allocation surveys20.
In hindsight, the main decision was not whether to have
EM in size in the portfolio, but whether to concentrate in
hard currency or local currency exposure – or whether to
position aggressively or defensively. Qualitatively, rather
than displaying the theoretical capital market line, global
asset allocation seemed to span ‚clusters‛ of more
defensive assets (mainly fixed income and higher grade
credit) and more bullish growth equities/EM currencies.
18 According to DB’s Institutional Investor Survey, EM ranks highest in the
list of investors’ intentions to add exposure (see ‚2011 Institutional Survey,
John Haugh, DB Cross Rate Sales, Pensions") 19
The shortcomings range from estimating returns and their distribution
amid structural breaks and shocks, non-normality, skew, non-zero and
time-varying serial and cross-correlation in returns. It is important to note,
however, that these do not necessarily bias EM’s ‚optimal‛ share
downwards (see Non-Normality of Market Returns: A Framework for Asset
Allocation Decision Making, in The Journal of Alternative Investments,
Winter 2010, V12, 3 for examples. 20
See EM Technicals Outlook: Structurally sound; cyclically vulnerable
included in this publication.
6 December 2011 EM Monthly
Efficient frontier: EM present on both ends
EMBI-G
GBI-EM
GBI-EM-H
EMFX (spot)
EM Eq
IG
HY
Comdty
SPX
UST
0%
2%
4%
6%
8%
10%
12%
14%
0% 5% 10% 15% 20% 25% 30%
8Y
6Y
4Y
2Y
2Y (w/o UST)
Average weekly returns
Annualized weekly return volatility
Note: The lines represent frontiers calculated based on return data for
various historical periods to date; the dots are past 8Y returns vs. volatility.
GBI-EM-H is the fx-hedged version of the GBI-EM index. Source: Deutsche Bank
The past eight years of data comprise more bullish years,
while the past four years have been mostly crisis years
with short-lived rebounds. Accordingly, EM played an
important role in expanding the frontier. As growth
prospects dimmed and risk aversion surged over the latter
years, the ‚optimal‛ set shrunk. But rather than dropping
out of the portfolio, local markets gave way to a strong
participation of hard currency debt. Note that the past two
years have seen an increase in risk-adjusted returns for
lower-risk portfolios that seem atypical. The frontier does
not shrink significantly once we exclude UST from the
optimization because the rally in UST continues to be
captured by credit (high and low grade).
Focusing on the past two years, which seem a more likely
reference for the near future, the chart below shows that
external debt appears on the portfolio frontier for higher
risk tolerance portfolios (it takes 100% of the weight at
6.65% return volatility, the end point of the efficient
frontier). The total return was boosted by the rally in UST
and this is unlikely to repeat – at least in the similar
magnitude. But the rally in UST has been the main driver
of returns across all the competing assets (for the more
defensive allocation cluster that we show) so that the net
effect on portfolio is moot. Note from the chart above that
– for the more bullish ‚optimal‛ portfolio composition –
EM equities and local markets (unhedged) allocations
dominate US equities and commodities. From a
fundamentals and valuation standpoint, we believe EM
could still figure prominently in ‚optimal‛ portfolios for
both defensive and more bullish allocation ‚clusters‛.
External debt as a defensive trade
EMBI-G
GBI-EM
GBI-EM-H
EMFX (spot)
EM Eq
IGHY
Comdty
SPX
UST
-4%
-2%
0%
2%
4%
6%
8%
10%
0% 5% 10% 15% 20% 25%
Average weekly returns (past 2Y)
Annualized weekly return volatility(past 2Y) Source: Deutsche Bank
Concluding remarks
A dim growth prospect suggests that optimal portfolios
will likely remain skewed toward fixed income – at least in
the beginning of 2012. After two doses of QE, fixed
income returns are unlikely to repeat the performance of
2011. From a portfolio perspective, ‚optimal‛ allocation
weights of EM assets have been consistently above
average holdings in global portfolios, according to
institutional investors’ surveys, despite diminishing
returns – both in risky and defensive portfolios over the
past eight years. From a fundamentals and valuation
standpoint, EM currencies seem broadly undervalued,
sovereign and corporate balance sheets tend to be
healthier than their developed markets counterparts, and
EM remains an important source of carry, nevertheless.
If returns are less appealing in EM as they used to be, the
opportunities in global markets seem even less so.
History has shown that debt overhang has often times
been accompanied by negative real rates in many
countries after World War II 21 . Financial repression
accounted for roughly 20% of tax revenues in the sample
of countries facing debt overhang and around 2% of GDP
(3-4% in the US and UK, and 5-6% in Italy). Looking
beyond bouts of deleveraging and flight-to-quality,
developed markets may set an even lower bar for EM in
the years ahead.
Drausio Giacomelli, New York, (1) 212 250 7355
Hongtao Jiang, New York, (1) 212 250 2524
Jack Zhang, New York, (1) 212 250 0664
21 See Reinhardt and Rogoff: Growth in a Time of Debt, 2009.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 57
Appendix A: Asset average returns and volatility for past 8Y, 6Y, 4Y and 2Y periods
Return and Risk are based on weekly return
(annualized)
Return Risk Return Risk Return Risk Return Risk
EMBI* 9.1% 10.0% 8.7% 10.9% 8.9% 13.0% 9.5% 6.6% * JPMorgan EMBI Global Total Return Index
GBI-EM ** (Unhedged) 11.7% 12.0% 10.7% 13.0% 7.8% 14.6% 6.6% 11.2% ** JPMorgan GBI-EM Global Diversified Composite
GBI-EM ** (Hedged) 6.3% 3.7% 6.0% 4.1% 5.8% 4.7% 6.2% 3.0% *** JPMorgan EM Currency Index
EMFX *** 0.8% 8.1% -0.1% 9.0% -3.0% 10.2% -3.3% 8.9%
EM Equity 13.1% 26.3% 8.8% 28.8% -3.6% 31.4% -1.2% 23.3%
US IG 5.3% 4.9% 6.1% 5.2% 6.8% 5.9% 7.5% 4.5%
Glolbal HY 7.4% 7.7% 7.6% 8.6% 7.9% 10.4% 9.0% 5.8%
CRB 5.0% 19.7% 1.0% 20.6% -0.2% 23.3% 7.8% 18.3%
SPX 3.0% 19.2% 1.2% 21.5% -2.3% 25.0% 5.6% 18.7%
US Treasury Total Return 5.3% 4.5% 6.2% 4.7% 6.2% 5.3% 6.8% 4.2%
8Y 6Y 4Y 2YAsset
Appendix B: Portfolio weights on efficient frontiers
8Y History
Asset
EMBI 0% 0% 0% 0% 0%
GBI-EM (Unhedged) 0% 32% 61% 91% 0%
GBI-EM (Hedged) 48% 1% 0% 0% 0%
EMFX 0% 0% 0% 0% 0%
EM Equity 0% 0% 0% 0% 100%
US IG 0% 0% 0% 0% 0%
Glolbal HY 9% 17% 8% 0% 0%
CRB 1% 0% 0% 0% 0%
SPX 0% 0% 0% 0% 0%
US Treasury 42% 50% 31% 9% 0%
Port. Return 6.0% 7.7% 9.4% 11.1% 13.1%
Port. Risk 2.9% 4.9% 7.7% 10.8% 26.3%
Portfolio Composition
6Y History
Asset
EMBI 0% 0% 0% 0% 0%
GBI-EM (Unhedged) 0% 18% 45% 72% 100%
GBI-EM (Hedged) 43% 0% 0% 0% 0%
EMFX 0% 0% 0% 0% 0%
EM Equity 0% 0% 0% 0% 0%
US IG 0% 0% 0% 0% 0%
Glolbal HY 10% 20% 10% 1% 0%
CRB 1% 0% 0% 0% 0%
SPX 0% 0% 0% 0% 0%
US Treasury 46% 63% 45% 27% 0%
Port. Return 6.2% 7.3% 8.3% 9.4% 10.7%
Port. Risk 3.1% 4.1% 6.3% 9.3% 13.0%
Portfolio Composition
4Y History
Asset
EMBI 0% 6% 28% 51% 100%
GBI-EM (Unhedged) 0% 0% 0% 0% 0%
GBI-EM (Hedged) 42% 9% 0% 0% 0%
EMFX 0% 0% 0% 0% 0%
EM Equity 0% 0% 0% 0% 0%
US IG 0% 0% 2% 20% 0%
Glolbal HY 9% 25% 27% 24% 0%
CRB 2% 0% 0% 0% 0%
SPX 0% 0% 0% 0% 0%
US Treasury 48% 59% 42% 4% 0%
Port. Return 6.1% 6.7% 7.4% 8.1% 8.9%
Port. Risk 3.5% 4.2% 6.0% 8.9% 13.0%
Portfolio Composition
2Y History
Asset
EMBI 0% 0% 14% 38% 100%
GBI-EM (Unhedged) 0% 0% 0% 0% 0%
GBI-EM (Hedged) 41% 21% 0% 0% 0%
EMFX 0% 0% 0% 0% 0%
EM Equity 0% 0% 0% 0% 0%
US IG 0% 0% 0% 0% 0%
Glolbal HY 8% 32% 40% 41% 0%
CRB 0% 0% 0% 0% 0%
SPX 5% 2% 0% 0% 0%
US Treasury 45% 45% 46% 21% 0%
Port. Return 6.7% 7.4% 8.1% 8.7% 9.5%
Port. Risk 2.3% 2.6% 3.3% 4.4% 6.6%
Portfolio Composition
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 58 Deutsche Bank Securities Inc.
EM Technicals in 2012: Structurally Sound; Cyclically Vulnerable
A broad set of metrics encompassing institutional
guidelines, relative amounts outstanding, basic
portfolio allocation, and the structural indications from
EPFR flows suggest that global investors are still
structurally underweight EM
However, valuation, lack of depth, and market access
suggest that the pace of strategic inflows will be
considerably slower going forward when compared
with 2003-2007.
In sovereign credit, we expect an increase in gross
issuance in 2012 due to higher financing need in a
few countries and higher than usual principal and
interest payment. Venezuela will clearly present the
largest amount of net supplies, while Brazil, on the
other hand, will likely have the largest amount of net
redemptions.
In local markets, a major pressure point will be
foreign investor positioning, which remains close to
historical highs. We see risks of outflows as highest
in Hungary and to a much lesser extent Poland.
Otherwise, Hungary stands out having the largest
financing requirement increases (from 10% to
14.5%), while Egypt features the largest absolute
financing need (30.5% of GDP).
EM corporates have surpassed sovereigns in
issuance by a large margin and the primary market
activities have become quite resilient to the ebbs and
flows of global capital markets, thanks in part to the
higher quality and relatively low leverage amongst the
issuers.
The strong strategic inflows of 2003-2007 have given way
to more gradual allocations that at times have been
dwarfed by bouts of risk aversion. As we discuss in more
detail below, emerging economies are likely to command
an increased share in global portfolios for several years
from a structural standpoint, but the combination of less
appealing valuation and lingering risk aversion bodes for
gradual inflows at best amid likely surges in deleveraging
in 2012.
Tactically, after months of risk reduction EM technicals
seem positive not only structurally but also from a
(shorter-term) cyclical standpoint. The chart below shows
speculative FX data – a timely gauge for leveraged
positions – hovering near historical lows. However, light
speculative positioning (be it in FX forwards or options,
and CDS or swaps) is a partial metric that ignores
potential unwinding of real investments in EM that have
built over the years. In 2011 investors initially hedged core
EM positions (thus pushing speculative positioning into
light territory) to eventually capitulate on relentless market
pressure. Therefore, despite light speculative positions
EM FX in particular remains vulnerable to bouts of
deleveraging as we saw in 2011 should the global
economy enter recession and risk aversion surge again. In
the following sections we shed more light into the various
(structural and cyclical) aspects of EM technicals.
EMFX positioning is very light
-1
0
1
2
3
4
5
ARS BRL CLP COP MXN PEN
2-Nov-11 25-Nov-11 2-Dec-11
FX Spec. Positioning Z-scores (2Y)
Light
Source: Deutsche Bank
Structural under-allocation faces capacity constraints
Are global investors still under-allocated to EM? The
evidence indicates that – structurally – they are.
Incidentally, the latest DB Institutional Survey22 indicates a
strong positive bias towards EM assets, both equities and
debt – as shown in the graph below. For example,
according to the anticipated allocation changes for the
next 12 months, the percentage of funds looking to add
EM Debt vs. those looking to reduce is 28% vs. 3%.
However, there is really no simple answer to the question
above given the difficulties in reliably estimating current
vs. ‚optimal‛ portfolio allocations. We thus look at a
broad set of metrics encompassing institutional
guidelines, relative market size, basic portfolio allocation
benchmarks, and structural drivers for EPFR flows.
22 See 2011 Institutional Survey, John Haugh, DB Cross Rate Sales,
Pensions. The report presents a survey of 101 institutional asset owners,
taken between Mid-July and end of August 2011.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 59
DB survey: String bias towards EM assets
Source: Deutsche Bank 2011 Institutional Survey
a) Benchmark indices: One common institutional
guideline takes the form of benchmark indices23.
In the case of equities, anecdotal evidence points
to an average allocation to EM equities just above
5% - still a fraction of the almost 14% share of
EM in the MSCI. Moreover, long-term growth
differentials in favor of EM point to an increasing
share in the MSCI.
In the case of fixed income, anecdotally (from our
survey) we believe that EM’s share in global
portfolios is less than 3%, while the latest IMF
survey shows it is less than 5%24. This is still a
small number when compared with EM’s
debt/GDP and it’s almost 50% share in global
GDP (according to the latest IMF estimate, using
PPP exchange rates). However, while increasing
allocations to equities faces adverse market
conditions, investing in EM fixed income is
hindered by numerous accessibility hurdles – a
constraint that will likely be lifted only gradually.
Accordingly, foreign investors have favored the
most accessible markets such as CE3, Mexico,
and South Africa so that technicals actually look
heavy in these casesi.
b) Portfolio allocation: Although the standard
model is plagued by non-normality, serial, and
cross-correlation in returns, it remains the
workhorse in the industry. As we show in a
separate article in this publication25, EM tends to
figure prominently in global ‚optimal‛ portfolios
that also include global equities, high-yield, high-
23 From a fundamentals standpoint, savings ultimately match investments,
so that assessing whether investors are under-allocated hinges on their
preferences and the relative performance characteristics of investable
assets. Since the determination of the optimal portfolio is no easy task,
investors often times resort to benchmarks. Although benchmark indices
can be a useful reference, they are rather static and detached from market
incentives. In fact, since weighs increase when assets appreciate or
indebtedness rises, index weights and prospective returns tend to be
negatively correlated. 24
See September’s Global Financial Stability Report 25 See EM Performance: grass is greyer on the other side
grade, and US bonds, and global FX or
commodities. Although the ‚optimal‛ portfolio
shares obviously depend on risk tolerance,
(typical) moderate risk portfolios often post
‚optimal‛ EM allocations well in excess of the
weights in global portfolios discussed in the
previous paragraph. Whether this will hold is
questionable, as valuation is now less appealing.
But – from a long-term perspective – the pull
factors (such as EM’s superior carry and balance
sheets) will likely still compare favorably with
developed markets push factors such as balance
sheets, growth prospects, and possible financial
repression26.
EM expands efficient frontiers
EMBI-G
GBI-EM
GBI-EM-H
EMFX (spot)
EM Eq
IG
HY
Comdty
SPX
UST
0%
2%
4%
6%
8%
10%
12%
14%
0% 5% 10% 15% 20% 25% 30%
8Y
6Y
4Y
2Y
2Y (w/o UST)
Average weekly returns
Annualized weekly return volatility
Source: Deutsche Bank
c) Fundamental drivers of EM flows. Since
portfolio analysis is rather static, we model EM
portfolio inflows (using EPFR data since 2004;
weekly and monthly) aggregated by local currency
debt fund (LC), hard currency (HC), and equities.
The results for LC and HC debt based on standard
CCAPM are presented in the tables below. Our
results indicate that EM flows respond to
fundamentals and risk in line with intuition: 1) A
surge in risk aversion is associated with
substantial outflows; 2) Higher yield differentials
between local currency debt vs. hard currency
debt favors inflows into the former vs. outflows
from the latter; 3) inflation weighs on local
markets inflows, while growth differentials are
most relevant for equity inflows (not shown in the
table); 4) flows are most vulnerable to risk and risk
26 See Reinhardt and Sbracia, 2011
6 December 2011 EM Monthly
Page 60 Deutsche Bank Securities Inc.
aversion (proxied by the VIX), as we discuss in
more detail below 27.
EM flows supported by fundamentals
Dependent Var.: LC (AUM%) Dependent Var.: HC (AUM %)
Variable Coeff. t-stat. Variable Coeff. t-stat.
C 4.72 2.4 C 12.27 5.4
Ln(VIX) -1.83 -3.7 Ln(VIX) -2.43 -6.1
Yield diff 0.53 2.6 EM yield -0.42 -2.8
EM inflation -0.19 -1.5 UST yield -0.53 -3.2
R-squared 59% R-sq. 64%
Adjusted R-sq 55% Adjusted R-sq. 51%
S.E. of regr. 0.79 S.E. of regr. 0.39
F-statistic 14.53 DW stat 1.71
DW stat. 1.94
Sample: 2004-2011, monthly Source: Deutsche Bank, EPFR
d) Receding home bias. Missing in the portfolio-
based approaches we use is the prevalence of
home bias in international allocation decisions28.
Home bias has been falling, however. As it seems
inversely related to GDP/capita, it has been on a
downward trend (see the graph below). Since
financial assets are still concentrated in developed
markets, this trend should benefit EM allocations.
Home bias ratios trend down
0.5
0.6
0.6
0.7
0.7
0.8
0.8
0.9
0.9
1.0
1.0
Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
Emerging Market Developed Market
Home Bias Trend
Note: the figure plots the simple mean home bias ratios over time, with numbers taken
from Solnik and Zuo, 2011, A Global Equilibrium Asset Pricing Model with Home
Preference Source: Solnik and Zuo, 2011
27 Although the sensitivity to VIX shown is higher for hard currency flows,
this is because of the additional variables included in the local flows
regression (such as FX vols and local yield variance) that reduce the
elasticity of local flows to VIX. The dynamics version shown below
indicates - in line with intuition and anecdotal evidence - that local markets
investments are more sensitive to surges in risk aversion. 28 See Karen k. Lewis, International Home Bias in International Finance and
Business Cycles, 1998. The paper suggests that domestic investors hold a
substantially larger proportion of their wealth portfolios in domestic assets
than standard portfolio theory would suggest. In the absence of this home
bias, investors would optimally diversify away domestic output risk.
Assessing risks of reversals and EM capacity
The analysis above supports continued strategic inflows,
but it also highlights the sensitivity of these flows to bouts
of risk aversion. One natural by-product of the dynamic
modeling of these flows (on weekly data) is the impulse
response to a shock in VIX. As the chart below shows, the
response of flows to shocks is remarkably quick appearing
in the data already the week after shock. The impulse
responses we obtain from the dynamic version of the
regressions above show that they peak one week after
the shock and then gradually revert over the following
months.
The reversion is faster in hard currency (HC) than in local
markets (LC) and the impact of shocks to LC also tends to
be higher than shocks to HC funds. The chart below
shows the response to 10-point increases in the VIX - the
most important source of risk for flows. Although the
sensitivity to one point deviations in variables such as
growth, yield differentials, and inflation are comparable to
the VIX, the potential changes in the VIX are much larger.
Altogether, from a tactical standpoint, risk remains the
most important driver of flows dynamics. In addition, the
data patterns we have observed suggest that the VIX
threshold for outflows is around 30.
EM flows are quite sensitive to surges in the VIX
-1.8
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
1 2 3 4 5 6 7 8 9
Impact of a 10-point rise in VIX on AUM %
LC response to VIX shock
HC response of to VIX shock
weeks following surge in VIX
DB research, EPFR
Although not destabilizing, these fund outflows amplify
market pressure, highlighting that – despite the
improvement of the past decade – emerging markets
remain relatively shallow. Therefore, although EM
performance would warrant larger allocations in global
portfolios, EM’s sheer lack of depth already poses
capacity constraints. While investable EM fixed income
markets hovers below USD1.5trn, global mutual funds
alone amount to USD26trn – followed by similar stocks in
pension funds and insurance companies. With Sovereign
Wealth Funds contributing with almost USD5trn, private
wealth funds hovering above USD42trn, and alternative
investments possibly adding USD10trn (o.w.USD2trn in
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 61
hedge funds), a mere percentage point relocation into EM
would amount to one-third of its equity capitalization or
about all the investable fixed income pool29.
In sum, although fundamentals and institutional guidelines
indicate that global investors remain under-allocated to
EM, valuation, lack of depth, and market access suggest
that the pace of strategic inflows will be considerably
slower going forward when compared with 2003-2007.
A closer look at EM: Amortization and supply
Having discussed tactical and structural drivers of
technicals from EM at large, we now assess specifics for
sovereign credit, local markets and EM corporate credit in
2012, mostly from the perspective of supply vs. demand.
In sovereign credit, external issuance by EM governments
has been very strong post 2008 crisis, peaking in 2010,
but even in 2011 it has remained close to the 2010 high.
We expect issuance in 2012 to remain elevated (and most
likely above 2011) given the higher than usual external
debt payments (principal and interest, in total of
USD60bn). We project total principal and interest
repayment to cover over 70% of our projected gross
issuances across the major countries, in comparison with
the average 65% of the past three years. See the graph
below. This suggests an increase in total gross issuance
to $80bln from the average of $70bln of the past three
years, mostly due to significant increase of issuances by
Venezuela, Russia, UAE, and also due to a substantial
increase in net issuance by the smaller countries and less
frequent borrowers (e.g. Gabon, Ghana, and Egypt).
Project net supply by major EM governments in 2012
Net supply = projected gross issuances - total principal and interest payments
(bonds only)
Argentina: repayment include estimated warrant payments (excl. public holdings)
issunce projection is $2bln local law bonds
Venezuela: excludes PDVSA interest payments
UAE: include both Abu Dhabi and Dubai
-6000
-3000
0
3000
6000
AE VE CZ UA HU ID RO RU PE PH ZA CO MX LT PL LB TR BR AR
2012 hard currency bonds net supplies
DB research
29 Note that EM pension funds and mutual funds are among those with
highest growth rates, thus adding an important source of demand to this
equation. See OECD, ICI, The City UK, and Towers Watson statistics for
more information.
Among the countries, Venezuela is clearly the credit with
the largest amount of net supply, and the number above
does not even include PDVSA. Ukraine and Hungary are
two issuers with pressing financing needs. They could
place bonds only if market conditions are conducive; so
that external support (e.g. the IMF) may be required to
solve the liquidity problem they are facing. For Argentina,
we pencil in $2bln of local law bonds supply (likely to be
placed with the Anses), with the remainder of financing
gap ($3.5bln) to be likely filled with the use of Central
Bank reserves and loans with the Banco Nacion. The large
amount of negative net supply in Argentina is a double-
edged sword: on the one hand it suggests that investors
will get large redemptions, but on the other hand it is
indicative of demand constraints and lack of market-based
means of financing. Brazil’s large amount of negative net
supply, on the other hand, indeed represents a very
positive technical condition30.
Total public borrowing requirements are little
changed in 2012 from 2011 for most countries
BG
HRCZ
HU
LT
LUPL
RO
TR
IL
ZA
UA
RU
AR
BR
CL
CO
MX
VE
CN
IN
ID
KR
MY
SGPH
TH
0
5
10
15
0 5 10 15
2012 Gross Financing Requirement (% of GDP)
2011 Gross Financing Requirement (% of GDP)
Note: Data source for most countries is the IMF, with notable exception of Brazil,
Venezuela, Korea, and the Philippines, for which we get the amount of debt maturing
from Bloomberg. Source: Deutsche Bank, IMF
Data on local markets amortization schedule is scarcer.
We thus look at total public borrowing requirements and
investor positioning in selected markets for potential
pressure points. Based on IMF projections, the total gross
financing requirements will change little in 2012 compared
to 2011 (see the graph above). Countries that stand out
include Hungary, whose financing requirement increases
to 14.5% from 10%. Hungary has initiated talks with IMF
with the aim of accessing a precautionary credit line.
30 For a more detailed discussion on the supply/demand outlook as well as
other aspects of the technical conditions on Sovereign credit, please see
‚Sovereign Credit in 2012: Diminished returns; country selection key‛ in
this Monthly publication
6 December 2011 EM Monthly
Page 62 Deutsche Bank Securities Inc.
Egypt features the largest financing need (30.5% of GDP),
but for scaling purposes it is not shown in the graph.
For EMEA local markets, 2012 is likely to see a marginal
increase in net issuance, but the growth in volume is likely
to be in line with GDP and the increase is concentrated in
states that enjoy a comfortable fiscal position (Turkey,
Russia)31
the typically high financing needs in Brazil.
Otherwise, in local markets, a major pressure point will be
foreign investor positioning. Foreign investors have been
remarkably resilient even in markets (such as Hungary)
that have been hit hardest by the turmoil in the EU. As the
chart below shows, non-residents share of local currency
government debt markets is at an all time high in Poland,
Russia, South Africa, Turkey, and Hungary. The recent
years have been a reminder that these positions can be
unwound once risk aversion surges and – despite its
resilience – we see foreign positioning as vulnerability for
these markets. Risk is highest in Hungary and to a much
lesser extent Poland. On the other hand the likely
introduction of Euroclearable government bonds in Russia
is supportive in attracting inflows.
Foreign ownership of local fixed income still high
Source: Deutsche Bank
Corporates: The rising of the asset class is on track
It is no news that corporates have surpassed sovereigns
in issuance by a large margin (chart). For EM corporate,
the significant increase in bond issues after the 2008 crisis
has been in part to substitute for the contraction in bank
lending as development market banks have reduced their
balance sheets. In addition, the past few years have
shown that corporate issuance has become quite resilient
to the ebbs and flows of global capital markets. Dedicate
mandates are still minor when compared to sovereign and
31 See ‚EMEA Local Debt Supply and Demand in Focus‛ in this Monthly
publication for more details.
now local markets, but EM corporates bonds outstanding
already amount to about two-thirds of the HY and more
than 15% of IG.
Corporate-Sovereign supply gap likely to widen
19.0
59.072.6
55.5 57.6 63.050.4
57.3
83.794.1
122.0
176.4189.7
94.9
229.5
295.7286.5
245.3
0.00
50.00
100.00
150.00
200.00
250.00
300.00
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
10
YT
D
20
11
YT
D
USDbn
Sovereign Corporate
Source: Deutsche Bank
Higher quality and relatively low leverage also played a
role in explaining this resilience. Average corporate cash /
short term debt ratio is above 2x in LatAm and in
CEEMEA and has been growing in the past quarters. At
the same time, corporate net leverage has been declining
steadily in both LatAm and CEEMEA (see the graph
below), leaving the corporate sector in robust shape to
face a downturn in economic and financing activity.
Low leverage tames risk of reversals
Source: Deutsche Bank
Drausio Giacomelli, New York, 1 212 250 7355
Hongtao Jiang, New York, 1 212 250 2524
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 63
A Closer Look at Real-Money Positioning
EM local currency funds have grown by a factor of
almost 3.5x over the past four years. One of the
implications of this rise is that such funds have an
increasing impact on the behaviour of local markets.
In this article we examine the rise of these funds and
the impact it has had on cross-correlation within EM
local markets.
We also introduce a new analysis of fund positioning,
which we believe will serve as a useful tool for
gauging relative technicals across EM local markets.
The past few years have seen a dramatic rise in the
amount of funds managed according to dedicated, global
EM bond mandates. This rise has been particularly
significant for EM local currency debt funds; the AUM of
such funds has gone from USD24bn at the end of 2007 to
USD82bn32.
Recently however, inflows to EMD funds have stalled and
after over two years of consistent inflows, the past two
months have brought outflows. Within this article we
discuss some of the implications of the rise of local
currency funds. We also introduce a new approach for
assessing the relative position and appetite of real money
investors with respect to individual countries within both
local currency and hard currency funds.
EM Local Currency Bond Fund Flows
-5,000
-4,000
-3,000
-2,000
-1,000
0
1,000
2,000
3,000
4,000
5,000
Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11
0
10
20
30
40
50
60
70
80
90
100
Inflows, USD mm AUM, USD bn
Source: EPFR Global
32 This is according to data provided by EPFR Global which tracks primarily
publicly listed funds. The actual number is likely substantially larger, as we
discuss later.
Foreign holdings of several local currency markets has
mirrored the growth of global local currency funds...
0
50
100
150
200
250
300
350
400
450
Jan 08 Jan 09 Jan 10 Jan 11
Index of foreign holdings of domestic currency government bonds
USD-equivalent value, end 2007=100
Brazi
Indonesia
Malaysia
Mexico
AUM of EM Local
Currency Bond Funds
Brazil
Source: Haver, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research
One of the consequences of the rise of the global local
currency funds is of course that foreign investors now
hold fairly substantial proportions of the outstanding stock
of many local currency debt markets. By comparing the
data from the countries themselves on foreign holdings
with the flow data from EPFR we can build a picture of
the impact of the global funds on the rise in foreign
holdings. As the chart below shows, there is a striking
correlation in the holdings of a number of major local
markets with respect to the AUM of local currency funds.
It is remarkable that since the end of 2007, the percentage
increase in the stock of foreign holdings for all four
countries (Brazil, Mexico, Indonesia and Malaysia) and of
the total AUM of global local currency funds is in each
case in the range 200-250%.
...and the impact of the fund growth can also be seen
in many other markets
0
50
100
150
200
250
300
350
400
Jan 08 Jan 09 Jan 10 Jan 11
Index of foreign holdings of domestic currency government bonds
USD-equivalent value, end 2007=100
Korea
Turkey
Poland
Hungary
AUM of EM Local
Currency Bond FundsS. Africa
Source: Haver, EPFR, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research
6 December 2011 EM Monthly
Page 64 Deutsche Bank Securities Inc.
While not all countries have seen a percentage rise in
foreign holdings comparable to that of the four shown
above, a number of others also reflect the same pattern of
inflows. A likely reason why these particular countries
have seen a smaller percentage increase is that each of
these markets had significant proportions of foreign
investors prior to the recent rise of the global local
currency funds.
One of the implications of this remarkable rise of global
local currency funds is that markets which were once
almost entirely independent of one another are now being
linked by a common factor: the behaviour of the local
currency fund managers and in particular, the in/out flows
that they are experiencing.
The impact of this increasingly common factor can be
seen by looking at the average of all pair-wise correlations
of the returns of individual local markets. The chart below
shows the history of this cross-correlation, along with the
cross-correlation of (a) the FX component of the returns of
each market and (b) the fixed income component of the
returns. Most striking is the recent rise in the intra-FI
cross-correlation, coincident with the period of sharp
outflows shown in the first chart of this article.
Cross-correlation among EM local currency fixed
income has recently jumped higher
0
0.1
0.2
0.3
0.4
0.5
0.6
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Total USD Return
FI Return
FX Return
Cross-correlation (60d mov.avg of 5d returns)
Source: DB Global Markets Research
As global fund flows are of greater importance in
determining the behaviour of local currency bond markets,
the appetite of fund managers for different countries is
likely to have an increasingly impact, as they represent a
far larger share of holdings in each market. For this
reason, understanding how such funds are positioned
with respect to individual countries should be valuable.
For a number of years we have analysed such positioning
data for external debt funds, but only recently has the
coverage of local currency funds within the sample 33
reached a point at which we feel it is sufficiently
representative as to be able to provide meaningful
insights. While widening our analysis of local currency
fund positioning, we have also enhanced the way we
analyse the data.
We believe that there are two important factors to
consider when judging what the data on exposures tells
us about the technical position for a given country:
How are funds positioned relative to their respective
benchmark and how does this relative exposure
compare with history?
What has the recent appetite been for the country in
question? Have funds generally been adding or
reducing exposure?
For fund exposures we focus on how the exposure
deviation varies over time
Local currency fund exposure to Hungary
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
Jul10 Oct10 Jan11 Apr11 Jul11 Oct11
Benchmark
Avg Portfolio
Weight, %
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
Jul10 Oct10 Jan11 Apr11 Jul11 Oct11
Avg Fund Exposure
12m MA
MA +/- 1StDev*
Avg Exposure vs. benchmark
*The standard deviation measure used for the bands is based on the monthly changes
in the average exposure vs. benchmark.
Source: EPFR Global, DB Global Markets Research
33 We use data provided by EPFR Global on fund country exposures. This
data is provided on a monthly basis and at present covers USD28bn AUM
of hard currency funds and USD25bn AUM of local currency funds.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 65
For the first question, the analysis is relatively
straightforward. We simply take the average exposure of
the funds and compare this to the appropriate
benchmark 34 weight for the asset class. Since not all
funds will be benchmarked to the specific indices we use,
we do not place great emphasis on the absolute
difference between the exposure and the benchmark;
rather we focus on how that difference has evolved over
time.
The charts above illustrate this for the exposure of local
currency funds to Hungary. The first chart shows the raw
data: the average exposure of the funds and the weight of
the country in the benchmark. The second chart shows
the difference, along with the 12-month moving average
of the difference. These charts highlight the relevance of
looking at the deviation over time. The average fund
exposure has historically been below the benchmark
weight, but the deviation has been relatively stable
between 1-2pp below.
Notice that in the chart above, the relative rise in the fund
exposure which occurred in Q2 of this year was entirely
due to the reduction in the benchmark weight, not
because funds were actively increasing exposure. This is
clearly an important distinction and leads us to the second
factor we examine.
To answer the second question, for each fund in the
sample we examine the changes in country exposures
from one month to the next and estimate the extent to
which those changes are (a) passive – i.e. would have
34 For the local currency funds we use JP Morgan’s GBI-EM Broad
Diversified weights from Bloomberg. For the hard currency funds we use
our own EM USD Sovereign Index (which is very similar in composition to
JP Morgan’s EMBI Global Diversified and other similar constrained market
cap indices for EM sovereign USD bonds).
occurred due to relative price movements, without any
trading activity and (b) active – i.e. resulted from active
trading. We then examine the whole sample of funds and
see what proportion of the funds actively added exposure
and what proportion reduced exposure. We call the
difference between these two the ‘buyers v sellers index’.
The chart below illustrates this for Hungary and clearly
shows that funds were, on balance, actively reducing in
Q2.
Having constructed the relative weight and the buyers v
sellers index, we now have a pair of simple metrics with
which to compare fund exposure and appetite for
different markets. For the positioning we take the
difference between the average deviation from the
benchmark and the 12-month average, divided by the
standard deviation of the monthly changes of the
deviation.
The exposure z-score indicates how ‘over-/under-
weight’ funds are at present
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
BR ZA MY TH KR HU MX CO RU CZ ID PL EG RO PE IL TR
Oct 11
Prev. Mth
Exposure Z-score*
*-Avg exposure vs benchmark, relative to 12mth MA, divided by StDev of monthly
change in exposure
Source: EPFR Global, DB Global Markets Research
The chart clearly shows that funds are currently most
‘overweight’ with respect to Brazil and South Africa, while
Turkey is the biggest ‘underweight’.
For the comparison of recent ‘appetite’ we compare the
3-month moving average of the buyers vs. sellers index
for each country, as shown below.
Our buyers v sellers index illustrates the appetite for a
country among benchmarked real-money investors
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Hungary - buyers v sellers index
* A value of +1.0 indicates that all funds in the sample added exposure during the given
month. A value of -1.0 indicates that all funds in the sample reduced exposure.
Source: EPFR Global, DB Global Markets Research
6 December 2011 EM Monthly
Page 66 Deutsche Bank Securities Inc.
The buyers v sellers index gives an impression of the
relative strength of appetite for different countries
-0.5
-0.4
-0.3
-0.2
-0.1
0
+0.1
+0.2
+0.3
+0.4
+0.5
ZA TH RU BR KR CO CZ HU RO MX MY TR PL PE IL ID EG
Oct 11
Prev. Mth
Buyers v sellers index, 3m MA*
*-Number of funds actively increasing exposure minus number of funds actively
decreasing exposure, divided by the total number of funds
Source: EPFR Global, DB Global Markets Research
This shows that funds have been most consistent in their
appetite for South Africa; while there have been few
countries which have seen consistent selling pressure in
the past few months. The chart above also shows a sharp
change in the appetite for Colombia, from selling to
buying. This can be seen more clearly by looking at the
underlying index, as shown below:
Detailed country-specific charts (such as these) are
included in the Appendix
-7.4-7.2-7.0-6.8-6.6-6.4-6.2-6.0-5.8-5.6-5.4-5.2
Jan 10 Jan 11 Jan 12
Colombia - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Colombia - buyers v sellers index
Source: EPFR Global, DB Global Markets Research
The following pages contain charts like those shown
above for Colombia for all countries in the analysis. In
addition, we include similar analyses for the exposure of
hard currency funds. The interpretation of these is
discussed in the Sovereign Credit Outlook article within
this report.
Finally, we mentioned at the outset that the total amount
of assets managed by global EM local currency funds is
likely to be considerably larger than the USD80bn figure
indicated by EPFR. One way to gauge the order of
magnitude of the true figure is to compare the average
country weights of fund managers with the total stock of
foreign holdings in each market, as reported by the
various national sources (as shown below). If all the
foreign holdings in each market were held within global
local currency funds and if the country weights in our
sample is reflective of the overall market, then the points
on the chart below would all lie on a straight line, the
slope of which would reflect the total AUM of the funds.
As it is, a portion of the holdings are certainly not
managed within such funds, but this analysis nevertheless
allows some approximation to be made for the possible
size of this family of funds. The chart below would
suggest that there may be as much as USD200bn
managed in such funds.
The total size of the global local fund universe may be
as much as USD200bn
TH
ZA
TR
RU
PL
MY
MX
KR
IDHU
EGCZ
BR
$400bn
$300bn
$200bn
$100bn
0
20
40
60
80
100
120
0 5 10 15 20
Foreign Holdings of Domestic Government Debt (USD bn)
Average % allocation within Global Local Currency EMD Funds
Source: Haver, Bloomberg LLP, BIS, Country Sources, DB Global Markets Research
Marc Balston, London, (44) 20 7547 1484
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 67
Exposures of Local Currency EM Bond Funds
0
2
4
6
8
10
Jan 10 Jan 11 Jan 12
Brazil - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Brazil - buyers v sellers index
-7.4-7.2-7.0-6.8-6.6-6.4-6.2-6.0-5.8-5.6-5.4-5.2
Jan 10 Jan 11 Jan 12
Colombia - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Colombia - buyers v sellers index
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Jan 10 Jan 11 Jan 12
Czech Republic - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Czech Republic - buyers v sellers index
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Jan 10 Jan 11 Jan 12
Egypt - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Egypt - buyers v sellers index
0
1
2
3
4
5
Jan 10 Jan 11 Jan 12
Hungary - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Hungary - buyers v sellers index
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan 10 Jan 11 Jan 12
Indonesia - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Indonesia - buyers v sellers index
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
Jan 10 Jan 11 Jan 12
Israel - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Israel - buyers v sellers index
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Jan 10 Jan 11 Jan 12
South Korea - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
South Korea - buyers v sellers index
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
Jan 10 Jan 11 Jan 12
Mexico - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Mexico - buyers v sellers index
-6
-4
-2
0
2
Jan 10 Jan 11 Jan 12
Malaysia - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Malaysia - buyers v sellers index
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
Jan 10 Jan 11 Jan 12
Peru - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Peru - buyers v sellers index
-3
-2
-1
0
1
2
Jan 10 Jan 11 Jan 12
Poland - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Poland - buyers v sellers index
0.0
0.2
0.4
0.6
0.8
1.0
Jan 10 Jan 11 Jan 12
Romania - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Romania - buyers v sellers index
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Russia - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Russia - buyers v sellers index
Source: EPFR Global, DB Global Markets Research
6 December 2011 EM Monthly
Page 68 Deutsche Bank Securities Inc.
Exposures of Local Currency EM Bond Funds (cont...)
-6
-5
-4
-3
-2
-1
0
Jan 10 Jan 11 Jan 12
Thailand - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Thailand - buyers v sellers index
0
2
4
6
8
Jan 10 Jan 11 Jan 12
Turkey - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
Turkey - buyers v sellers index
-2
-1
0
1
2
3
Jan 10 Jan 11 Jan 12
South Africa - avg exposure vs b'mark
-1.0
-0.5
0.0
0.5
1.0
Jan 10 Jan 11 Jan 12
South Africa - buyers v sellers index
Source: EPFR Global, DB Global Markets Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 69
Exposures of Hard Currency EM Bond Funds
0
2
4
6
8
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Argentina - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Argentina - buyers v sellers index
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Bulgaria - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Bulgaria - buyers v sellers index
-6
-4
-2
0
2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Brazil - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Brazil - buyers v sellers index
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Chile - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Chile - buyers v sellers index
-3
-2
-1
0
1
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
China - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
China - buyers v sellers index
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Colombia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Colombia - buyers v sellers index
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Egypt - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Egypt - buyers v sellers index
-0.4
-0.2
0.0
0.2
0.4
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Ghana - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Ghana - buyers v sellers index
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Hungary - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Hungary - buyers v sellers index
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Indonesia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Indonesia - buyers v sellers index
-9
-8
-7
-6
-5
-4
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
South Korea - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
South Korea - buyers v sellers index
-8
-6
-4
-2
0
2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Mexico - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Mexico - buyers v sellers index
-3
-2
-1
0
1
2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Malaysia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Malaysia - buyers v sellers index
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Panama - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Panama - buyers v sellers index
Source: EPFR Global, DB Global Markets Research
6 December 2011 EM Monthly
Page 70 Deutsche Bank Securities Inc.
Exposures of Hard Currency EM Bond Funds (cont)
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Peru - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Peru - buyers v sellers index
-4.0
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Philippines - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Philippines - buyers v sellers index
-0.4
-0.2
0.0
0.2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Pakistan - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Pakistan - buyers v sellers index
-1.8
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Poland - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Poland - buyers v sellers index
-0.4
-0.2
0.0
0.2
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Serbia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Serbia - buyers v sellers index
-2
0
2
4
6
8
10
12
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Russia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Russia - buyers v sellers index
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
El Salvador - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
El Salvador - buyers v sellers index
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Tunisia - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Tunisia - buyers v sellers index
-6
-5
-4
-3
-2
-1
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Turkey - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Turkey - buyers v sellers index
0.0
0.5
1.0
1.5
2.0
2.5
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Ukraine - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Ukraine - buyers v sellers index
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Uruguay - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Uruguay - buyers v sellers index
-2
-1
0
1
2
3
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Venezuela - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Venezuela - buyers v sellers index
-0.6
-0.4
-0.2
0.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Vietnam - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
Vietnam - buyers v sellers index
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
South Africa - avg exposure vs benchmark
-1.0
-0.5
0.0
0.5
1.0
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12
South Africa - buyers v sellers index
Source: EPFR Global, DB Global Markets Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 71
IMF Financing: Possibilities and Limitations
The IMF currently has EUR 285bn in its locker for new
lending. This would be enough to provide newly-
launched Precautionary and Liquidity Lines for both
Italy and Spain (up to EUR 138bn), though we have
doubts about whether they would qualify for this
instrument. It would not be enough to cover a fund
arrangement for Italy (EUR 292bn) proportionate in
size to that put together for Greece
Various options have been proposed for increasing
the IMF’s financial firepower, including voluntary
contributions to an IMF special structure, pooling
European SDR allocations, or ECB lending to the IMF.
There are political and technical drawbacks with each
of them.
A further increase in bilateral contributions to the IMF
would seem more viable, though this would rule out
using the additional resources to buy bonds or lend to
the EFSF. Non-European countries will also want to
see greater clarity regarding Europe’s financial
commitment before they go down this route.
Were it not for the potential calls from the euro area,
the IMF already has enough firepower to meet the
probable needs of emerging market countries. The
requests are most likely to come from emerging
Europe, where a toxic combination of relatively
weaker fundamentals and higher exposures to the
euro area have left several countries facing
difficulties. Four countries in the region (Poland,
Romania, Serbia, and Macedonia) already have IMF
arrangements in place. Ukraine also has an
arrangement although this has been dormant for the
past year because Ukraine has not yet met the
requisite policy conditions (e.g. raising gas tariffs).
Hungary has also requested a program, though these
negotiations could well be difficult.
The IMF’s Financial Firepower35
The IMF’s resources come from two principal sources: (i)
the capital subscriptions (or ‚quotas‛) made available by
each member country – with the size of a country’s quota
determined mainly by its economic size; and (ii), IMF
borrowing, typically from its stronger member countries.
35 The IMF’s financial resources and transactions are denominated in
Special Drawing Rights, the value of which are based on a basket of
currencies including the dollar, euro, yen and pound sterling. The dollar and
euro amounts quoted in this note are based on exchange rates as of
November 22 (1 USD = SDR 0.639; 1 EUR = SDR 0.865) but might vary a
little with exchange rate movements.
These resources have expanded significantly in response
to the 2008-09 crisis:
IMF quota resources are in the process of being
doubled to approximately EUR 575bn. This increase is
still working its way through the domestic approval
process among the IMF’s member countries. The aim
is to get this done by October 2012, though there is a
risk that this date could slip, not least given the need
for US congressional approval the increase.
In the meantime, the credit lines available to the IMF
from stronger countries have been boosted to about
EUR 428 billion. The amount available to the IMF is, in
practice, rather less than this. Some creditor
countries could themselves run into balance of
payments difficulties and the IMF sets aside a portion
of these credit arrangements to reflect this risk.
Greece, Ireland, and Portugal, for example, participate
in these arrangements; but their portion of these
credit lines is effectively unavailable to the IMF. When
the quota increase becomes effective, the intention is
to scale back the borrowing arrangements
correspondingly.
That currently gives the IMF about EUR 620bn of total
resources, of which about EUR 590bn comes from quotas
and borrowing arrangements in roughly equal measure.
This compares with total resources of EUR 244bn in
December 2007 prior to the last crisis.
However, the amount the IMF has to lend to countries is
significantly less than this, primarily reflecting: (i) its
holdings of non-usable currencies (e.g. Zimbabwe dollar);
(ii) the amounts it has already lent or has committed to
lend (including precautionary arrangements or credit lines);
and (iii) a prudential balance or safety margin. Once all this
is factored in, that leaves the IMF with some EUR 285bn
available for new lending.
Potential lending to Europe
The IMF has a variety of lending facilities through which it
can lend to its member countries:
At one end of the spectrum is the Flexible Credit Line
(FCL) designed to provide to large upfront financing
to countries with very strong fundamentals and a
clear track record of implementing good policies.
Critically, for those countries that qualify, there are no
strings attached in the sense that disbursements
6 December 2011 EM Monthly
Page 72 Deutsche Bank Securities Inc.
under an FCL are not phased or conditional on a
country meeting certain policy understandings as is
Current IMF quotas (EUR bns)
Euro area 63.8 Selected others
Austria 2.4 Brazil 4.9
Belgium 5.3 Canada 7.4
Cyprus 0.2 China 11.0
Estonia 0.1 Japan 18.1
Finland 1.5 Mexico 4.2
France 12.4 Russia 6.7
Germany 16.8 UK 12.4
Greece 1.3 US 48.7
Ireland 1.5
Italy 9.1
Luxembourg 0.5
Malta 0.1
Netherlands 6.0
Portugal 1.2
Slovakia 0.5
Slovenia 0.3
Spain 4.7
Source: IMF, Deutsche Bank
the case under a traditional IMF-supported program.
There is no cap on the amounts made available,
which are based on an assessment of a country’s
potential financing need. But we can get a sense of
what is ‚normal‛ from the three countries that
currently have such arrangements, Mexico (1500% of
its quota), Poland (1400%), and Colombia (500%).
Somewhere in the middle is the IMF’s new
Precautionary and Liquidity Line, introduced earlier
this week.36 This is intended for countries with sound
fundamentals and policy track records, but which face
moderate vulnerabilities and do not qualify for the
FCL. Access is limited to 500% of quota up front and
up to a total of 1000% after 12 months subject to
satisfactory progress in addressing remaining
vulnerabilities. There is also a short-term liquidity
window under which countries could access between
250% and 500% of quota. We do not think there will
be much demand for this, with countries that qualify
for the PLL likely to prefer the longer 12-24 month
arrangement.
To give a sense of how much the IMF could lend to
Europe, using its existing instruments and given its
current firepower, we show some illustrative program
36 This is very similar to the Precautionary Credit Line (PCL), which it
replaces: Macedonia is currently the only country that has a PCL. Aside
from the new short-term liquidity window, the only other material change
is that a country can now request a PLL when it has an actual balance of
payments need versus potential need under the old arrangements. In
practice, however, defining whether a country faces an actual or potential
balance of payments need is not a precise exercise. We think it unlikely
that the distinction was much of a barrier to countries accessing the PCL.
sizes for Italy and Spain in the table below. Were it to
qualify for a PLL, for example, Italy would be able to
access up to EUR 91bn. The corresponding amount for
Spain would be EUR 47bn. In both cases, only half of
these amounts would be available upfront. The IMF would
be able to finance these amounts, totaling EUR 138bn,
from within its existing EUR 285bn available for new
lending.
It would be more difficult for it to accommodate programs
significantly larger than this. If, for example, Italy were to
request a ‚Greek-size‛ program (i.e. 3200% of quota), this
would amount to EUR 292bn, which would entirely wipe
out the IMF’s new lending capacity. The Irish and
Portuguese programs were a little smaller than this at
about 2300% of quota, which in Italy’s case would
amount to EUR 210bn. This is within the IMF’s new
lending capacity but would leave it with little (EUR 75bn)
to meet the needs of other potential borrowers, such as
Spain, let alone emerging markets that are facing
difficulties in the current environment. Hungary, for
example, has already indicated its intention to seek
another arrangement with the IMF.
Illustrative IMF program sizes (EUR bns)
Italy Spain Total
PLL (1000% of quota) 91 47 138
of which available immediately: 46 23 69
Traditional program (3200% of quota) 292 149 440
Traditional program (2300% of quota) 210 107 316
Source: Deutsche Bank
It is debatable whether Italy or Spain would qualify for the
PLL. The IMF has, for example, indicated that the PLL is
intended for ‚crisis bystanders‛. The qualification criteria
(see box below) involve some subjective judgments. But
we think that both Italy and Spain need to undertake large
macroeconomic and structural policy adjustment, which
would appear to rule them out as PLL candidates. If that is
the case, then they would need to seek more traditional
programs with their more intrusive (and politically
unpalatable) policy conditionality.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 73
IMF Precautionary and Liquidity Line
Qualification requires that a country: (i) has sound
economic fundamentals and institutional policy
frameworks; (ii) is implementing—and has a track record
of implementing—sound policies; and (iii) remains
committed to maintaining such sound policies in the
future.
The criteria used to assess whether a country qualifies for
the PLL are: (i) external position and market access; (ii)
fiscal policy; (iii) monetary policy; (iv) financial sector
soundness and supervision; and (v) data adequacy. While
requiring strong performance in most of these areas, the
PLL permits access to precautionary resources to
members that may still have moderate vulnerabilities in
one or two of these areas.
Countries suffering any of the following problems at
approval cannot access the PLL: (i) sustained inability to
access international capital markets; (ii) the need to
undertake large macroeconomic or structural policy
adjustment; (iii) a public debt position that is not
sustainable in the medium term with a high probability; or
(iv) widespread bank insolvencies.
Source: IMF and based on the qualification criteria for the Precautionary Credit Line.
Options for increasing IMF firepower
There has already been some discussion, notably among
the G20 at the Cannes Summit, of further increasing the
financial firepower of the IMF. G20 Finance Ministers will
return to these issues when they meet in the new year.
Mirroring its primary sources of funds, there are two basic
ways in which to increase the general resources that the
IMF has available to lend:
A further increase in IMF quota subscriptions. This
seems unlikely, with the last increase still winding its
way through a lengthy and cumbersome approval
process. It was also not among the options
mentioned by G20 leaders in their Cannes
communiqué.
Additional increases in IMF borrowing. There are a
variety of ways in which this could be done. The IMF
could, for example, borrow from the private sector
although it has never done so. The IMF’s current
borrowing takes place primarily through a multilateral
agreement, the "New Arrangements to Borrow"
(NAB). The quickest way, however, is through
bilateral agreements with individual countries. This is
the route that was followed after the last crisis. These
bilateral commitments were then folded into an
expanded NAB.
Our reading of the G20 meetings a few weeks ago was
that while the BRICS and others were reluctant to lend
directly to the EFSF, they were open to the idea of
providing support through the IMF, not least because the
IMF would then bear the credit risk. No firm pledges were
made, though the table below (showing the current
breakdown of bilateral credit lines to the IMF through the
NAB) shows the amounts that countries eventually
stumped up following the last crisis.
The US seems less enthusiastic about increasing the size
of the IMF. In his statement to G20 Finance Ministers in
mid-October, for example, Secretary Geither note that,
‚The IMF has a substantial arsenal of financial resources,
and we would support further use of those existing
resources to supplement a comprehensive, well-designed
European strategy alongside a more substantial
commitment of European resources‛.
Ultimately, however, the main stumbling block was an
unwillingness outside the euro area to commit resources
to a bigger IMF while the financial commitment from
Europe was itself unresolved.
A number of other proposals potentially involving the IMF
in providing financial support to Europe have been floated.
We go through these below and offer our views on
whether they are likely to work or garner much support.
Increased IMF Special Drawing Rights (SDRs).
Countries hold SDRs as part of their reserve assets and
are able, through the IMF, to exchange them for the freely
usable currencies of other IMF members (e.g. dollars or
euros). The IMF can create SDRs – it is (roughly) the IMF
equivalent of printing money. There have only ever been
three such SDR allocations. The last allocation of EUR
186bn in 2009 was by far the largest and the first since
1981. Some countries converted their allocations into
usable currencies which they then spent. Ukraine, for
example, used its allocation to pay Russia for gas
supplies; and Serbia used its allocation to finance its
budget. For the most part, however, countries held on to
their allocations.37
The problem with this as a means of providing financial
support to Europe is that SDRs are allocated in proportion
to a country’s quota. So for every EUR 10bn that would
get allocated to, say, Italy, the US would receive EUR
53bn because its quota is over five times the size of
Italy’s. It would be technically possible to have an SDR
allocation just for Europe, but it’s hard to see why other
countries would agree to this.38
37 Total SDR sales between the allocation in August 2009 and June 2011
were only about EUR 8bn. 38
There was a special one-time allocation of EUR 25bn in which some
countries received more than their quota share. But this part of efforts to
6 December 2011 EM Monthly
Page 74 Deutsche Bank Securities Inc.
Pooling Euro area SDRs. There has been some
discussion of the euro area countries pooling their SDR
allocations, which could then be used to provide capital
for the EFSF. The current SDR holdings of the euro area
are about EUR 52bn, not insubstantial but certainly no
panacea in terms of increasing the size of the EFSF. Our
understanding is also that Germany does not support the
proposal.39
The IMF’s New Arrangements to Borrow (EUR bns)
Country commitments :
Eurozone 108.0 EM 66.4
Aust 4.1 Brazil 10.1
Bel 9.1 Russia 10.1
Cyp 0.4 India 10.1
Fin 2.6 China 36.1
Fra 21.6
Ger 29.3 Other EM 35.1
Gre 1.9 Chile 1.6
Ire 2.2 Israel 0.6
Ita 15.7 Hong Kong 0.4
Lux 1.1 Korea 7.6
Net 10.5 Kuwait 0.4
Por 1.8 Malaysia 0.4
Spa 7.7 Mexico 5.8
Philippines 0.4
Other DM 218.1 Poland 2.9
Australia 5.1 Saudi Arabia 12.9
Canada 8.8 Singapore 1.5
Denmark 3.7 South Africa 0.4
Japan 76.2 Thailand 0.4
New Zealand 0.7
Norway 4.5 Total 427.6
Sweden 5.1
Switzerland 12.6
UK 21.6
US 79.8
Source: IMF, Deutsche Bank
IMF administered accounts or trusts. In addition to its
general resources, the IMF has a number of administered
accounts and trusts that have been established to meet
specific purposes.40 The main requirement is that such
accounts need to be consistent with the purposes of the
IMF. One option would therefore be set up such an
account or trust for Europe, to which others could then
contribute financial resources. The IMF could then either
rebalance the IMF and address some obvious inequities, including the fact
that some members (those joining after 1981) had never received an SDR
allocation. 39
It is also not clear how using these SDRs as capital for the EFSF would
square with the IMF’s arrangements for ensuring that SDRs can be
converted into freely usable currencies. 40
Trusts (largely financed by donors) have been used to enable the IMF to
lend money to low-income countries on concessional terms or to provide
debt relief. Administered accounts have been used to enable countries to
finance technical assistant. Spain also used an administered account to
provide financing to Argentina alongside its IMF program in 2000-01.
lend these resources to euro area countries or, potentially,
buy bonds and/or lending to the EFSF.
We think this is unlikely to happen for three reasons: (i)
other countries will be reluctant to support a vehicle that
is designed solely for the benefit of Europe; (ii)
contributing countries rather than the IMF would still bear
the credit risk from such loans; and (iii) in contrast to the
extension of credit lines to the IMF (discussed above),
country contributions to an administered account or trust
could not be included as part of the contributing country’s
foreign reserves.
IMF as a conduit for ECB financing. This is essentially
the same option as above but simply involving the ECB.
As such, it could be a way of getting round the EU treaty
restrictions that have so far precluded larger ECB bond
purchases or lending to the EFSF. It would likely therefore
be subject to the same (German) objections.
Summary of options for IMF financing Loans to IMF
genera l resources
account
Loans to an IMF
administered
account/ trust SDR Allocation SDR Poo ling
Approval IMF board decision
(simple majority).
Funding from donor
country need to be
approved at the
national level (See
below).
IMF board decision
(simple majority).
Funding from donor
country need to be
approved at the
national level (see
below).
IMF board decision
with 85% majority
Country decision as to
how to use the
reserves (could be
national Treasury or the
national central banks).
Amount In 2009 EUR 428bn of
additional funding was
committed initially as
bilateral loans
subsequently folded
into an expended NAB
Only a few examples
in the past (e.g. loan
from Spain to
Argentina).
In 2009 increased the
SDR allocation by
EUR189bn
The current SDR
holdings of the EUR
area amount to
EUR52bn
Conditions Usual IMF procedure.
Loans will have
preferred creditor
status
Has to be‛ consistent
with the purpose of the
IMF‛. Could be more
flexible than IMF
General Resources: i.e.
does not need to be
limited to loans to IMF
member states nor
does it have to enjoy
preferred creditor
status.
Country decision as to
how to use the
reserves (could be the
central bank or the
fiscal authority). For
instance, Ukraine in
2009 exchanged its
SDR for hard currency
via the IMF and used
the proceeds to pay
Russia for gas
supplies
Not clear, but
presumably could be
rolled into the EFSF or
have EFSF like
procedure. ECB will
need to agree to
exchange the SDRs
against euros
Funding In most countries it is
the national Treasury
that provides the loan,
but the net debt is
unchanged as there is
a claim against the
IMF. In the case of
Germany, it is the
Bundesbank that
provides the loan,
without an impact on
the net debt position of
Germany.
The source could be
either national central
banks or national
Treasuries. May have
an impact on the net
debt position of the
lender
De facto money
printing by the IMF. In
accounting terms, the
national central banks
have increased
reserves and against it
a long term liability to
the IMF that never gets
called unless the
country exits the IMF
De facto money
printing by the ECB
Comments Non-EU countries have
withheld their support
pending further
financial commitment
from Europe.
Have more flexibility
than General Resources
usage. Not clear
however that non-EU
countries will agree to
take directly the credit
risk of the recipient
country. May also lead
to the loans being
accounted as debt in
the national accounts
A generalised SDR
issuance implies that
the US would receive a
disproportionate
amount of SDR relative
to Spain and Italy that
would presumably
need the funds. Also,
there is no
conditionality
automatically attached
to the use of the SDR.
Small amount
available.
Assessment Most likely outcome.
Can be agreed by the
next G20 meeting in
February. Would need
Bundesbank Approval
Less market friendly
than administered
account as the IMF
seniority may
complicate the return
to market for program
countries.
Unlikely and inefficient.
Would need to be
combined with SDR
pooling to be material.
Lacks conditionality for
using the funds. Not
clear why
Germany/ECB would
agree to this vs. other
alternatives.
Unlikely and too small
to matter. Not clear
why Germany/ECB
would agree to it vs.
other alternatives
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 75
Implications for EM
The current debate about increasing the financial
firepower of the IMF is largely about giving it sufficient
resources to increase its lending operations in the euro
area. Its current resources are adequate to handle the
most likely requests for financial assistance from EM,
though these resources would certainly be stretched if
one or two larger emerging markets, particularly Brazil but
also Turkey, were to request financial assistance (e.g. in
the form of Flexible Credit Lines or Precautionary and
Liquidity Lines).
The requests are most likely to come from emerging
Europe, where a toxic combination of relatively weaker
fundamentals and higher exposures to the euro area have
left several countries facing difficulties. Four countries in
the region (Poland, Romania, Serbia, and Macedonia)
already have IMF arrangements in place as a financial
safety net. Ukraine also has an arrangement although this
has been dormant for the past year because Ukraine has
been unable to meet the conditions required (e.g. higher
domestic gas tariffs) for further disbursements of financial
support.
Current IMF programs for EM
Type Amt (USD bn) % Quota
Colombia Flexible Credit Line 6.1 500
Macedonia Precautionary Credit Line 0.3 314
Mex ico Flexible Credit Line 74.0 1304
Poland Flexible Credit Line 30.0 1135
Romania Precautionary Standby 4.8 300
Serb ia Precautionary Standby 1.5 200
Sri Lanka Standby Arrangement 2.6 400
Ukra ine Standby Arrangement 15.6 729
Source: Deutsche Bank
Hungary has announced that it is seeking a precautionary
financing package with the IMF (and EU). The government
has indicated that it would like an insurance-type
arrangement (i.e. upfront access with little or no policy
conditionality). But our assessment is that they are more
likely to get a traditional Precautionary Standby
Arrangement (like Romania and Serbia) – see also the
Hungary section later in this EM Monthly for a more
detailed discussion of our views on this issue, including
some of the potential policy sticking points in the
negotiations.
Other countries in south eastern Europe (e.g. Croatia)
could also be candidates for IMF financial assistance in
this environment. Outside of Europe, Egypt’s external
position remains under significant pressure with reserves
more than halving since the revolution earlier this year.
The government had reached preliminary agreement on a
USD 3bn Standby Arrangement with the IMF but stopped
short of going forward with the arrangement for political
reasons.
Robert Burgess, London, (44) 20 7547 1930
6 December 2011 EM Monthly
Page 76 Deutsche Bank Securities Inc.
EMEA Domestic Debt: Supply and Demand in Focus
2011 was a positive year for fiscal performance in
most EMEA countries. In most instances fiscal
targets were exceeded and debt issuance programs
progressed without interruption. A performance that
contrasts with the situation prevailing in developed
markets and more specifically Eurozone countries.
2012 is likely to see a marginal increase in net
issuance in our view, but the growth in volume is
likely to be in line with GDP and the increase is
concentrated in states that enjoy a comfortable fiscal
position (Turkey, Russia)
EMEA countries have been cautious in managing
their debt issuance plan, often front-loading issuance
(Poland, Hungary), pre-funding for 2012 (Poland) and
preserving healthy cash balances (Poland, South
Africa). Hungary has initiated talks with IMF with the
aim of accessing a precautionary credit line.
EM local currency debt funds continued to see strong
inflows, but the momentum has been lost in the
second half of the year as Eurozone worries forced a
derisiking across financial markets.
Appetite for local currency debt has seemed at times
indiscriminate (Hungary) and excessive (Poland, South
Africa). Non-residents share of local currency
government debt markets is at an all time high in
Poland, Russia, South Africa, Turkey, Hungary
We see risks of outflows as highest in Eastern
Europe: Hungary and to a much lesser extent Poland.
On the other hand the likely introduction of
Euroclearable government bonds in Russia should
attract inflows
In the following note we take stock of the lessons
learned in 2011 and address the specifics of each
market in terms of supply/demand over 2012
Inflows have been on an exponential trend (USD bn)
Source: Deutsche Bank
…modest outflows despite a negative performance
Source: Deutsche Bank
Foreigner positioning is at new highs in most markets
TH
ZA
TR
RU
PL
MY
MX
KR
ID
HU
CZ
BR
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0% 5% 10% 15% 20% 25% 30% 35% 40%
Foreign Holdings of Domestic Government Debt (latest data)
Foreign Holdings of Domestic Government Debt on 31-Aug-08
Source: Deutsche Bank
2011: Lessons from a volatile year
A combination of factors arguably made EM Local debt
appear to be the ideal asset class in which to invest in
2011. The global backdrop was characterized by low
expectations for global growth/inflation which should be
supportive for rates However, investors in DM rates
products were faced with new risks: the potential
negative impact of successive rounds of QE on the USD,
financial repression via the imposition of negative real
yields and the emerging risk of default in several Eurozone
names. As such EM, enjoyed better fiscal fundamentals,
and seemed to offer an ideal investment environment.
The asset class has for example attracted much more
inflows than EM equities.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 77
Despite a positive start to the year, performance turned in
the third and fourth quarter as DM troubles caught up
with EM investors via the USD funding channel. The
spread of Greek crisis to other Eurozone assets made US
money market funds reluctant to fund European banks,
thereby triggering a scramble for USD funding which
penalized EM FX. The impact was severe enough to cause
fears of FX pass-through into inflation. Turkey and Russia
were forced to allow money market rates to rise. As a
result the benchmark index has delivered a negative
performance (at time of writing -3%).
Some investors would have been reassured that outflows
were relatively modest at (-2.5% of total assets) and the
trend reversed quickly, compared to EM hard currency.
However, anecdotal evidence suggests that bond
investors themselves were at least partly responsible for
the weak EM FX performance in an attempt to hedge
bond holdings via a more liquid instrument. The low risk of
default and the absence of client redemptions make it
hard to justify the transaction costs of an outright
reduction in bond holdings. This form of ‚synthetic
outflows‛ via FX hedging or even over-hedging (whereby
investors attempt to hedge both FX and duration exposure
via FX) can lead to higher rates with central banks forced
to react to FX weakness to reduce the FX-pass through to
inflation It therefore seems to us that even in the relatively
supportive environment of 2011, weak technicals did play
a role in the negative performance for the year.
At the start of 2012, Turkey looks to be the largest
underweight position, while South Africa is the biggest
overweight in EMEA.
In the following section, we analyse on a country by
country basis the supply/demand picture for 2012 and
compare this to the existing positioning.
Local debt performance turned in September
-6
-4
-2
0
2
4
6
8
10
01/11 04/11 07/11 10/11
EM LC Index
EM LC Index Hedged
Year to date total returns (%)
Source: Deutsche Bank
FX positioning turned sharply since September
Source: Deutsche Bank
Turkey is the most underweight position
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
BR ZA MY TH KR HU MX CO RU CZ ID PL EG RO PE IL TR
Oct 11
Prev. Mth
Exposure Z-score*
*-Avg exposure vs benchmark, relative to 12mth MA, divided by StDev of monthly
change in exposure
Source: Deutsche Bank
Hungary: an arduous 2012
Fiscal: Our economists expect GDP growth of -0.8% for
2012 after an expected 1.4% outturn for 2011. The
government has penciled in 2.5% of GDP fiscal deficit in
2012, which we believe is too optimistic and expect the
deficit to be close to 3.2%.
Supply: Favourable risk appetite in the first half of the year
allowed Hungary to issue significantly more than planned
at the end of 2010. Indeed, in 2011, gross issuance in
Hungarian bonds was approximately HUF 1.7tn versus
HUF 1.5tn planned. In 2012, DB forecasts a 3.2% deficit
in Hungary from a 1.9% surplus in 2011 which translates
to an increase in net financing need by approximately HUF
360bn. However, we expect gross issuance next year to
increase only by HUF 220bn to HUF 1948bn as
redemptions are set to fall to a low of HUF 738bn. We
assume zero net issuance in the external debt market. We
expect Hungary to look to issue EUR 4-4.5bn in external
debt in 2012, almost unchanged from 2011. This financing
6 December 2011 EM Monthly
Page 78 Deutsche Bank Securities Inc.
is intended to cover repayment to the IMF and
redemptions in the Eurobond market. Such issuance will
clearly be susceptible to the external environment. If the
market is not conducive to such issuance then this could
result in higher domestic issuance to compensate
Demand: We were surprised by the resilience of demand
for HGBs despite three factors: 1/ Worsening outright and
relative performance of Hungarian bonds since August. 2/
Deterioration of the economic prospects in the Eurozone
3/ Investor unfriendly government measures that
culminated in the loss of investment grade status.
A probable explanation is that demand was supported by
benchmarked investors who adopted an overall
underweight position but not a deep underweight
considering the cost of carry.
The government’s cancellation of USD 4.5bln of bonds
held by pension funds was a one off event in 2011.
However, going forward the disappearance of yearly
transfers (amounting to 8 % of GDP) to those funds will
imply either a further increase in non-residents take up or
an increase in banks share. Both instances imply higher
yields at the back-end of the curve.
Foreigners compensated for pension funds forced exit
Source: Deutsche Bank
Poland: Gross issuance increases, but net
issuance falls
Fiscal: We expect the current state budget which targets
sub-3% of GDP fiscal gap to be revised, since the growth
estimate at 4% does not take into account the increased
likelihood of weak economic performance in the
Eurozone. Having said that, the pre-financing already
executed in 2011 (10% of issuance needs) and MinFin’s
ample cash buffer (2.8% of GDP), reduce roll-over risks on
the domestic debt front in 2012. One source of worry is
the current talk of redefinition of the 55% debt/GDP
constitutional limit from Gross to Net, since that may
herald more fiscal drift in the future.
Supply: In the financing outlook for 2012, it is worth
highlighting the increase in redemptions in T-bonds in
2012 from PLN 101bn in 2011 to PLN 123bn in 2012. The
deficit for 2012 is expected to remain approximately the
same at PLN 35bn. Hence, gross issuance in Polish T-
bonds is expected to reach PLN 123bn in 2012 versus
PLN 100.5bn in 2011. Issuance in the external debt
market is estimate by MinFin to remain the same at PLN
24.1bn gross issuance. Overall, the issuance program
plans to increase the proportion of domestic debt
issuance denominated in zloty from 61% in 2011 to 70%
in 2012.
Demand: The reduction in government transfers to
pension funds and rather timid demand for banks which
preferred to allocate their balance sheet to higher margin
loan demand, have left the treasury reliant on external
financing to cover the sharp increase in net issuance. We
are concerned that a deepening of the Eurozone crisis
would cause foreigners to reduce exposure and the bond
curve to steepen further.
Increased reliance on external funding
0%
10%
20%
30%
40%
50%
60%(External + foreign held PLN debt)% of state debt
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 79
… has led to a widening of ASW41
Source: Deutsche Bank
South Africa: Stable issuance plan
Fiscal: According to the Medium Term Budget Policy
Statement (MTBPS) the Treasury sees a narrowing of the
fiscal gap from current 5.5% to 3.3% of GDP by
2014/2015.
Supply: The borrowing requirement was revised higher by
R 9bn, R 20bn and R 27bn over the next 3 years.
However, the bond markets were not rattled by this
development as the announcement was made that cash
balances will be used to finance these additional
shortfalls. Consequently, this means that net issuance in
T-bonds in FY 2012 is set to be approximately R 135bn,
the same as FY 2011. Net issuance in T-bills too is
expected to remain unchanged at R 22bn. Therefore, we
do not expect any immediate change to the weekly fixed-
rate (R 2.1bn every Tuesday), and inflation-linked bonds (R
800mn every Friday) auctions that are held currently.
However, it is likely that if the global markets recover,
issuance at the back-end is stepped up again.
Demand: A striking feature of the market has been the
increase in foreigner holdings compared to pre-2007. It is
clear that this was linked to the huge increase in issuance
over the past two years and the lack of willingness/ability
of the domestic investor base to increase purchases at
the same pace as supply. In the case of the PIC, the
largest domestic pension fund, it seems that preference
lies either with linkers or higher yielding Parastatal debt.
Mutual funds have also lagged in terms of demand due to
the positive performance of equities. The local domestic
base continues to hold an insular view of the market that
states that long-term yields should settle around 8.5-9%
(inflation of 5.5-6% + real yields of 3% + term premium).
41 The columns represent the annual 10-90% range, the dash shows the
annual median and the square is the latest value
This contrasts with the bullish view expressed by foreign
investors who have been more focused on the lack of
global inflationary pressures and the high yield
differentials offered by exposure to South Africa. South
Africa is currently the largest overweight for real money
investors42, which suggests reducing positions at times
where rates rally away from the ‚local bid‛ level and
where risks of outflows from EM local debt are high.
The share of non-resident holders is at the highs
0%
5%
10%
15%
20%
25%
30%
35%
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Share of non-residents in the local bond market
Source: Deutsche Bank
Turkey: Comfortable fiscal position
Fiscal: The primary surplus and overall budget deficit is
projected to be close to 2% of GDP and below 1% of
GDP, respectively in 2011.
Supply: Net issuance in the domestic market in Turkey is
set to significantly increase in 2012 to reach TRY 37.5bn
from TRY 22bn in 2011. This is despite domestic bond
redemption falling to TRY 81.6bn next year from TRY
97.1bn in 2011. In the FX market, the Treasury plans to
issue bonds almost at the same levels as 2011(both gross
and net), hence keeping net issuance in external market at
under TRY 1bn. The increase in net issuance in the
domestic market is being caused by a lower primary
budget balance next year (2%) from 2.5% in 2011
Demand: Foreign investors have increased their
underweight position in Turkey due to the uncertainty
created by the complex monetary policy strategy
conducted by the CBT. In a scenario of a controlled
economic slowdown, that helps rebalancing the economy,
Turkish paper could see a large bid from non-residents.
While the main risks lie in the local banks ability to roll
42 See 'A Closer Look at Real-Money Positioning' also in this
report.
6 December 2011 EM Monthly
Page 80 Deutsche Bank Securities Inc.
over about USD 32 bln in short-term debt, mostly owed to
European banks.
Tight TRY liquidity has cheapened bonds
Source: Deutsche Bank
Russia: Likely to see a surge in foreign
participation
Fiscal: Russia seems in line to post a 0.2%/GDP fiscal
surplus, thanks to higher than expected oil prices. The
overall performance for next year will be extremely
dependent on oil prices, but MinFin predicts an increase
in the non-oil budget deficit to 11%/GDP from 10.2%
Supply: MinFIn tends to be extremely flexible and
opportunistic in conducting its bond issuance plan. We
expect an average of RUB 20 bln/ week supply with an
average maturity of 7Y.
Demand: Preparations for enabling Euroclearability of OFZ
bonds has entered its final stages. We expect this to
increase foreign demand for OFZ paper, particularly that
Russia’s weight in the benchmark index has become
significant. Based on the success of Russia’s first RUB
Eurobond earlier this year, it is possible to envisage that
foreigners could take up 20% of new issuance. To put
things in perspective, their share has consistently
averages below 5% in the past few years.
The domestic debt market is growing rapidly
0
10
20
30
40
50
60
70
y/y % growth in outstanding RUB debt
Source: Deutsche Bank
Israel: Net issuance increases as fiscal backdrop
gets challenging
Fiscal: In 2011, domestic the deficit continued to remain
above the seasonal path and is likely to exceed the
Ministry of Finance's working target of 2.9% by c0.4pp to
reach 3.3% of GDP (that is ILS 28.2bn). DB economics
attribute this to a weakening domestic demand and
possibility of higher spending in light of public protests. In
2012, growth is set to moderate and we expect the deficit
to worsen to 3.5% percent of GDP which translates to
approximately ILS 32bn as the budget deficit. This should
increase net issuance in the Israeli government paper
market from ILS 7.2bn in 2011 to ILS 11bn in 2012.
Supply: Repayment to the market in 2012 is likely to be
ILS 46.7bn, ILS 5.1bn lower than 2011. However, an
increase in the deficit offsets the fall in redemptions and
hence gross issuance in 2012 is projected to be only
marginally lower at ILS 57.6bn. Net issuance consequently
increases from ILS 7.2bn in 2011 to ILS 11bn in 2012, a
52% rise.
Demand: Foreign involvement in bonds has remained low
at 4% of the total market. We see this as a supportive
factor for adding exposure.
Lamine Bougueroua, London, (44) 20 7545 2402
The author of this report would like to thank Raj
Chatterjee, an employee of CIB Centre, a wholly owned
subsidiary of Deutsche Bank, for his contribution to this
piece
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 81
Appendix 1: Historical Monthly DV01 issuance
South Africa Turkey
0.0
0.4
0.8
1.2
1.6
2.0
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
USD mm
-
1.0
2.0
3.0
4.0
5.0
Jan06 Jan07 Jan08 Jan09 Jan10 Jan11
USD mm
Source: Deutsche Bank
Source: Deutsche Bank
Hungary Poland
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
Jan06 Jan07 Jan08 Jan09 Jan10 Jan11
USD mm
0
1
2
3
4
5
Jan06 Jan07 Jan08 Jan09 Jan10 Jan11
USD mm
Source: Deutsche Bank
Source: Deutsche Bank
6 December 2011 EM Monthly
Page 82 Deutsche Bank Securities Inc.
Appendix 2: Expected issuance program
Expected issuance in EMEA (% of projected GDP)
0%
2%
4%
6%
8%
10%
12%
14%
16%
2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F
Gross Issuance % GDP
Net Issuance % GDP
HU PL
ZA TR
IL RU
Source: Deutsche Bank
Expected issuance in EMEA (absolute amounts)
0
20
40
60
80
100
120
2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F 2010 2011 2012F
Gross Issuance (USD bn)
Net Issuance (USD bn)
HU
PL ZA
TR
IL RU
Source: Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 83
Appendix 3: 2012 Local bonds redemption schedule
bonds (local currency bn)
CZ
HU
IL
PL
RU
ZA
TR
Source: Global M arkets Research
0.00.0 0.0 0.014.8
0.0
0.0 0.0393.0
12.30.0 12.2 4.4
13.6 8.9 11.9 5.6 0.5 18.3
4.4 1.3 11.6 11.7 0.0 0.0
0.0 0.0 44.0 181.0
1.30.0
0.0 0.00.0 0.0 26.5
45.0 0.0 0.0 44.0 45.0
25.514.8 0.0 0.0 0.0 26.7
0.0 0.0 0.0
4.1 6.4 0.8
0.0368.6 0.0 0.0
DecJan Feb Mar Apr
0.0 0.0 0.0 0.0 0.045.3 70.3 0.0
0.0
Sep Oct NovJul Aug
0.0
0.5 16.5 7.3
2012 redemptions
May Jun
0.0 0.00.0 0.0
13.9
0.0
0.0 42.1
0.0 8.52.7 2.4 5.1 4.5
6 December 2011 EM Monthly
Page 84 Deutsche Bank Securities Inc.
Argentina B3/B-/B Moodys /S&P/ /Fitch
Economic Outlook: The government seems to be
ready to combine some fiscal consolidation with
tighter FX and price controls, and labor union
persuasion aiming at managing a soft landing to a 5%
growth pace. Nonetheless, inflation stability together
with FX sustainability will demand an even weaker
economy. The sooner the government accepts that
reality, the smoother the expected economic path
ahead. A likely resistance will only accelerate
economic slowdown, and short term inflation.
Main Risks: Further confirmation of current policy
continuity could only preserve an on-going currency
run and a severe capital flight. Lack of investment
amid fiscal expansion, together with unfriendly
policies, could maintain high inflation, reinforcing
fears of potential financial stress. The current pace of
real appreciation is leading to a rapid and sharp
deterioration of external accounts, while strong fiscal
spending is adding stretch to difficult financing.
Strategy Recommendations: Remain neutral in the
currency, but the front-end of the NDF curve offers
attractive carry for those willing to sustain elevated
risk. Continue avoiding the CER curve which offers
unfavorable FX/inflation breakeven. Badlar-linked
bonds are more attractive for those seeking local
peso exposure. Stay neutral on external debt but be
conservative on duration, favor credit to Warrants and
favor global bonds (especially the Global 17s) over
local law bonds. In addition we recommend long
basis on Global 17s vs. 5Y CDS.
Macro view
Time for policy fine tuning
On November 24th, a month after her landsliding re-
election victory, President Cristina Fernandez de Kirchner
(CFK) addressed businessmen at the closing of the
Industrial Chamber´s (UIA) Annual Conference. In this
speech, CFK appeared setting the guidelines for her new
four year mandate that starts on December 10th,
acknowledging the need to improve policies fostering
investment while containing inflation. CFK also stated that
her government does not like extraordinary rents from
business and that growth, not inflation, should be the
target of a proper national policy. Nonetheless, the overall
pro-business tone of the speech was a welcome change
as well as the focus on inflation and investment.
A few days earlier, Economy Minister Amado Boudou and
Planning Minister Julio de Vido announced further
subsidies removal to the once announced at the beginning
of the month. From December 1st, subsidies will be cut
to big companies in the fuel sector, natural gas
production, bio-fuels and agrochemicals industry. Mr.
Boudou noted that, as a consequence, government
spending will be reduced by ARS 3.468mn. Subsidies cuts
will also be extended on January 2012 to high income
homes and, according to authorities, this will represent an
extra ARS1500mn saving. Additionally, Mr. De Vido
announced the creation of a register for those consumers
that voluntarily want to renounce to subsidies on water,
gas and electricity consumption. The cuts announced are
still symbolic for the size of subsidies in place (at best
10%-15% of an estimated total subsidy bill of 4% of
GDP), but the government is at least recognizing that
subsidies cannot longer be extended or increased.
The ‚prudent‛ set of policy initiatives even included a
number of comments asking for moderation in wage
demands. Furthermore, President CFK explicitly rejected
the convenience of a rule based distribution of corporate
profits to the worker force to be discussed in Congress,
as lobbied by labor unions. CFK argued that not all
companies are in the same situation and such a
discussion should be a negotiation between interested
parties without intervention of the Congress. For many
these remarks were a clear warning message to labor
union leaders that seem ready to increase confrontation
with the government, as demonstrated in the recent
conflict in the state owned airline.
On the other extreme, the government further reinforced
constrains on dollar buying by individuals or corporations.
The local newspapers still report that approvals from the
tax authority have remained in the 20%-30% of requests.
In addition, the Central Bank and the government have
been persuading corporation and banks to postpone any
potential demand for dollars, from imports and trade
finance, to transfers abroad in any concept. As a result the
CB has been able to stop the heavy drain of dollars of
previous weeks but creating a new source of capital flight:
dollar deposit withdrawals. As of November 18th the CB
reported the fall of some USD2.2bn of dollar deposits in
the system during the month or 15% of the total held
before the last FX measures were introduced. This flow is
believed to have slowed down in recent days but the
system is still losing an estimated USD200mn a week. All
this notwithstanding, Argentina is projected to have
already experienced USD24bn of foreign asset formation
in the first eleven months of the year, representing more
than 5% of GDP.
The inflation/FX threat
As discussed previously, we believe policy continuity
does face a strong challenge. In the very short term,
capital flight is still the main threat to stability. A simple
solution, in our minds, calls for a faster pace of currency
depreciation and tighter monetary and fiscal policies. The
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 85
faster depreciation rate seems a possibility but the
authorities are revealing strong fear to float, probably
misled by past experiences of currency moves in the
country. More importantly, it is still unclear whether the
government will accept tight policies. Needless to say, the
absence of more conservative policies could only
accelerate capital flight and economic slowdown. In the
end, a weaker economy would allow for a necessary
convergence between inflation and depreciation rate. The
question is whether policy hesitation would push for
inflation acceleration before a recession is generated or
smooth the slowdown process. In the medium term, the
challenge is about sustainable growth. In our view,
without a more-friendly policy set up for private sector
investment, Argentina might grow at a much slower pace
than in the last few years with embedded volatility.
The next few days might reveal some indications about
the government’s true understanding of the problems and
its will to fix them. The very first reaction was not exactly
encouraging, as the authorities simply decided to move to
much tighter capital controls as a way of moderating hard
currency accumulation. This decision does not only reveal
the risk of extreme policy preferences in some key policy
makers; it also made it evident that there is not a single
individual in charge of economic policy. The President
appears to be making the final calls even in technical
matters. We still believe that the confirmation of Minister
Boudou’s leadership in fiscal and monetary policy
decisions would be a positive development. In this regard,
the naming of current Secretary of Finance Lorenzino as
the new Minister of Finance could signal a vote of
confidence for Minister Boudou, who is believed to favor
pragmatism over blind policy continuation. In the last few
days, however, Minister Boudou´s looked more detached
from economic policy initiatives, while new candidates are
emerging, like re-elected Tucuman governor Jose
Alperovich, who could be a less technical choice for the
task but yet a successful entrepreneur.
The very first recognition that subsidies will have to be
revised represents a welcomed leap forward.
Implementation risks are huge and a real improvement
will demand solid conviction to confront clear political
costs. The absence of tighter monetary policy is rather
disappointing though. Private banks have started to offer
higher interest rates to preserve their clients as a stable
source of funding, but the Central Bank is still pushing
short term rates low, in the 10% range, or unacceptably
low to compete with 23% inflation or any consistent
exchange rate expectation.
We hope the government will take advantage of the tighter
controls to let the currency move more in line with inflation
expectations (20% a year or so), which in our view is the
main reason behind the growing demand for the dollars. If
accompanied by the CB validation of short-term rates in a
similar range, we believe this could be enough to eventually
stop the capital flight. More international reserve losses
seem inevitable at this stage, but stability could be regained
over time with clear policy signals.
Alternatively, the CB could keep the currency in the current
path, or at a much slower depreciation rate, while
maintaining all controls or even tightening some of them
further. This could place the authorities in a dead end,
where reserves could be going away from the banks and
the Central Bank, while standard policies could be
becoming increasingly ineffective to re-create credibility in
the short term.
Given all the considerations above, and relatively high
international reserve levels at USD46bn, we foresee a
gradual slide of the peso during the next few months.
Afterwards, the real economy will likely help to close the
gap between expected inflation and currency depreciation,
as a recession will be the likely outcome of increased
control tightening. It is worth recalling, Argentina’s private
and public sectors have very little external debt (USD128bn
gross debt or 30% of GDP, or less than the USD180bn in
external assets held by residents), thus it only takes a small
depreciation or a significant economic slowdown to
rebalance the dollar flows of the country without triggering
major balance sheets or real problems like in the past.
On the positive side, La Nacion newspaper reported last
week feedback from three European countries that are
expecting to see progress on Paris Club debt after the new
Minister of Finance is named. The report suggested that a
deal could include a 4 year payment plan with a large initial
disbursement. An important caveat: officials consulted by
the newspaper noted that the potential benefit in terms of
FDI could be very limited given increasing trade and capital
restrictions in Argentina. As of now, we should be very
cautious on any Paris Club deal mainly because of
increased hard currency scarcity. Argentina can only avoid
the IMF involvement by canceling the debt (even in
installments given some US support). Government officials
argued that FDI flows would largely compensate the initial
disbursement but that seems rather difficult in the current
circumstances. La Nacion is talking about USD6.0bn initial
disbursement which would add to the USD6.0bn dollar
financing gap Argentina will face in 2012, as discussed in
detail below.
The 2012 outlook
In the next few months, we foresee a rapid deceleration
of the economy, in line with expectations that the
government will keep tight controls on the current and the
capital account of the balance of payments for the time
being. Exchange rate flexibility is likely to be gained only
after the economy is weaker and inflationary pressures
are subsiding. Thus, we anticipate a gradual slowdown in
the pace of economic growth towards a less than 3% YoY
range by the last quarter of 2012, from 6%-6.5%
currently. In addition, a weak economy, together with an
6 December 2011 EM Monthly
Page 86 Deutsche Bank Securities Inc.
‚expensive‛ peso, would only make more evident the
worrisome fiscal and external dynamic, forcing reduced
fiscal spending and weaker imports to eventually help
equilibrate those trends. Whether the government can
avoid the temptation to try help the economy with fiscal
expansion is the pending question mark. Fiscal expansion
with tensions in the FX market and inflation could only
exacerbate the problem, just deepening the economic
slowdown. In other words, risks to our 2012 growth
forecasts are biased to the downside.
Thus, under a muddling through scenario, the lower
economic growth will allow inflation not to accelerate
much despite increasing pace of peso depreciation and
tariff increases, but still remaining around 25% YoY.
Similarly, this will permit the trade balance to remain high
enough to avoid a major deterioration in the current
account. Furthermore, helped by different barriers to
import and transfer money abroad, the current account
could end up with a deficit of less than 0.5% of GDP in
2012. In this regard, it is worth looking at recent trade
numbers, where imports growth is decelerating rapidly
(29%-27% YoY in September-October from around 40%
in previous months).
Notwithstanding a relatively small external imbalance
projected for next year, financing it could be a real
challenge, in particular if we continue to see some level of
capital flight. The latter is unavoidable as stricter controls
will simply foster misreporting of trade transactions and
the seeking of any possible loophole to transfer dollars
abroad. We estimate international reserves will fall by
USD7.2bn this year, mostly explained by USD25.6bn
capital formation abroad, and despite increased private
sector net financing for more than USD6.0bn. Based on
current trends, reserve loss could be similar next year if
capital flight were to slow from this year peak to
USD15.0bn average of the last few years. The table below
shows the main drivers of the balance of payment
forecasts for next year.
A full flavor of the potential scarcity of dollars next year is
only completed once public sector financing is added to
the picture. The table below summarizes this financing
task, netting out government holdings and also multilateral
re-financing, both expected to provide a full rollover.
Thanks to Central Bank reserves and advances, the
government basically had more resources than needed in
2010 and this year, fostering the accumulation of reserves
at the treasury. This could not prevent this year that
international reserves at the Central Bank are estimated to
be falling by more than USD7.0bn by the end of this year.
This situation becomes even more critical in 2012, as the
Central Bank will not have excess reserves to allocate for
government debt payments. It is worth noting that excess
reserves are defined as international reserves at the
Central Bank that exceed money base at the current
exchange rate.
Balance of payment forecast (USD mn)
2010 2011 2012
Current account 3,081 3,713 (2,194) % GDP 0.84% 0.85% -0.47%
External debt amortization 47,596 50,874 56,537 Public 5,342 5,277 6,775
Private 42,254 45,597 49,762
Debt new issues 54,920 55,773 56,175
Public 3,234 2,960 3,656
Private 51,686 52,813 52,519
BCRA (2,910) 3,500 1,500
Net FDI 5,372 6,298 7,055
Net portfolio flows (11,410) (25,650) (15,000)
Errors and valuation (2,700) - -
Change in Reserves 4,157 (7,240) (7,000) Source: Economic Ministry, Central Bank, and Deutsche Bank Research
After the election, there are probably no severe political or
institutional obstacles to the government’s continued use
of Central Bank reserves after changing the existing
legislation. Nonetheless, any additional fiscal use of CB
international reserves is going to directly affect the net
international reserve level. In the past, ample trade
surpluses and moderated capital flight have allowed the
CB to compensate reserve losses from fiscal financing
with true trade surplus. In the months to come, the trade
balance is unlikely to be large enough to prevent a further
decline in international reserves. Thus, this evident
weakening of the CB balance sheet could create another
powerful motive for capital flight to continue or even
accelerate unless policy changes are implemented.
Financing constrains might be biding soon (USD mn)
2010 2011 2012
Net amortizations 4,775 4,859 4,758
Net interest payments 2900 3100 3338Warrants (exc. Public holdings) - 1,543 2,106
Total financing needs 7,675 9,502 10,202
Primary surplus (exc. BCRA & ANSES profits) 139 (2,731) (1,606)
%GDP 0.0% -0.6% -0.3%BCRA & ANSES profits 6,256 5,821 4,902
Net financing needs 1,279 6,412 6,906
BCRA reserves 9,500 9,877 -
BCRA advances 2,549 3,464 1,500
Banco Nacion 1,612 2,667 -
Financing gap (12,382) (9,596) 5,406
Source: Economic Ministry, Central Bank, and Deutsche Bank Research
As we noted repeatedly, public sector financing in
Argentina is greatly simplified by high inflation, as it
provides relatively cheap (short term!) financing sources
as long as money demands remain stable. This,
unfortunately, does not solve the dollar financing
conundrum that demands improved policies, and/or a
weaker economy, or a weaker currency in real terms.
Gustavo Cañonero, New York, (1) 212 250 7530
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 87
Investment strategy
FX: Managing a difficult trade-off. The pressure on the
currency continues to increase but the central bank seems
engaged in avoiding any meaningful depreciation. Amid
increasing volatility in global financial markets, the ARS
has weakened approximately 1% per month during the
last 2 months. In our view, the government will find
increasingly difficult to continue with this strategy due to
the combination of worrisome levels of capital flight and
double digit inflation. Additionally, the bleeding of
international reserves has accelerated after the
implementation of the latest FX measures. The freely
available reserves -those in excess of the monetary base
at the current exchange rate- have now disappeared. If the
government insists in using the central bank as financing
source, the pressures in the currency will continue to
mount. Nevertheless, the NFD curve is already pricing a
depreciation of 30% in 12M, which might be excessive.
Due to elevated risks and low liquidity we recommend
avoiding exposure to this curve, but some investors may
find attractive the elevated carry in the front-end (1M
offers 31% implied yield versus 3% depreciation).
Rates: Not longer attractive. With real yields in low
double digits, a compensation for inflation which does not
reflect macroeconomic dynamics, and expected high
depreciation of the currency, CER-linked bonds do not
offer an attractive return for foreign investors. Additionally,
the risks affecting the currency are amplified for the blue-
chip swap. Apart from potential government measures
affecting this transaction, liquidity could dry very rapidly. In
relative terms, we continue to favour Badlar linkers, which
benefit from nominal instability. The recent withdrawal of
deposits made evident that the central bank will find
increasingly difficult to contain nominal interest rates.
Credit: Neutral. The external risk environment in 2012 is
unlikely to be supportive for Argentina, and we remain
doubtful there will be any meaningful policy changes.
What prevent us from being underweight are the
attractive valuation and the risk of squeeze as reaction to a
positive headline. We stay long Boden 12s (hold to
maturity) for carry, and overall are conservative on
duration. In addition, extending duration on the local law
curve (via placing bonds to Anses) will likely one of the
main financing vehicles for the government in 2012 due to
declining reserves, and this will not be supportive to the
long end of the local law curve from a technical
perspective. We favour the Global 17s over the local law
bonds (switching from Boden 15s). We also recommend
buying basis on Global 17s vs. 5Y CDS. Finally, we remain
of the view that GDP Warrants are no more than a
leverage beta pay over credit, and as such, the global
bonds arguably offers superior risk/reward.
Mauro Roca, New York, (1) 212 250 8609
Hongtao Jiang, New York, (1) 212 250 2524
Argentina: Deutsche Bank forecasts
2010 2011E 2012F 2013F
National Income
Nominal GDP (USD bn) 368 439 475 491
Population (m) 40.1 40.5 41.0 41.5
GDP per capita (USD) 9,169 10,936 11,576 11,854
Real GDP (YoY%) 9.2 7.3 3.1 2.9
Priv. consumption 9.0 8.9 2.8 2.7
Gov't consumption 9.4 13.2 7.5 5.0
Gross capital formation 15.5 12.2 4.0 3.6
Exports 14.6 5.4 7.1 6.0
Imports 34.0 19.3 9.7 7.2
Prices, Money and Banking CPI (YoY%) (*) 25.2 23.1 25.4 22.6
Broad money (M2) 28.0 33.0 28.0 22.0
Bank credit (YoY%) 37.8 33.4 28.0 22.0
Fiscal Accounts (% of GDP)
Budget surplus -1.5 -2.3 -2.0 -1.5
Gov't spending 30.0 31.6 31.3 31.1
Gov't revenue 28.4 29.3 29.3 29.6
Primary surplus 0.0 -0.6 -0.3 0.2
External Accounts (USD bn)
Merchandise exports 68.1 85.1 87.8 92.5
Merchandise imports 56.5 75.0 83.8 89.5
Trade balance 11.6 10.1 4.0 3.0
% of GDP 3.2 2.3 0.8 0.6
Current account balance 3.1 3.7 -2.2 -1.7
% of GDP 0.8 0.8 -0.5 -0.3
FDI (net) 5.4 4.3 3.4 2.8
FX reserves (USD bn) 52.2 44.9 37.9 33.4
FX rate (eop) ARS/USD 3.98 4.35 5.21 6.24
Debt Indicators (% of GDP)
Government debt 23.8 21.8 22.3 23.6
Domestic 9.8 9.0 9.2 9.8
External 13.9 12.8 13.0 13.8
Total external debt 35.0 30.9 29.7 29.3
in USD bn 128.6 135.7 141.1 143.8
Short-term (% of total) 35.5 35.9 42.0 42.0
General
Industrial production (YoY)
(nominal) 8.7 4.6 3.1 2.9
Unemployment (%) 7.3 7.1 7.5 7.5
Financial Markets (EOP) Current 3M 6M 12M
Overnight rate 10.3 13.5 17.0 19.5
3-month Baibor 12.8 14.7 18.5 20.5
ARS/USD 4.28 4.51 4.76 5.17 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 88 Deutsche Bank Securities Inc.
Brazil Baa2(pos)/BBB/BBB Moody’s/S&P/Fitch
Economic Outlook: The government has showed
that it intends to use all possible instruments to
prevent a strong economic deceleration by easing
monetary policy aggressively, revoking some ‚macro-
prudential‛ measures, and introducing fiscal
measures to stimulate consumption. Therefore, we
expect the economy to grow slightly above 3% in
2012 despite the bleak global outlook. Although
inflation is poised to decelerate in the next months
due to the recent economic slowdown and lower
commodity prices, it will likely remain above 5% due
to high inertia and aggressive monetary easing.
Main Risks: The government’s initiative to
aggressively ease monetary policy to prevent a
significant economic slowdown could damage its
credibility and lead to permanently higher inflation,
especially if not accompanied by the promised fiscal
austerity. The large increase in the minimum wage
and mounting pressure on the government to
increase investment in infrastructure do not bode well
for fiscal restraint in 2012. The BRL remains
vulnerable to lower commodity prices.
Strategy Recommendations: Take profits on long
1M USD/BRL FVA and enter zero-cost 1M USD/BRL
put spread Take profits on Jul ’12- Jan ’17 steepener
and enter Jan ’13- Jan15’ flattener. Stay neutral on
external debt and continue to favor 41s and 40s (to
call) vs. 21s. In addition, we favor short basis at the
10Y sector as a tactical trade.
Macro view
We expect the Brazilian economy to grow 3.0% in
2011 and 3.3% in 2012. The economy decelerated
significantly in 3Q11, reflecting tighter fiscal and monetary
policies, as well as contagion from Europe’s never-ending
debt crisis. The slowdown was particularly strong in the
manufacturing sector, as industrial production dropped a
seasonally-adjusted 0.8% QoQ in 3Q11 even after falling
0.6% QoQ in 2Q11. The sector has also been hurt by an
increase in competition from imported goods (mainly due
to the strong BRL), and its malaise is attested by the
steady decline in business confidence (the FGV index of
business confidence dropped 12% between December
2010 and November 2011) and capacity utilization (which
reached 83.3% in November, the lowest level in two
years). Due to weak industrial production, we estimate
that GDP dropped a seasonally-adjusted 0.2% in 3Q11.
We expect a mild recovery in 4Q11 (+0.3% QoQ) due to
the incipient effect of the monetary easing and the recent
measures to stimulate consumption, but are keeping our
2011 GDP growth forecast unchanged at 3.0%. In 2012,
the economy will face a challenging international
environment with a recession in Europe and tighter global
credit conditions. Thus, although we believe that
additional monetary and fiscal easing and the unwinding
of the ‚macro-prudential‛ restrictions on credit will help to
keep consumption afloat, we expect investment to
decelerate further. The recent drop in domestic
production and imports of capital goods already reflects a
slowdown in investment. Another problem is that,
according to our calculations, the GDP growth carryover in
2012 will be only 0.3%, compared to 1.1% in 2011. In
other words, if GDP remains unchanged at 4Q11 levels
during the whole year, it will grow only 0.3% in 2012.
Therefore, we expect the economy to grow 3.3% in 2012,
which would be much less that the government’s target
of 5.0%, but not a bad result considering the uncertain
global scenario.
Brazil: Capacity utilization and business confidence
76
78
80
82
84
86
88
70
80
90
100
110
120
Business confidence
Capacity utilization (RHS)
%
Source: FGV
Although the labor market remains tight, job creation
has decelerated, and we expect a gradual increase in
unemployment. Brazil’s unemployment rate fell to 5.8%
in October from 6.0% in September, dropping below our
6.0% forecast. On a seasonally-adjusted basis, according
to our calculations, the unemployment rate dropped back
to 5.9% (the all-time low) from 6.1%. Nevertheless, the
drop in unemployment was mainly caused by a 0.1%
MoM drop in the labor force, as new jobs rose only 0.1%
MoM. Job creation rose 1.5% YoY, the lowest year-on-
year rate since December 2009. Furthermore, average real
earnings remained unchanged in October even after
dropping a hefty 1.8% MoM in September. Consequently,
real earnings fell 0.3% YoY, the first drop since January
2010. While the deceleration in real earnings reflects the
slowdown in job creation, it can also be explained by high
inflation, and the latest wage negotiations suggest that
wages could recover some ground in the following
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 89
months. However, we believe this scenario is consistent
with a very gradual increase in unemployment, which we
expect to rise to 6.4% in 2012 from 6.1% in 2011. The
persistence of a relatively low rate of unemployment will
likely provide important support for domestic
consumption.
Brazil: Job creation and labor force growth
-1%
0%
1%
2%
3%
4%
5%
6%
7%
Labor force
Jobs
YoY
Source: IBGE
Brazil: Credit delinquency
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
Consumers
Corporates
Source: BCB
Credit growth has decelerated, prompting the
government to revoke some of the ‚macro-
prudential‛ measures. Total bank loans grew 0.8% MoM
in October, the slowest MoM increase since January
2011. Although October’s poor performance was probably
influenced by the strike of bank employees, credit
origination has decelerated significantly this year,
especially in the area of consumer financing. Consumer
credit origination rose a hefty 6.4% MoM in October, but
the increase was led by expensive facilities such as
overdraft loans and credit cards, mainly due to the bank
strike that reduced the supply of other consumer loans,
according to the Central Bank. However, the increase in
expensive revolving credit lines might also reflect an
increase in non-performing loans, which climbed to 7.1%
in October, the highest since February 2010. Since
unemployment is one of the main determinants of credit
delinquency and we expect it to rise gradually, we believe
that NPLs have not peaked yet (although the fast decline
in interest rates tends to mitigate this effect). Fearing the
effect of the slowdown in credit growth on consumption,
the government revoked some of the macro-prudential
measures enacted last year, reducing the capital
requirements on payroll debit-loans, car loans, and
personal loans of up to 36 months, scrapping the
minimum 20% credit card balance payment obligation
that was scheduled to become effective in December,
and cutting the IOF tax on consumer loans to 2.5% from
3.0%. Moreover, the government reduced taxes on
domestic appliances and low-income housing, and
eliminated the 2% IOF tax on foreign portfolio investment
in equities to stimulate the stock market.
Brazil: IPCA weight revision
Old IPCA New IPCA
Food at home 15.0% 15.0%
Tradables (ex-food) 20.4% 25.2%
Services 24.8% 22.3%
Other non-tradables 10.8% 10.4%
Administered prices 29.0% 27.1%
Source: IBGE, DB Global Markets Research
We still see inflation above 5% next year despite the
changes in the IPCA methodology. The IPCA consumer
price index rose 7.0% YoY in October, confirming that 12-
month inflation peaked at 7.3% in September, as we had
expected. Although 12-month inflation remains
significantly above the target of 4.5% and even above the
6.5% ceiling of the inflation target’s tolerance band, we
expect it to decline further in the coming months due to
the base effect, the economic slowdown and a drop in
commodity prices. We expect the IPCA to climb 6.4% this
year, just slightly below the top of the band. For 2012, we
have lowered our IPCA forecast slightly to 5.3% from
5.5% due to the changes in the index weighting structure
that will take place in February 2012. This week, the
official statistics agency IBGE announced a revision to the
IPCA methodology that will essentially reduce the weight
of services to approximately 22% from 25%, (mainly due
to a surprisingly large drop in the weight of school fees,
and despite a relatively small increase in the weight of
housing rentals), and raise the weight of tradable goods
(excluding food) roughly to 25% from 20% (led by a
significant increase in the relative importance of
automobiles). The change could be relevant because
service prices have been rising well above the headline
inflation (9.0% YoY in October), reflecting the strength of
domestic demand and the tight labor market. Thus,
although we remain concerned about the potential
inflationary effect of the hefty 13.6% minimum wage
increase programmed for January 2012, we estimate that
the new weighting structure will shave off approximately
20bps from our IPCA forecast. On the other hand, we
6 December 2011 EM Monthly
Page 90 Deutsche Bank Securities Inc.
note that the increase in the weight of tradable goods in
the index might somewhat raise the exchange rate pass-
through to inflation.
We still do not see inflation returning to 4.5% next
year, but continue to expect more rate cuts ahead.
Europe’s sovereign debt crisis and the change in the IPCA
methodology have contributed to stabilize inflation
expectations, offsetting the negative effect of the
surprising 50bp interest rate cut in August. The Central
Bank repeated the dosage in October and November,
reducing the SELIC rate to 11.0%. The authorities also
indicated that they plan to maintain the same pace of rate
cuts for now, claiming that ‚a moderate adjustment in
rates is consistent with convergence of inflation to the
target.‛ We continue to forecast that three additional
50bp rate cuts will lower the SELIC rate to 9.5% by April
2012, although we believe the risk is tilted to the
downside, considering our revisions to GDP growth and
inflation forecasts. Moreover, given the increasingly
tighter liquidity conditions produced by Europe’s crisis,
we would not be surprised if the Central Bank reduces
reserve requirements on bank deposits. This week, the
government relaxed the rules for banks to sell their loan
portfolios, so as to help small and mid-sized banks. That
said, we believe interest rates will drop below their
equilibrium level and will eventually rise again after the
global economy recovers. We expect the Central Bank to
initiate a new tightening cycle in 2Q13, raising the SELIC
rate back to 11.0% by the end of 2013.
We expect the government to meet its full primary
fiscal surplus target of 3.15% of GDP in 2011, but
project a smaller surplus for 2012. As tax collection has
risen more than expected this year (mainly due to high
inflation and a tax amnesty program), the government
raised this year’s primary fiscal surplus target by 0.25% of
GDP (BRL10bn) to 3.15% of GDP. The Finance Minister
also pledged to meet next year’s primary surplus target of
3.1% of GDP without resorting to accounting adjustments
(i.e., without deducting PAC investments from the primary
balance). Nevertheless, we project a primary surplus of
2.7% of GDP for 2012. Barring the introduction of a new
tax, government revenues could decelerate more than
expected due to slower GDP growth (the budget
assumed real GDP growth of 5.0% for 2012). Moreover, it
is not clear whether the government will be able to keep a
lid on public spending. This year’s moderation has been
achieved mainly by compressing public investment, which
is probably not sustainable in the medium term due to the
growing demand for infrastructure investment and
projects related to the 2014 World Cup and 2016 Olympic
Games. Furthermore, the generous 13.6% minimum
wage increase scheduled for 2012, the ‚Brasil Maior‛
stimulus program, and the ‚Amendment 29‛ (which aims
to increase mandatory spending on healthcare) could all
cost approximately BRL60bn (1.4% of GDP) next year,
while the latest tax cuts announced to stimulate
consumption could cost as much as BRL8bn. That said,
we cannot discard the possibility of another positive
surprise in fiscal performance next year, which could
make it easier for the Central Bank to ease monetary
policy without fueling inflation.
While risk of currency depreciation remains high due
to global environment, we continue to assume a
relatively benign scenario for the currency. We have
kept year-end BRL forecast at BRL1.80/USD for 2011 but
raised it to BRL1.80/USD from BRL1.75/USD for 2012 due
to the potential negative effects of the European crisis on
global growth, commodity prices, and credit supply. The
good news is that the BRL continues to benefit from a
slow increase in the current account deficit and huge
volume of foreign direct investment (FDI). This year’s
trade surplus has been surprisingly strong and will likely
reach USD29bn, mainly due to high commodity prices.
Although exports will probably suffer as commodity prices
decline, we expect imports to decelerate as well due to
softer domestic demand. We still forecast a sizeable trade
surplus of USD20bn for 2012, and therefore project a
modest increase in the current account deficit, from an
estimated USD53bn (2.2% of GDP) in 2011 to USD64bn
(USD2.6% of GDP) in 2012. In the financial account, the
main highlight has been the massive inflow of foreign
direct investment, which we estimate will reach USD64bn
in 2011. We expect FDI to drop to USD52bn in 2012 due
to the bleak global outlook, and believe the risk is tilted to
the downside given that approximately 60% of the FDI
this year originated from Europe. Critical risks to the BRL
lie in the external credit crunch and in the existing large
stock of foreign portfolio investment, especially the
USD129bn in local bonds (as reported by the Central Bank
for October), which include a large amount owned by
Japanese retail investors. Nevertheless, the Central Bank
has a strong incentive to intervene in the FX market to
avoid excessive BRL weakness. Since the authorities’
main priority is to cut interest rates, a strong depreciation
of the BRL could become a problem because of its
potential inflationary effect. This view is reinforced by the
Central Bank’s intervention in September, by offering FX
swaps when the currency traded above BRL1.90/USD,
and by the recent decision to scrap the 2% IOF tax on
foreign portfolio investments in the stock market. Since
the Central Bank currently owns approximately USD350bn
in international reserves (compared with USD207bn in
September 2008), the authorities have plenty of
ammunition to intervene in the spot market as well. In the
worst-case scenario, the government might even revoke
the 1% IOF tax on FX derivatives.
José Carlos de Faria, São Paulo, (5511) 2113-5185
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 91
Investment strategy
FX: Position for short-term retracement. The BRL –as
other liquid EM currencies- has suffered from increased
volatility on the back of developments in core markets.
This has favored our long 1M FVA position, which has
reached its target. The better tone in risk sentiment after
the coordinated action by main central banks, and the
potential intervention of the Central Bank of Brazil (BCB) in
the FX market, could help BRL to recover. However,
behind the short-term overshooting, the currency is still
overvalued from a more fundamental perspective.
Additionally, carry is expected to decrease further as the
central bank continues easing monetary conditions
aggressively with a focus on economic activity. Moreover,
both the trade balance and current account are expected
to deteriorate amid a reduction in FDI flows. As a
consequence, we recommend positioning for potential
short-term retracement with zero-cost 1x2 USD/BRL put
spreads, but maintaining a neutral stance at longer
horizons.
Rates: Stretched valuation in short-term receivers. The
market is widely expecting that BCB will continue
reducing rates aggressively during 1Q12 (150bp to 9.5%).
With domestic and external activities trending lower, the
risks to this scenario are still biased to the downside due
to BCB’s increasing focus on growth. Nevertheless, the
risk/reward of short-term receivers is not longer attractive
with this stretched valuation. As a consequence we
recommend taking profits on our July ’12-Jan ’17 DI
steepener recommendation and position for a setback in
short-term rates with a Jan ’13- Jan’15 DI flattener (entry:
65bp, target: 40bp, stop: 80bp).
Credit: Stay neutral. We believe 2012 will likely be
another year of outperformance of high quality, low beta
credits such as Brazil, but we prefer Colombia and Peru.
Though fiscal performance appears to be on track in 2011,
we project it to underperform budget in 2012. Though not
our baseline, risk remains that the aggressive monetary
easing could damage Central Bank’s credibility and lead to
permanently higher inflation, especially if the promised
fiscal austerity does not materialize. Technical condition
looks supportive given Brazil’s $5.5bln principal and
interest repayment in 2012 (vs. our issuance projection of
<=3.0bln), especially if Brazil’s Treasury returns to the
market and resume buying its legacy bonds. In terms of
positioning in the global curve, we believe 10s30s looks
excessively steep (among LatAm low betas) while 5s10s
still looks too flat; we continue to favor the barbell
strategy of 41s and 40s to call vs. 21s. In addition, we
believe 10Y basis (vs. 21s) should continue to tighten,
especially if the recent positive market tone continues.
Mauro Roca, New York, (212) 250-8609
Hongtao Jiang, New York, (212) 250-2524
Brazil: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USDbn) 1,626 2,090 2,388 2,425
Population (m) 191 193 195 197
GDP per capita (USD) 8,490 10,814 12,240 12,319
Real GDP (YoY%) -0.3 7.5 3.0 3.3
Private consumption 4.1 7.0 4.7 4.2
Government consumption 3.7 3.3 2.1 2.8
Gross capital formation -6.7 22.0 5.5 2.6
Exports -6.7 22.0 5.5 2.6
Imports -10.3 11.5 4.0 3.0
Prices, Money and Banking
CPI (YoY%) 4.3 5.9 6.4 5.3
Money base (YoY%) 4.6 19.5 10.0 10.0
Broad money (YoY%) 7.0 17.0 8.0 10.0
Fiscal Accounts (% of GDP)
Consolidated budget balance -3.3 -2.5 -2.1 -1.6
Interest payments -5.3 -5.3 -5.2 -4.3
Primary balance 2.0 2.8 3.2 2.7
External Accounts (USDbn)
Merchandise exports 153.0 201.9 253.0 272.0
Merchandise imports 127.6 181.7 224.0 252.0
Trade balance 25.3 20.2 29.0 20.0
% of GDP 1.6 1.0 1.2 0.8
Current account balance -24.3 -47.6 -53.0 -64.0
% of GDP -1.5 -2.3 -2.2 -2.6
FDI 25.9 48.5 64.0 52.0
FX reserves (USDbn) 239.1 288.6 350.6 360.6
FX rate (eop) BRL/USD 1.74 1.67 1.80 1.80
Debt Indicators (% of GDP)
Government debt (gross) -9.0 -9.8 -12.4 -11.9
Domestic 62.0 54.8 56.6 54.6
External 58.5 51.8 52.8 50.9
Total external debt 17.1 16.8 17.1 17.8
in USDbn 277.6 350.4 407.4 432.4
Short-term (% of total) 11.2 16.4 12.0 12.0
General (YoY%)
Industrial production (YoY%) -7.4 10.5 0.5 2.0
Unemployment (%) 8.1 6.7 6.1 6.4
Financial Markets (EOP) Current 3M 6M 12M
Selic overnight rate 11.00 10.00 9.50 9.50
3-month rate (%) 10.6 9.8 9.4 9.6
BRL/USD 1.80 1.80 1.80 1.80
6 December 2011 EM Monthly
Page 92 Deutsche Bank Securities Inc.
Chile Aa3/A+/A+ Moodys/S&P/Fitch
Economic Outlook: The economy continues to
decelerate along an unbalanced path, with domestic
demand still growing at a higher pace than supply.
Nevertheless, albeit some surprises, domestic
inflationary pressures are still subdued. A weakening
CLP and tight labor markets have so far had little
impact on inflation. The Central Bank of Chile (BCCh)
is increasingly considering easing monetary
conditions to counteract negative effects from the
external scenario.
Main Risks: Domestic demand could adjust faster
than expected due to uncertainty in external
conditions. A slowdown in global growth and a
potential deceleration in China could affect copper
prices. There could be some form of contagion from
a credit event in Europe due to the links between
local and Spanish banks.
Strategy Recommendations: Maintain short
EUR/CLP. Shift from 2Y to 5Y breakeven inflation and
enter 2s5s CLP/CAM steepener. Underweight
sovereign credit, and buy 5Y CDS vs. Brazil as a
defensive trade.
Macro view
Latest figures confirm the declining trend in activity…
Recently, the Central Bank of Chile published the quarterly
report of the national accounts. It showed that GDP
increased by 4.8% YoY (0.6% s.a. QoQ) during 3Q11,
considerably below the 9.9% and 6.6% observed during
the first two quarters of the year (which were
nevertheless favored by a low comparative base). As in
the previous quarters, domestic demand continued to
show important dynamism. It increased 9.4% YoY on the
back of growth in investment in machinery and equipment
(31.5%), construction (9.8%), and private consumption
(7.5%). All sectors exhibited positive performance, with
the exception of the crucial mining sector, which
decreased by 6.5% due to a reduction of ore grades,
strikes and the impact of adverse climate conditions. In
contrast, fishing was the sector showing the highest
dynamism, increasing 59.4% YoY due to the control of the
virus ISA that affected the production of salmon and
created a low comparative base effect.
Preliminary figures for the last quarter seem to confirm
this trend. The Institute of National Statistics (INE)
reported that, in October, industrial production and sales
declined by 0.8% YoY (-3.2% MoM sa) and 0.6% YoY (2.2
MoM sa) respectively, markedly below consensus
expectations of 4.1% and 2%. This differs from previous
months, during which the mining sector was the main
culprit of disappointing figures, the slowdown was now
noticeable in several sectors. The sectors with the biggest
contraction were oil refining, clothing and wood products,
which jointly contributed with -1.3pp to the index. In
contrast, mining increased by 2.9% YoY mainly driven by
higher production of copper (from 462k to 467k metric
tons) and, to a lesser extent, of gold and molybdenum.
Domestic demand growth also suffered some
deceleration, with retail sales increasing by 8.6% YoY, in
line with expectations but below the 9.6% observed in the
previous month. Consequently, the supply-demand
growth imbalance continues to widen.
Regarding the external sector, the current account
showed a deficit of USD2.9bn (4.9% of GDP) during
3Q11, in contrast with the balanced level of 3Q10. This
decline was more than compensated by important capital
inflows of USD4.5bn. During October, there was a
positive contribution from the trade balance, which
increased to USD837mn The accumulated surplus has
reached USD10.8bn during 10M11, representing a
decrease of 7.31% YoY. The recovery in the trade balance
was the result of a much larger decline in imports
(10.75% MoM) than in exports (2.46% MoM). The
relatively good performance of exports was in part
explained by a recovery in copper exports, which
increased 6.86% MoM, or 24.35% YoY, to USD3.5bn.
…but the labor market remains tight…
Regardless of declining activity, the unemployment rate
for the August-October moving quarter decreased to
7.2% from 7.4% in the previous measuring period.
Following the trend observed during the year, the decline
in the unemployment rate was explained by a larger
increase in employment (3.5% YoY) than in the labor force
(3.1% YoY).
…and inflation surprised to the upside
The latest inflation data available showed a surprising
increase in prices during October (0.5% MoM), which
drove the index to 3.7% YoY. Nevertheless, as the spike
could be partially attributed to a one off effect in some
items (meat), the inflation outlook is still relatively benign.
Seasonal factors should help to decrease headline
inflation during the last part of the year. In fact, the
surprise in inflation had a muted effect on inflation
expectations. According to the latest BCCh survey, the
median monthly inflation forecast remained at 0.1% for
the month of November while expectations for annual
inflation continued to be anchored at the 3% inflation
target from 12 months onwards.
BCCh still has room to wait
At the latest monetary policy meeting, the BCCh decided
to maintain the policy interest rate (TPM) unchanged at
5.25% for a fifth consecutive month. The minutes of that
meeting showed that it also evaluated a 25bp reduction.
The monetary authority believed that the easing of
monetary conditions would have been a preventative
move against an increasingly adverse external
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 93
environment. However it acknowledged that such a
decision could have led the market to believe that it was
more concerned about the external outlook. Moreover,
the Board agreed that there was considerable uncertainty
regarding the potential effects of the worsening external
environment in the domestic economy. In contrast, the
Board considered that the alternative of keeping the
interest rate unchanged, but conveying a dovish tone,
would give more time to evaluate those effects. It was
agreed that the risk of this alternative was to fall behind
the cycle due to the lagged effects of monetary policy.
However this risk was tempered by the elevated
dynamism of domestic demand, a closed output gap and
tighter labor market conditions. Additionally, the Board
considered that a more aggressive policy could later
compensate for a delayed implementation. Finally, the
Board hinted to an increasing probability of an imminent
cut during the next months, probably after the revised
monetary policy views have been published in the next
inflation report (IPOM).
Mauro Roca, New York, (212) 250-8609
Investment strategy
FX: At the tone of global growth. During next year, the
CLP will continue to be affected by the continuous
revisions of expectations regarding global growth and
copper prices. A soft landing of China and the finalization
of the rule-based intervention could benefit the CLP and
counteract the potential setback from reduction in carry
due to monetary easing. The main short-term risks are
related to the direct and indirect effects of a potential
escalation in the European crisis. We recommend
maintaining a short EUR/CLP position (entry: 690, target:
660, stop: 685)
Rates: Position for further steepening. As the economy
continues to decelerate, the BCCh seems closer to ease
monetary conditions. While enough easing is already
priced in the short-end of the local curve (150bp during
9M11) we think the cuts will be more frontloaded.
Additionally, they could help to build up additional risk and
inflation premium in the belly of the curve. We therefore
recommend shifting the 2Y breakeven inflation position to
the 5Y sector (entry: 2.8%, target: 3.1, tighten stop: 2.6%)
and entering a 2s5s CLP/CAM steepener.
Credit markets: Underweight. Despite its solid
fundamentals, the tight credit spread, financial risk (albeit
moderate) as shown in our vulnerability indicators, and the
likely lack of support from the USTs in 2012 mean risk is
biased towards lower returns. In addition, real money
investors have been significantly overweight Chile,
creating a non-supportive technical condition. We look to
buy CDS as a defensive trade at good levels, and
recommend buying Chile CDS vs. Brazil as a defensive
trade with asymmetric payoff (more limited loss under a
bullish scenario vs. the large gain under a bearish
scenario).
Mauro Roca, New York, (212) 250-8609
Hongtao Jiang, New York, (212) 250 2524
Chile: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National income
Nominal GDP (USDbn) 204.0 224.1 230.4 242.3
Population (m) 16.9 17.1 17.3 17.5
GDP per capita (USD) 12,040 13,098 13,334 13,882
Real GDP (YoY%) 5.2 6.0 4.2 3.9
Priv. consumption 10.4 7.8 6.1 5.8
Gov't consumption 3.3 6.2 5.6 5.5
Investment 18.8 13.8 8.2 7.4
Exports 1.9 6.5 4.3 4.8
Imports 29.5 9.2 5.8 5.5
Prices, money and banking
CPI (Dec YoY%) 3.0 3.7
2.9 3.2
Broad money 10.9 12.6 11.2 11.8
Credit 25.3 13.5 12.8 12.5
Fiscal accounts (% of GDP)
Consolidated budget balance -0.3 0.8 0.2 -0.5
Government spending 22.7 21.9 21.2 21.6
Government revenues 22.4 22.7 21.4 21.1
External Accounts (USDbn)
Exports 71.0 81.5 82.0 83.0
Imports 55.2 71.0 72.0 74.0
Trade balance 15.9 10.5 10.0 9.0
% of GDP 7.8 4.7 4.3 3.7
Current account balance 3.8 -2.4 -3.9 -4.6
% of GDP 1.9 -1.1 -1.7 -1.9
FDI 6.4 11.4 13.5 15.0
FX reserves 27.9 40.0 41.0 42.0
FX rate (eop) USD/CLP 468 505 510 525
Debt indicators (% of GDP)
Government debt 9.1 7.4 6.9 6.5
Domestic 6.9 5.6 5.2 5.0
External 2.2 1.8 1.7 1.5
Total external debt 42.5 43.1 40.3 39.5
in USDbn 86.7 94.0 95.0 96.0
Short-term (% of total) 22.4 22.1 22.0 21.0
General
Industrial production (YoY%) 3.8 4.1 3.2 3.0
Unemployment (%) 7.1 7.0 7.2 7.6
Financial markets (end)
period)
Current 3M 6M 12M
Overnight rate (%) 5.25 4.75 4.25 4.25
6-month rate (%) 4.56 4.17 4.01 4.11
USD/CLP 515 500 490 510 Source: Deutsche Bank Global Markets Research, National Source
6 December 2011 EM Monthly
Page 94 Deutsche Bank Securities Inc.
Colombia Baa3 (stable)/BBB- (stable)/BBB- (stable) Moodys/S&P/Fitch
Economic outlook: Economic activity keeps growing
robustly, while inflation has risen temporarily, fueled
by food prices. BanRep has begun to hike the policy
rate again, and will continue to do so in 2012. The
fiscal accounts are improving on the back of tax
collection outperformance.
Main risks: Higher inflation because of stronger
commodity prices and/or domestic demand
pressures. Overheating and bubbles prompted by a
credit boom. A relapse in the US economy,
destination of more than one third of the country’s
exports.
Strategy recommendations: Remain on the
sidelines waiting for better entry levels to get
exposure to COP. Close 2s3s COP/IBR steepener and
receive 5Y COP/IBR (or TES Jun ’16) against 5Y USD
swap. Stay overweight external debt and favor
shorter-end of the curve, where we favor off-the-run
19s and 20s over the benchmark 21s.
Macro view
BanRep hikes reference rate
On November 25, Banco de la Republica raised its target
interest rate by 25bp to 4.75%. The decision was not a
complete surprise, as market forecasts were fairly evenly
divided between no hikes and a 25bp increase. The press
release that accompanied the decision highlighted that the
policies implemented in Europe to deal with the debt
crisis have yet to yield results, and that the emerging
market consensus is that the US will grow at a moderate
pace for a protracted period. Commodity prices, however,
remain high and continue to benefit producers in the EM
world. The Bank also acknowledged that in Colombia,
domestic demand continues to expand at a very robust
pace, so that the optimistic growth prospects presented
earlier this year continues to be valid. That is, the Bank
expects the economy to grow by about 5.5% in 2011.
Bank credit keeps growing at a very fast pace, especially
consumer credit which is expanding at roughly three
times the pace of nominal GDP, while housing prices are
at historically high levels. BanRep admitted that inflation
during the past two months exceeded its expectations,
leading to an upward revision in short term projections.
For next year, however, the Bank remains confident that
the temporary shocks to inflation will recede and that the
annual rate will converge towards the target range. It
pointed out, however, that stronger than expected
domestic demand pressures represent an inflationary risk
for the coming months. On the growth front, the risks are
mainly external, i.e. represented by a disorderly
adjustment in Europe.
Colombia: COP and policy interest rates
1500
1700
1900
2100
2300
2500
2700
2
3
4
5
6
7
8
9
10
11
Repo rate (% pa) COP spot (rhs)
Source: Banco de la República, Deutsche Bank
The tone of the communiqué was measured, suggesting
that BanRep may hike the reference rate some more
although proceeding in a rather gradual fashion. We
indeed expect the Central Bank to proceed with caution in
the coming months, hiking the target rate by some 50bp
to 75bp more during 2012, possibly pausing in between
rate movements. Over time, we believe the Central Bank
will adjust its monetary policy stance to reach short term
real interest rate levels nearing 200bp. In the press
conference that followed the announcement, BanRep’s
authorities hinted that the hike ‚was enough for now‛.
Inflation on a temporary high
Increases in consumer prices accelerated in September
and October, coming out above expectations and
resulting in annual inflation that is now a shade above the
ceiling of the target band. BanRep has indicated that this
is a temporary phenomenon, associated with seasonal
increases in food prices, and that it remains confident that
in 2012 inflation will converge towards the 3% medium
term target again. Food and beverages are the fastest
rising items of the index, having increased by 6.6% yoy
through October, on the back of weak supply because of
heavy rains in agricultural areas. Meanwhile, core prices
continue to behave well, remaining at or below the
medium term target. We expect annual inflation to end
the current year just below the ceiling of the band, and to
drop further in 2012, although we see the convergence
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 95
towards 3% as a significant challenge. This is so because
Colombia will be among the fastest growing economies in
the region next year too, with a robust performance of
domestic demand, and with credit expanding fast. In
addition, concerns about financial developments in
industrialized countries have increased risk aversion,
prompting currency weakness, which if maintained over
time could contaminate domestic prices.
Colombia: Inflation rates (% yoy)
-2
0
2
4
6
8
10
12
14
16
CPI CPI food
Source: DANE, Deutsche Bank
Lowest unemployment rate in a decade
The official statistics office DANE reported that the urban
jobless rate (for the country’s 13 largest cities) came out
at 10.2% in October, the same level as in the previous
month and above market expectations of 9.9% as per
Bloomberg’s poll. The nationwide unemployment,
however, was 9.0%, significantly below the 9.7%
registered in September and the lowest since 2001. The
figure represents not only good economic news but also
another political for President Juan Manuel Santos, who
had set the goal of driving unemployment to the single
digit range during his administration. Santos indeed
celebrated the release and pointed out that this record is a
great accomplishment ‚considering the unfavorable
external scenario where economies like United States,
Europe and Asia have seen their unemployment rates
increasing‛. According to DANE, Colombia has 2.13m
unemployed workers, a reduction of 129,000 people
relative to a year ago, while the occupied population is
now at 21.5m. So far this year, the unemployment rate
has dropped even though the participation rate has
increased, which means that job creation is outstripping
labor supply. We expect the open unemployment rate to
continue dropping in 2012, with the nationwide figure
reaching 9%.
Colombia: GDP and unemployment
9
10
11
12
13
14
15
0
1
2
3
4
5
6
7
8
9
Jan
-07
May-0
7
Se
p-0
7
Jan
-08
May-0
8
Se
p-0
8
Jan
-09
May-0
9
Se
p-0
9
Jan
-10
May-1
0
Se
p-1
0
Jan
-11
May-1
1
Se
p-1
1
GDP Unemployment Source: DANE, Deutsche Bank
IP and retail sales below expectations
The official statistics office DANE reported that industrial
production rose by 5.2% yoy in September, below
expectations of a 5.9% increase according to
Bloomberg’s poll. Industrial sales expanded by 5.9%,
while employment in the industrial sector increased by
1.6%. During the first nine months of the year, industrial
output grew by 4.9% yoy. DANE also reported that retail
sales rose by 8.1% yoy in September, below expectations
of an 11.3 increase, and the lowest print since April 2010.
Despite these softer than expected figures, we project
that the Colombian economy will grow by more than 5%
this year, while inflation is temporarily above the ceiling of
the target band.
Colombia: IP and retail activity (% yoy)
-15
-10
-5
0
5
10
15
20
25
Jan
-08
Ap
r-0
8
Ju
l-0
8
Oct-
08
Jan
-09
Ap
r-0
9
Ju
l-0
9
Oct-
09
Jan
-10
Ap
r-1
0
Ju
l-1
0
Oct-
10
Jan
-11
Ap
r-1
1
Ju
l-1
1
Sales IP Source: DANE, Deutsche Bank
Trade balance in September
The official statistics unit DANE reported a trade deficit of
USD337m in September, below consensus expectations
of a USD90m deficit as per Bloomberg’s poll. The
accumulated surplus year-to-date reached USD3236m,
which represents a 131% increase vis-à-vis the same
period from previous year. During the month, total
6 December 2011 EM Monthly
Page 96 Deutsche Bank Securities Inc.
imports increased by 29% yoy. Regarding exports,
traditional products rose by an impressive 56.3% yoy, on
the back of strong sales of oil and oil derivatives, while
those of non-traditional products rose by 6.3% yoy. As a
result, total exports increased by 36.2% yoy. We expect
the trade surplus to shrink by year-end, as demand for
imports is typically strong during the latter part of the
year, and to contract further in 2012, as imports are
propped up by strong economic activity. Trade dynamics
will be impacted by the recently approved FTA with the
US, expected to become fully operational by 2013. In the
meantime, the US Congress approved the renewal of the
special trade preferences known as APTDEA retroactively
to February 2011 when they had expired, and until 2013
when they will probably be rendered unnecessary by the
enactment of the FTA. By virtue of the agreement, more
than 5,000 items of the tariff code that are currently levied
at 5% or above will face gradually decreasing tariffs,
converging to zero within the next two decades.
The current account balance, on the other hand, is
expected to continue showing a relatively large deficit
because of the unfavorable services balance. We project it
to be near 3% of GDP this year and next. As it has been
the case in recent years, FDI flows are expected to be
larger than the current account deficit over the forecast
period, thus suggesting no urgency whatsoever on the
external financing side. In addition, we are also of the idea
that Colombia would be in an optimal position within
LatAm to gain access to multilateral financing, if so
desired, in the event of a worsening of international
conditions. Public external debt amortization is to remain
below the USD2bn per year mark, almost half of which is
bilateral and multilateral.
Fiscal performance gradually improving
Because of the faster than initially expected growth of
economic activity, tax receipts are likely to come out
above budgeted levels during the current year by about
5%. During the first nine months of the year, VAT
collection and income tax receipts rose by 41% yoy a
piece, while the financial transactions tax revenue
increased by 76% yoy. This has resulted in a reduction in
planned domestic debt sales this year, and will also lower
TES issuance for 2012. We project this year’s
consolidated public sector deficit to be just above 3% of
GDP, instead of official estimates from early this year that
put it at 4.1%, as tax outperformance is to be in the order
of COP6trn (1% of GDP). This will be the case, in our
view, even if the authorities bring forward some expenses
originally slated for 2012, such as some pension outlays.
For 2012, we project such deficit to drop further towards
3% of GDP, as tax collection and compliance continue on
an upswing. Over the medium term, fiscal performance
should also benefit by the series of reforms approved by
Congress this year, something that should also increase
the chances of sovereign rating upgrades down the road.
Colombia: Tax outperformance in 2011
Actual
(COPtrn) % yoy
Internal 54.04 49.4 70.06 77.1
Income 27.74 40.6 32.00 86.7
VAT 18.37 41.1 31.69*
Financial transactions 3.68 76.3 4.04 91.3
Wealth 4.13 294.2 2.33 177.4
Stamp 0.11 -59.5 0.20 54.7
External 11.62 35.1 3.52
Total 65.66 46.7 73.78 89.0
* Domestic and external VAT receipts.
Jan-Sep 2011
Budgeted
for 2011
% of
budget
Source: DANE, GlobalSource, , Deutsche Bank
On Santos’ possible reelection bid
During a conference at the London School of Economics,
President Juan Manuel Santos said that ‚if he achieves
most of the goals of his administration‛ during the four
years of his mandate, he would prefer not to run for
reelection. He added that in the event of a reelection bid,
the process should be smoother than in the previous
political cycle, as no constitutional reform would be
necessary this time around. Thus, Santos did not close the
door to the possibility of a reelection, something that is
unlikely to be ruled out especially considering that his
popular support is currently at an all time high of well over
80%. Santos’ popularity is being supported by the good
economic performance of the country, especially in a
difficult international context, and the recent strikes on the
FARC, with several guerrilla leaders taken down.
Meanwhile, the local media reported that the relationship
between Santos and former President Alvaro Uribe is
somewhat strained, and that Uribe may support former
Finance Minister Oscar Ivan Zuluaga as presidential
candidate in 2014. It is, however, too early to determine
what the eventual political strategies will be, but it
appears that Santos is currently in a position of substantial
strength and would become a very powerful candidate for
reelection if so desired – and conveying a message of
policy continuity to the market. Santos met with British
Prime Minister David Cameron and Foreign Affairs
Minister William Hague, who highlighted Colombia’s
continued commitment to improve security and Santos’
compromise to avoid human rights abuses. Hague also
indicated that the bilateral goal is to double trade volumes
by 2015. Labor Party lawmakers, in turn, complained
about Colombia’s human rights record and requested the
British government to prioritize the guarantees to the
rights of labor union leaders in Colombia over bilateral
trade goals.
Fernando Losada, New York, (212) 250-3162
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 97
Investment strategy
FX: Constructive on fundamentals but beware of
short-term risks. Fundamentals keeps improving the
medium-term prospects for the COP, but the usual end-of-
year scarcity of USD in the local market create some
pressure on short-term points, increasing the volatility
during the next weeks. The favorable trade and fiscal
performance observed during this year is expected to
continue during 2012, and strong FDI flows will more than
compensate a growing deficit in the current account. The
latest activity and inflation data suggest that Banrep will
continue to tighten monetary conditions early into next
year. Together with lean positioning, the recovery in carry
could act as important short-term driver. Nevertheless, the
recent underperformance of the COP is an reminder that
the currency could also suffer from a more challenging
global environment, particularly as technical factors play a
role at the turn of the year. As a consequence, we
recommend remaining on the sidelines, waiting for better
entry levels at the beginning of next year.
Rates: Enough tightening priced in. The local curve has
been anticipating the on-going tightening cycle for some
weeks. With 75bp of additional tightening already priced
in, we consider that the risks are biased to the downside
for short-term rates, as the slowdown in global growth
may drag on domestic activity and reduce some
inflationary pressures. Nevertheless, we find that the belly
of the curve may offer more value, particularly relative to
core rates. We recommend closing 2s3s IBR/COP
steepener and entering a 5Y receiver, either in IBR/COP or
TES Jun ’16, against 5Y USD swap payer (swaps, entry:
440bp, target: 410bp, stop: 455bp).
Credit: Stay overweight. We keep Colombia at
overweight on the back of its strong macro momentum,
evidenced in its robust domestic driven growth as well as
the improvement in fiscal performance and debt
dynamics; marginally more attractive valuation relative to
its LatAm low beta peers; and supportive technicals.
Colombia will likely have (in a worst case) flat net issuance
in 2012 (maximum USD2bn external issuance met with
almost the same amount in principal and interest
payments). On the global curve, while the bonds at the
long end are trading almost flat to their counterparts on
peer curves, the shorter end still has room to catch up;
we favor the 19s and the off-the-run 20s over the 21s,
whose 20bp richness to the curve due to benchmark
premium looks somewhat excessive.
Mauro Roca, New York, (212) 250-8609
Hongtao Jiang, New York, (212) 250-2524
Colombia: Deutsche Bank Forecasts 2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 243.3 267.4 293.4 319.7
Population (m) 45.8 49.3 50.4 50.4
GDP per capita (USD) 5,312 5,424 5,822 6,343
Real GDP (YoY%) 4.3 5.5 5.0 5.0
Priv. consumption 5.0 6.0 5.0 5.2
Gov't consumption 3.5 3.0 3.5 3.3
Gross capital formation 6.0 11.0 10.0 11.0
Exports 18.0 25.0 21.0 18.0
Imports 20.0 28.0 22.0 20.0
Prices, Money and Banking
CPI (Dec YoY%) 3.2 3.7 3.4 3.2
Broad Money 8.1 13.5 13.0 13.0
Bank credit 10.0 12.0 15.0 15.0
Fiscal Accounts (% of GDP)
Consolidated budget balance -3.9 -3.3 -3.2 -3.0
Interest payments 3.3 3.3 3.2 3.1
Primary Balance -0.6 0.0 0.0 0.1
External Accounts (USD bn)
Exports 39.8 55.0 63.8 75.0
Imports 40.7 53.5 63.6 76.0
Trade balance -0.9 1.5 0.2 -1.0
% of GDP -0.4 0.6 0.1 -0.3
Current account balance -8.9 -8.5 -8.0 -8.5
% of GDP -3.7 -3.2 -2.7 -2.7
FDI 9.1 10.0 11.0 11.0
FX reserves 28.4 34.0 40.0 44.0
COP/USD (eop) 1908 1890 1850 1830
Debt Indicators (% of GDP)
Government debt 38.5 39.3 39.4 39.4
Domestic 26.5 27.5 27.9 27.9
External 12.0 11.8 11.5 11.5
Total external debt 22.6 22.4 22.5 20.6
in USDbn 55.0 60.0 66.0 66.0
Short-term (% of total) 8.0 8.0 8.0 8.0
General
Industrial production (YoY%) 5.0 6.0 7.0 7.0
Unemployment (%) 11.0 10.0 9.3 9.0
Financial Markets (eop) Current 3M 6M 12M
Overnight rate (%) 4.8 5.0 5.3 5.3
Three-month rate (%) 5.0 5.2 5.6 5.6
COP/USD 1946 1880 1870 1850 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 98 Deutsche Bank Securities Inc.
Mexico Baa1 (stable) / BBB (stable) / BBB (stable) Moodys/S&P/Fitch
Economic Outlook: Headline inflation has
accelerated but core remains well behaved, very near
the medium term target. Economic activity surprised
on the upside during 3Q11, and will decelerate very
gradually over the coming months. The negative
output gap will not close until 2012. Banxico is
unlikely to cut the funding rate unless the currency
appreciates back towards pre-US downgrade levels.
Main Risks: A relapse in US economic activity.
Higher inflation because of strong commodity prices
and/or higher pass-through from depreciation.
Volatility of political origin ahead of next year’s
presidential elections.
Strategy recommendations: Take profits on long
MXN/CZK and enter short CAD/MXN. Take profits on
5Y TIIE payer and enter 2s10s TIIE flattener vs. 2s10s
USD swap steepener. Neutral external debt. The old
19s remain significantly rich to the curve.
Macro view
Inflation edging upwards towards year-end
November’s fortnight inflation came out above
expectations at 0.97% mom. Core inflation was higher
than expected at 0.27%, but non-core soared by 3.41%
because of high agricultural prices and adjustments to
energy prices, as the summer season fares were phased
out. When measured with the fortnightly index, annual
inflation is now running at 3.44%, 30bp above the
previous month’s print.
Mexico: Inflation rates (% yoy)
2
3
4
5
6
7
8
9
10
CPI Core Food
Source: Banco de Mexico, Deutsche Bank
These developments, coupled with the fact that the
currency remains extremely weak and that 3Q11 GDP
came out stronger than expected, prevents easing on the
part of Banxico for the time being. We expect headline
inflation to be around 3.4% and core to near 3.2% by
year-end, and we also expect similar levels for headline in
2012 and slightly lower core, possibly at 3%.
GDP growth well above expectations
The official statistics office INEGI reported that GDP
expanded by 4.5% yoy during 3Q11, significantly above
expectations of a 3.9% increase according to
Bloomberg’s poll. On a qoq seasonally adjusted basis,
GDP expanded by 1.34%. The outperformance was
helped by a substantial 8.3% yoy, 11.8% qoq jump in
agriculture. Manufacturing, in turn, rose by 4.6% yoy. The
2Q11 figure was revised slightly downwards by 10bp to
3.2% yoy. GDP has expanded by 4.1% yoy during the first
nine months of the year, so that even if the growth pace
slows down in 4Q11 as we expect, the figure for the
entire year will be at least 3.8%. Amid global financial
turmoil and steady but slow growth in the US, we project
that economic activity growth will be weaker in 2012,
possibly just below the 3.5% mark.
Mexico: Actual and expected GDP (% yoy)
-8
-6
-4
-2
0
2
4
6
8
2005 2006 2007 2008 2009 2010 2011F 2012F
Source: Banco de Mexico, Deutsche Bank
Tasa de fondeo unchanged
On December 2, the last monetary policy of the year,
Banxico left the tasa de fondeo unchanged at 4.5%, in line
with expectations. The Bank highlighted that the financial
crisis in Europe has worsened, and that the chances of a
recession in the area next year have increased, while the
concerns about the health of some European banks have
increased volatility in international financial markets.
Banxico also pointed out that despite some recently
released positive economic indicators in the US, structural
problems persist, including unemployment and high
household leverage, with the additional difficulty
generated by the lack of political agreement towards a
sustainable fiscal path. Banxico sees heightened risks for
growth in the US, something that was corroborated by the
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 99
Fed’s downward revision of its GDP growth forecasts for
2011 and 2012, and the indication that monetary policy
will remain very accommodative at least through 2013.
Those subdued growth prospects suggest that
commodity prices may weaken and that inflation in
developed markets will soften.
In Mexico, Banxico acknowledged that although general
economic activity continues to expand, the industrial
sector has softened, reflecting weaker external demand.
Credit and labor markets still show signs of slack capacity,
and the negative output gap will take longer to close.
Banxico argued that the balance of risks for growth has
deteriorated but the balance of risk for inflation is neutral,
as inflation could fall because of weaker domestic and/or
external demand but it could increase as a consequence
of the currency depreciation and/or the movement in
some agricultural prices. In the previous monetary policy
meeting, Banxico had said that the balance of inflation risk
had improved, so the new statement can be construed as
marginally more hawkish. The Bank also reiterated the last
paragraph of the previous communiqué, pointing out that
depending on the impact of the global deceleration on the
Mexican economy and ‚in the context of great monetary
lassitude in developed countries‛, it may become
necessary to relax monetary policy in the future, but also
indicating that it remains vigilant of any possible impact of
the depreciation on inflation. All in all, the statement was
consistent with the 3Q11 inflation report, where Banxico
said to expect both headline and core to remain within the
3.0%/4.0% interval over the foreseeable future, and that
the current monetary policy stance is neutral, with
inflation expectations well anchored in spite of the recent
currency slide. Thus, we continue to be of the idea that in
order for Banxico to cut rates in 1Q12, we would need to
see a stronger exchange rate, possibly trading with a 12
handle, inflation edging downwards from current levels,
and some further signs of economic deceleration.
The new old FX intervention policy
On November 29, the Exchange Commission announced
the suspension of the monthly auctions to buy dollars, in
view of the sharp weakening of the currency observed in
previous weeks. The November 30 auction was called off.
In addition, Banxico rekindled the daily dollar auction
mechanism that has been used several times in the past.
The Bank will offer up to USD400m every day the
currency depreciates by at least 2% overnight. This move
confirms that Banxico is worried about the possible
impact of the depreciation on inflation, especially since
the last two inflation releases came out above
expectations, and with preliminary evidence that prices of
tradable goods are increasing faster than initially
expected. True to its tradition, Banxico will intervene in
the currency market via a transparent rule-based
mechanism rather than on a discretionary basis. The
instrument, which had been used two years ago when the
global financial turmoil was on the rise, is geared towards
providing liquidity to the fx market to reduce currency
volatility. It must be noted that the Bank is in a far stronger
position to intervene at the present juncture than in 2008-
09, as international reserves are twice as high as in 2007,
even before counting the IMF’s contingent financing. The
announcement of the contingent dollar auctioning
mechanism was made at the same time of the
coordinated action of the US Federal Reserve and five
other major central banks, thus resulting in a stronger
impact on the peso, provided support for the peso, which
appreciated by some 28 centavos in the three days that
followed the news to MXN13.54/USD.
Mexico: Exchange rates and international reserves
70
80
90
100
110
120
130
140
150
11.4
11.9
12.4
12.9
13.4
13.9
14.4
Exchange rate (MXN/USD) Reserves (USDbn, rhs)
Source: Banco de Mexico, Deutsche Bank
External accounts show comfortable situation
Through October, the accumulated trade deficit was just
below USD1bn. Given the seasonal behavior of the trade
accounts, we expect the imbalance to increase through
December, although remaining below the USD4bn mark.
The current account deficit, in turn, is also expected to
remain subdued at no more than USD7bn. For next year,
we expect those imbalances to increase to USD7bn and
USD10bn, respectively, on the back of lower export
growth given the weak prospects for the US. Similarly to
what has been the case in recent years, the external
imbalance does not pose any risk for the Mexican
economy, as the current account deficit will be more than
covered with FDI inflows alone, which we expect to hover
around the USD20bn per year during 2011-12. Given our
balance of payments projections, we expect a further
accumulation of international reserves next year, although
at a slower pace than in 2011.
2011 growth and inflation up in latest Banxico poll
The latest Banxico expectations survey showed market
participants revising their GDP growth forecasts for the
current year to 3.87%, 15bp above the previous month’s
poll. It was the first time in the past six months that the
growth projection is revised upwards, in what was a result
6 December 2011 EM Monthly
Page 100 Deutsche Bank Securities Inc.
of the higher than expected figure observed during 3Q11.
For 2012, GDP is expected to expand by 3.25%. Headline
inflation, in turn, was revised upwards to 3.36%, 6bp
above the October projection, also reflecting the recent
acceleration in prices and possibly the weakening of the
exchange rate, a phenomenon that is lasting more than
initially expected. The currency is now expected to be at
MXN13.32/USD by year-end, 36 centavos weaker than in
the previous poll. Regarding the tasa de fondeo, the
majority of survey participants projected no change during
this year, while one third of them expect to see monetary
easing during 1H12, and close to half of the respondent
project tightening since 2013.
Retail sales, unemployment better than expected
The National Institute of Statistics INEGI reported that
retail sales increased by 4.7% yoy in September, beating
expectations of a 3.1% increase as per Bloomberg’s poll.
Employment in the retail sector increased by 2.8%, while
average wages dropped by 1.5%. Wholesale activity, in
turn, rose by 6.3% yoy. INEGI also reported that
unemployment was 5.0% in October, way below
expectations of 5.7%. On a seasonally adjusted basis, the
jobless rate was 4.8%. These figures reaffirm the view
that fears about a quick and sharp deceleration of
economic activity were overblown. Instead, the real
economy is holding up pretty well, and the deceleration
expected for next year will proceed gradually.
Mexico: Industrial production and unemployment
3
4
5
6
7
90
100
110
120
130
IP (Jan 09=100) Unemployment (%, rhs)
Source: INEGI, Deutsche Bank
Peña Nieto likely PRI presidential candidate
Senator Manlio Fabio Beltrones from the opposition PRI
party announced his decision to step down from the race
to become a presidential candidate ahead of next year’s
election. Beltrones trailed former Mexico State Governor
Enrique Peña Nieto by a very large margin in all surveys,
but his decision definitely cleared the way to define Peña
as the party candidate. In a press release, Beltrones
indicated that his decision was ‚not a sacrifice, but rather
a contribution to help the PRI secure the victory in 2012‛.
He went on to say that the slim victory obtained by the
PRI in the recent Michoacan State election and the early
announcement of a coalition candidate by the leftist
parties suggest that the PRI also has to rally around a
consensus leader as soon as possible. Indeed former
Mexico City mayor and presidential candidate Andres
Manuel Lopez Obrador had edged current mayor Marcelo
Ebrard in a PRD party poll, with AMLO thus becoming the
presidential candidate from the left. Peña thanked
Beltrones via Twitter, acknowledging his ‚professionalism
and contribution towards PRI unity‛, and registered
formally as a presidential candidate. Beltrones’ decision
renders any primary election mechanism within the PRI
unnecessary, as the party will most likely line up behind
Peña, who in different national polls appears to be at least
ten percentage points ahead of any candidate from the
ruling PAN or the leftist PRD parties.
Las month, Peña addressed a group of investors in New
York, indicating that in the event of being elected next
year, his government program will have the following
priorities: (i) maintenance of macroeconomic stability as a
necessary (albeit not sufficient) condition for growth; (ii)
fostering competition in all markets; (iii) promoting Mexico
as a regional energy powerhouse; (iv) opening up of the
oil sector to private participation; (v) increase of
investment in human capital, modernization of educational
system; (vi) increase in bank penetration and credit
creation as a proportion of GDP; (vii) improvement in
physical infrastructure; (viii) implementation of a new
universal social security system, which will include health
coverage, unemployment insurance and pensions; (ix)
deepening of integration with the US, (x) implementation
of an integral fiscal reform; and (xi) implementation of
sector-specific promotion policies. He indicated that
economic policies geared towards accelerating growth
and reducing poverty will be the cornerstone of his
administration. His presentation was well suited for both
domestic and international investors, although he did not
provide details of implementation of each policy, as the
venue and the time constraint did not allow it. Regarding
the energy sector, he indicated that the public sector will
continue to have full ownership of the country’s natural
resources, which suggests that his plan may include a
twist to the existing arrangement of incentive contracts
for private firms, but with no changes to the constitutional
constraints on private participation in the sector.
Regarding security, he said the decision of the
administration of President Felipe Calderon to combat
organized crime was correct, although he added that
under his government he would try to increase the
operational force of the security forces, both expanding
the police and emphasizing intelligence activities.
Fernando Losada, New York, (212) 250-3162
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 101
Investment strategy
FX: Intervention may reduce volatility. MXN was one of
the currencies which suffered the most from recent
market volatility. Nevertheless, the recently announced
rule-based intervention by Banxico (will offer USD400mm
whenever the currency weakens by more than 2% in a
day) was successful in curbing the MXN depreciation and
may help to reduce its volatility. The effectiveness of the
intervention could be increased due to the important MXN
undervaluation and extreme short positioning MXN is
clearly undervalued both from a short-term perspective
based in recent evolution of financial drivers and from a
much longer valuation based on macroeconomic
fundamentals. Additionally, in our view it will be difficult
that Banxico eases monetary conditions unless the
currency appreciates considerably. We continue to find
attractive maintaining exposure to the peso, even when
acknowledging the potential risks posed by the external
environment. We recommend taking profits in our long
MXNCZK recommendation and switching to short
CADMXN (entry: 13.38, target: 13.10, stop: 13.50); this
cross still offers some positive carry while offering
protection against US risks.
Rates: Position to capture risk premium. Local rates have
been following the movements in the exchange rate. As
Banxico does not seem ready to ease monetary
conditions, at least until the currency appreciates further,
the short-end of the curve offers little value. Nevertheless,
the medium and long term sectors of the curve could
benefit from reduced exchange volatility due to Banxico’s
intervention and from a potential improvement in risk
appetite. After reaching the target, we take profits in our
5Y TIIE payer recommendation and switch to a box trade
of 2s10s TIIE flattener against 2s10s USD swap steepener
(entry: -15bp, target: 25bp, stop: -35bp). This trade could
benefit from the reduction in risk premia in Mexican rates
but also from some normalization of US rates.
Credit: Increase to neutral from underweight. Mexican
external debt has performed broadly in line with its LatAm
low beta peers, but an improving US economic activity
(especially relative to the rest of the world) in a way
removes a source that might negatively impact Mexico’s
debt dynamics. Valuation does not look attractive, but
Mexico is among the credits having the lowest risk on our
vulnerability indicators (see the special piece: EM: Survival
of the Fittest). On the UMS curve, a correction to the
mispricing of the 8.125% 19s (19Os) has taking place but
it remains significantly rich to the curve and should be
avoided; we continue to favor the 5.95% 19s (19N).
Mauro Roca, New York, (212) 250-8609
Hongtao Jiang, New York, (212) 250-2975
Mexico: Deutsche Bank Forecasts 2010 2011F 2012F 2013F
National Income Nominal GDP (USD bn) 995 1041 1121 1199
Population (m) 109 111 112 114
GDP per capita (USD) 9,120 9,411 9,990 10,544
Real GDP (yoy%) 5.5 3.9 3.3 3.5
Private consumption 4.1 4.0 3.0 3.3
Gov’t consumption 3.4 1.5 2.9 3.0
Investment 4.0 4.6 4.0 5.0
Exports 25.0 21.0 11.0 12.0
Imports 24.0 19.0 10.0 12.0
Prices, Money and Banking CPI (Dec yoy%) 4.4 3.4 3.4 3.4
Broad Money 13.0 11.0 12.0 10.0
Credit 9.0 11.0 12.0 10.0
Fiscal Accounts (% of GDP) Consolidated budget balance -2.8 -2.1 -2.3 -2.0
Primary Balance -0.5 0.1 0.0 0.0
External Accounts (USD bn)
Exports 297.0 341.2 362.0 395.0
Imports 300.1 345.0 369.0 404.0
Trade balance -3.1 -3.8 -7.0 -9.0
% of GDP -0.3 -0.4 -0.6 -0.8
Current account balance -5.6 -7.0 -11.0 -14.0
% of GDP -0.6 -0.7 -1.0 -1.2
FDI 18.0 19.5 20.0 21.0
FX reserves 113.6 140.0 161.0 180.0
MXN/USD (eop) 12.34 13.00 12.80 12.80
Debt Indicators (% of GDP) Government debt 34.4 35.2 35.3 35.8
Domestic 24.4 25.4 25.8 26.5
External 10.0 9.8 9.5 9.3
Total external debt 19.3 19.8 19.3 18.8
in USDbn 192.0 206.0 216.0 225.0
Short-term (% of total) 20.0 20.0 19.0 19.0
General
Industrial production (yoy%) 6.0 4.4 4.0 5.0
Unemployment (%, avg) 5.3 5.6 5.4 5.2
Financial Markets (eop) Current 3M 6M 12M
Overnight rate (%) 4.5 4.3 4.0 4.0
3-month rate (%) 4.4 4.2 4.0 4.0
MXN/USD 13.54 12.80 12.60 12.60 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 102 Deutsche Bank Securities Inc.
Peru Baa3 (pos)/BBB (neutral)/BBB (neutral) Moody’s/S&P/Fitch
Economic outlook: GDP growth is to be near 7%
this year, slowing down very gradually towards 6% in
2012. The inflation spike is likely to be temporary, but
it will prevent monetary easing for now. Structural
excess demand for dollars is to maintain the currency
well supported.
Main risks: Higher inflation because of food prices.
Weaker fiscal and external performance because of
softer mining prices, if global growth falters.
Strategy recommendations: Maintain long 3M
USD/PEN NDF and remain neutral on rates. Increase
to overweight external debt, take profit in the 37s to
19s switch and now favor the long end of the curve.
Macro view
3Q11 GDP in line with expectations
GDP expanded by 6.5% yoy during 3Q11, slightly below
expectations of a 6.6% increase according to
Bloomberg’s poll. This was the fifth consecutive quarter in
which growth slows down. The Central Bank has recently
upgraded its 2011 GDP growth forecast to 6.8% from
6.3%. In order to reach 6.8%, the economy should grow
by 4.8% yoy during 4Q11, something that looks feasible.
Although domestic spending appears to be holding up
well, the authorities have announced a stimulus plan to
offset a possible further deterioration in external
conditions. Currently, said plan stands at nearly 2% of
GDP, but Economy Minister Castilla hinted that it could be
increased if deemed necessary. We expect to see slower
growth next year, although Peru should still be among the
strongest performers in LatAm, expanding by almost 6%.
November inflation above expectations
INEI reported that consumer prices rose by 0.43% mom,
4.64% yoy, well above expectations of a 0.30% increase
as per Bloomberg’s survey. Year to date, prices increased
by 4.46%. Prices of food and beverages continue to lead
the increases. The Central Bank has argued that the spike
in inflation is a temporary phenomenon that will dissipate
next year, while core inflation remains better behaved at
3.50% and inflation excluding all food and energy items is
running at 2.50%, suggesting that there is no evidence of
substantial demand pressures. The increase in inflation
observed since June, however, has been very significant,
which suggests that next year’s figures could also be a bit
higher than initially thought, near 3.5%.
Policy rate unchanged for now
The Central Bank left its reference rate unchanged at
4.25% in October, in line with expectations. The decision
was made as the Bank acknowledged that aggregate
expenditure is growing at a slower pace than earlier in the
year, and also because of the higher risks stemming from
the international financial turmoil. While the Bank has
repeatedly indicated its concerns about a deteriorating
global environment, the inflation spike suggests that the
authorities have little to ease monetary policy at the
present juncture. We indeed expect the policy rate to
remain unchanged through 2012, as current levels
represent real short term rates that are well below 1%.
External accounts in good shape
September’s trade surplus reached USD656m, on track to
reach almost USD7bn this year. The current account
deficit, in turn, is to be below 1.5% of GDP. We project
similar figures for the next couple of years, with the
current account imbalance remaining below 2% of GDP
and more than covered by FDI inflows. We also project a
further accumulation of reserves, albeit at a somewhat
smaller pace than in the past two years.
Humala’s first 100 days – a mixed review in the polls
After 100 days in office, President Ollanta Humala’s
approval rate is still high at 56% but it has dropped from
more than 70% when he took office, according to a poll
conducted by local consultant Apoyo. He lost six points in
the last month alone. Those supporting him indicated that
he is promoting change to improve the country, that he is
fulfilling his campaign promises, and that he cares about
the poor. Those who disapprove of him mentioned that he
is not sticking to his campaign agenda, that he does not
generate confidence, and that there is evidence of
corruption in his government. First Lady Nadine Heredia is
the public figure with the highest popularity at 63%, even
surpassing the President. Prime Minister Salomon Lerner
received only 33% backing, while Economy Minister
Miguel Castilla reached 37% and Congress Chairman
Daniel Abugattas got 42%. Vice Presidents Marisol
Espinoza and Omar Chehade (currently under investigation
and suspended from his post) did not fare well, with
support of 34% and 8%, respectively. In terms of specific
areas of government work, the Humala administration
obtained a mixed review, with good marks regarding the
fight against poverty and the promotion of investment and
employment, while the efforts towards solving social
conflicts, fight drug trafficking and combat corruption
were disapproved.
Fitch upgrade
On November 10, Fitch ratings announced its decision to
upgrade Peru’s foreign currency issuer default rating (IDR)
and country ceiling to BBB from BBB-. The local currency
IDR was raised to BBB+ from BBB. The decision
represents an implicit endorsement for President Ollanta
Humala, as the agency indicated that the upgrade reflects
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 103
‚reduced uncertainty regarding macroeconomic policy
continuity and changes to the fiscal contribution of the
mining sector‛. Fitch said that the ratings are supported
by a strong net external creditor position, high and
increasing international reserves, and low external debt.
The vulnerabilities are mainly the high dependence on
commodities and the high degree of dollarization. Fitch
highlighted the commitment of the new administration to
a conservative fiscal stance and a credible monetary
policy, and the rapid and successful negotiation to
increase the fiscal contribution of the mining industry,
which reduced regulatory uncertainty. We believe
upgrades from other rating agencies are likely next year.
Gustavo Cañonero, New York, (212) 250-7530
Fernando Losada, New York, (212) 250-3162
Investment strategy
FX: Risks are biased toward depreciation. The
successful Central Bank intervention in the FX market has
shielded the PEN from the recent volatility in global
financial markets. However, as the currency continues to
trade close to multiyear high levels, the intervention has
helped to increase the currency overvaluation. While the
central bank will likely continue to intervene aggressively
to smooth the currency movements and capital flows may
still be favorable, the risks, in our view, are biased toward
depreciation. Next year, the currency will receive less
support both from economic growth and terms of trade.
We recommend maintaining 3M USD/PEN NDF (entry:
2.72, target: 2.80, stop: 2.68).
Rates: Remain neutral. The local curve, supported by
favorable technicals and a stable currency, has shown
extraordinary resilience to external events. With rates
trading at relatively low levels and the central bank with
little room to ease monetary conditions, the curve does
not offer much value. We recommend remaining neutral
on local rates, waiting for better entry levels to get
additional exposure.
Credit: Increase to overweight. Fundamentals remain
strong, anchored by robust growth, even though there is a
mild deterioration in fiscal and external accounts due to
weaker global demand for mining exports. While we value
Peru’s stability drawn from its fundamental strength,
valuation on the curve also looks marginally more
attractive in comparison with Brazil and Mexico. On the
global curve, the 19s/37s slope has significantly
steepened and we hence recommend taking profit in the
37s to 19s switch. We now find better value at the long
end of the curve.
Mauro Roca, New York, (212) 250-2975
Hongtao Jiang, New York, (212) 250 2524
Peru: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USDbn) 146.8 168.5 176.2 188.6
Population (m) 29.3 29.7 30.0 30.5
GDP per capita (USD) 5,009 5,672 5,874 6,182
Real GDP (YoY%) 8.8 6.8 5.9 5.5
Priv. Consumption 6.0 6.5 5.5 5.0
Gov't consumption 10.6 8.0 9.0 10.0
Investment 22.4 11.0 10.0 10.0
Exports 2.5 24.0 10.0 10.0
Imports 23.8 31.0 17.0 12.0
Prices, Money and Banking
CPI (YoY%) 2.1 4.4 3.5 3.2
Broad money 25.4 12.0 13.5 13.0
Credit 20.3 14.0 15.0 15.0
Fiscal accounts, % of GDP
Balance -0.7 0.1 -0.2 -0.4
Government spending 20.0 19.9 20.5 21.0
Government revenue 19.3 20.0 20.3 20.6
Primary surplus 0.6 0.8 0.4 0.3
External accounts (USDbn)
Exports 35.6 44.7 48.5 51.1
Imports 28.8 38.0 45.0 49.0
Trade balance 6.8 6.7 6.5 6.0
% of GDP 4.6 4.0 3.7 3.2
Current account balance -2.3 -2.3 -3.0 -3.5
% of GDP -1.6 -1.4 -1.7 -1.9
FDI 5.7 5.5 5.1 5.0
FX reserves (USDbn) 44.1 49.0 51.0 53.0
FX rate PEN/USD (eop) 2.80 2.72 2.85 2.90
Debt Indicators (% of GDP)
Government debt 24.1 22.9 23.4 23.7
Domestic 10.3 9.5 9.8 10.0
External 13.8 13.4 13.6 13.7
Total external debt 27.9 27.1 27.7 28.1
in USDbn 41.0 45.6 48.8 52.9
Short-term (% of total) 15.8 15.3 15.1 14.8
General
Industrial prod (%) 8.3 6.0 6.3 6.0
Unemployment (%) 7.6 7.3 7.0 6.9
Financial Markets (eop) Current 3M 6M 12M
Policy rate (interbank o/n) 4.25 4.25 4.25 4.25
6-month rate (interbank) 4.50 4.50 4.50 4.50
PEN/USD 2.71 2.75 2.80 2.85 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 104 Deutsche Bank Securities Inc.
Uruguay Ba1 (stable)/BBB- (stable)/BB+ (stable) Moodys/S&P/Fitch
Economic Outlook: Economic growth is decelerating
gradually, converging towards trend levels, although
risk of the projections is on the upside given the
pipeline of investment projects. Inflation remains well
above the ceiling of the target range, preventing any
monetary easing for the time being.
Main Risks: A drop in commodity prices. A further
acceleration in inflation. Weaker growth in the
country’s main trading partners.
Strategy Recommendations: We favor UYU ’18 as a
buy and hold strategy due to elevated carry and
diversification.
Macro View
Inflation remains well above expectations
Consumer prices rose by 0.42% mom, 8.40% yoy in
November, above expectations of a 0.30% increase as
per the Central Bank’s poll. Annual inflation jumped 52bp
relative to October. With the exception of entertainment,
all item groups posted price increases during the month,
led by apparel that rose by 1.47%. Prices of food and
beverages increased by 0.30% mom, 8.92% yoy. Inflation
has been fueled by high prices of commodity imports and,
in spite of the substantial monetary tightening
implemented this year, to the tune of 150bp, it remains
well above the ceiling of the official target that spans from
4% to 6%. Producer prices are increasing at double digit
pace, suggesting that both demand and supply factors are
playing a role in the acceleration of consumer prices. This
suggests that despite any concerns about global
economic growth and/or softening commodity prices in
the months ahead, the Central Bank has no room to ease
monetary policy at the present juncture. The next
monetary policy meeting is scheduled for December 29.
We expect the policy rate to remain unchanged at 8%
through next year.
Economic activity continues to expand
GDP rose by 5.7% yoy during 1H11, significantly below
the 8.4% increase observed during 2010. We expect the
slowdown to continue during 2H11, so that the annual
figure is likely to come out at around 5%. This weakening
trend is also behind our expectation of no more interest
rate hikes in the coming months, despite the evidence of
inflation pressures. The index of leading indicators
produced by local think tank Ceres continued to indicate
an expansion through September, which suggests that
economic activity will most likely grow during 2H11.
Ceres leading index has risen for 28 consecutive months.
Ceres diffusion index, in turn, is currently at 89%, which
indicates that most of the variables that are part of the
leading index continue to move forward. We project the
economy to grow at near trend levels of less than 5% pa
over the next couple of years, although we acknowledge
that the risk of the forecast is on the upside, as Uruguay
remains a significant attractor of strategic foreign
investment which, given the size of the economy, could
have an outsized impact on growth performance. In
addition, a recently approved public-private partnership
law could also have a beneficial effect on infrastructure
investment. Unemployment has averaged 6.1% so far this
year, which compares favorably with the 6.7% of 2010
and the 7.3% of 2009. We believe that the jobless rate
could continue dropping towards the high 5% level during
the next two years.
External sector dynamics
The current account deficit has widened this year and is
expected to surpass the 2% of GDP mark. The increase in
that imbalance will probably continue over the next couple
of years. Demand for imports is strong, fueled by private
consumption and investment, while exports are likely to
grow at a slower pace as the real exchange rate continues
to appreciate. The currency weakened since September
2011, in unison with most other EM currencies, and is
likely to end the year at nearly UYU20/USD, after
averaging UYU18.8/USD during 3Q11. The exchange rate,
however, has been on a major appreciation trend since
the beginning of 2009, on the back of stronger
fundamentals and robust capital inflows. Although we
expect the nominal rate to trade slightly above 20 going
forward, we estimate that the real effective exchange rate
is currently some 15% stronger than its average of the
past decade. Given that inflation will probably remain
above the ceiling of the target band during the next two
years, chances are good that the real appreciation will not
be corrected any time soon. In the event of excessive
short term currency volatility because of external
concerns, the Central Bank is in a strong position to
intervene successfully, as international reserves are
currently above the USD10bn threshold, more than triple
the level of 2007.
Although the external deficit is expected to increase, we
believe that it will be more than covered by FDI inflows,
which will contribute to maintaining the capital account of
the balance of payments in a surplus position. In May
2011, a consortium of foreign firms started the
construction of yet another pulp mill worth USD1.9bn, the
largest ever private FDI transaction in the country’s
history. According to the Finance Ministry, the project
should have a direct positive impact on GDP growth of
some 0.8% during 2011 and 2012, and 2% pa when it
becomes fully operational.
Public sector finances
In the 12 months to August 2011, the consolidated public
sector primary surplus was equivalent to 1.9% of GDP. As
the interest bill on public debt remained at 3% of GDP,
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 105
the overall deficit was just above 1% of GDP. We expect
the imbalance to increase towards 1.5% of GDP by year-
end, and to remain around those levels during 2012-13.
Gross public sector debt currently stands just below 60%
of GDP, of which 35% of GDP is external. We project
these ratios to fall further in 2012-13, although at a much
smaller pace than in recent years (gross debt/GDP was
over 100% in 2003). In July, S&P raised the country’s
foreign currency issue rating to BBB-, and Fitch did at the
same time to BB+. The upgrades were justified by the
track record of sound policy design and implementation,
and the evidence that the fiscal and monetary policy mix
was not changing after the administration of President
Jose Mujica took over.
Fernando Losada, New York, (212) 250-3162
Investment Strategy
Rates: Linkers are attractive as a buy and hold proposition.
While Uruguayan linkers suffer from reduced liquidity, the
attractive carry and good prospects for the carry make
them an attractive proposition to buy and hold. In our
view, inflation expectations will remain elevated as
inflation remains above the upper band of the target.
Additionally, while high inflation continues to appreciate
the currency which is arguably already overvalued, the
central bank will likely intervene to stop any sharp
depreciation of the currency. Finally, as shown by the
recent credit rating upgrades, the credit will remain solid
on the back of sound policy design. As a consequence,
we believe that short duration linkers –like the UYU ‘18s-
could be an interesting source of carry while offering an
attractive diversification opportunity.
Mauro Roca, New York, (212) 250-8609
Uruguay: Deutsche Bank Forecasts 2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 41.0 46.3 49.2 52.3
Population (mn) 3.4 3.4 3.4 3.4
GDP per capita (USD) 12,059 13,619 14,477 15,380
Real GDP (YoY%) 8.0 5.0 4.8 5.0
Consumption 10.1 8.0 7.5 8.0
Gross capital formation 19.0 18.0 18.0 19.0
Exports 23.0 27.0 25.0 24.0
Imports 24.1 30.0 28.0 28.0
Prices, Money and Banking
CPI (Dec YoY%) 6.9 8.1 6.5 6.0
Broad Money 31.0 23.0 18.0 17.0
Fiscal Accounts (% of GDP)
Consolidated budget balance -1.1 -1.1 -1.1 -1.0
Interest payments 2.8 3.0 2.9 2.8
Primary Balance 1.7 1.9 1.8 1.8
External Accounts (USD bn)
Exports 10.7 12.0 11.0 11.0
Imports 9.9 11.7 9.8 9.8
Trade balance 0.8 0.3 1.2 1.2
% of GDP 1.9 0.6 2.4 2.3
Current account balance -0.5 -1.0 -1.2 -1.4
% of GDP -1.1 -2.2 -2.4 -2.7
FDI 2.4 2.5 2.5 2.5
FX reserves 7.7 10.5 11.6 13.0
UYU/USD 19.9 20.0 21.0 22.0
Debt Indicators (% of GDP)
Government debt 41.4 44.0 43.0 42.0
Domestic 7.5 10.1 9.9 9.7
External 33.9 33.9 33.1 32.3
Total external debt 35.5 32.6 31.7 30.8
in USDbn 14.6 15.1 15.6 16.1
Short-term (% of total) 5.3 5.0 5.0 5.0
General
Unemployment (%) 6.9 6.0 5.9 5.7
Financial Markets (eop) Current 3M 6M 12M
Overnight rate (%) 8.0 8.0 8.0 8.0
3-month rate (%) 4.5 5.0 5.0 5.0
UYU/USD 19.8 20.0 20.5 21.0
Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 106 Deutsche Bank Securities Inc.
Venezuela B2 (stable)/B+ (stable)/B+ (stable) Moodys/S&P/Fitch
Economic Outlook: Economic activity is picking up
speed, following the contraction of the past two
years and beating expectations. The recovery should
continue next year on the back of very expansive
fiscal and monetary policies, ahead of the presidential
elections. Inflation remains the highest across the EM
universe.
Main Risks: Lower oil prices as a result of softer
global growth or a financial disruption in Europe.
Further acceleration in inflation because of food
prices and/or pressures from very loose fiscal policy.
Volatility of political origin before next year’s
presidential elections.
Strategy Recommendations: Increase to a small
overweight, favoring the Republic over PDVSA. On
Venezuela, 28s look the most attractive. On PDVSA,
we continue to favor the 13s (for carry-oriented
investors) but also consider moving to the mid-end of
the curve where we favor the 22s. In addition, while
we continue to recommend long basis on the
sovereign curve (24s vs. 10Y being the best trade at
the moment), we also like PDVSA 22s vs. Venezuela
10Y CDS.
Macro View
GDP growth well above expectations
GDP expanded by 4.2% yoy during 3Q11, surpassing
expectations of a 3.1% increases according to
Bloomberg’s survey. Earlier on, President Hugo Chavez
had hinted that the economy grew by 3.5% during the
period, but the actual number was even stronger than his
initial estimate. Thus, GDP has risen by 3.8% during the
first nine months of the year (0.2% for the oil sector and
4.1% for the non-oil economy), and it is now on track to
expand by about 4% during 2011 – well above
expectations. Financial services led the increases with a
15% increase, while the construction sector jumped by
10%. The communications sector increased by 7.9% and
mining by 7.6%. The oil economy expanded by 0.3%
during the quarter, a small contribution in spite of the very
high crude prices, which according to Finance Minister
Jorge Giordani is due to the compliance with the OPEC
quotas. Giordani added that the government will target
5% GDP growth in 2012, something that we see as a very
tall order, especially considering that global growth will be
weak and that 2011 figures will represent a higher
comparison point, making fast growth more difficult to
achieve. As the administration will face a crucial
presidential election, however, chances are that fiscal and
monetary policy will take on a very expansive stance,
preventing economic activity from decelerating much. It
remains to be seen, however, whether that policy impulse
will be sustainable over time, especially in the absence of
changes to the policy mix that could provide further
stimulus to the demand for investment.
Venezuela: GDP growth is picking up (% yoy)
-8
-6
-4
-2
0
2
4
6
8
10
12
Source: BCV, Deutsche Bank
Highest inflation across EM
As of the end of October, annual inflation as measured by
the national index was running at 26.8%, while the old
Caracas index showed a 27.7% increase, posting the fifth
consecutive month of increases. Inflation has not been
below the 23% mark since December 2007. The
government established an informal target of 22% to 24%
for the current year, which will likely be surpassed,
especially considering that there could be additional
adjustments to regulated prices while public spending
continues to grow at a fast pace. Core inflation was
running at 27.7% as of October, i.e. head to head with the
general index, which suggests that inflationary pressures
are broad based and will probably be persistent rather
than temporary. For next year, we expect inflation to
remain very high, fueled by very loose fiscal and monetary
policies, combined with an uncertain supply reaction given
the recent implementation of the new price and cost
control norms. Year to date, M2 increased by 41%, even
surpassing inflation, and we expect the rapid rise in
liquidity to continue at least until the November elections.
The bank credit portfolio, in turn, rose by 35%. According
to the Superintendency of Banks, however, the non
performing remains very low at 1.8% of total.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 107
Venezuela: Inflation rates (% yoy)
0
10
20
30
40
50
60
Jan-0
6
Jun-0
6
Nov-0
6
Apr-
07
Sep-0
7
Feb-0
8
Jul-08
Dec-0
8
May-0
9
Oct-
09
Mar-
10
Aug-1
0
Jan-1
1
Jun-1
1
CPI Food
Source: Bloomberg News, Deutsche Bank
New price and cost controls law enacted
A new law that regulates prices across the board became
effective last month, allowing the government to establish
caps on prices of some 15,000 goods and services. A
small group of personal hygiene products had their prices
frozen effective immediately, and going forward all firms
will have to report their cost structure to the authorities in
order for ‚fair‛ prices to be calculated by the government.
Companies will also have to provide information about
their domestic and foreign suppliers, as well as
technological transfers that affect costs. The norm does
not establish any methodology to determine when profits
are ‚excessive‛, although Commerce Minister Edmee
Betancourt hinted that 10% would be a ‚reasonable‛
figure. Official inspectors will work inside firms to monitor
production and cost. Thus, it has become evident that
President Chavez is to toughen his rhetoric against the
corporate world. Before announcing the new law, he
accused local firms of ‚behaving like big monopolies …
that dominate and ransack people‛. Given the high
ongoing inflation rate, the government’s strategy is to
shift its policies towards a stricter control mode to
prevent further price increases ahead of next year’s
election.
The strategy, however, is risky for the chavismo, as the
implementation of a full price control strategy is
logistically difficult, and if the government toughens the
rules in excess for the private sector, shortages will
probably appear, which would take a toll on economic
activity and could backfire and lower popular support for
the administration. Central Bank Director Armando Leon
provided a cautionary note about the law. Leon warned
that exerting control over the 500,000 items traded in the
Venezuelan economy would be ‚absurd‛, and that the
new norm could represent ‚a straitjacket‛ for the
economy. Enforcement of the new regulation would
require some 40,000 inspectors nationwide, he said. Leon
highlighted the challenges such policy entails, as possible
delays in providing permits for companies to produce may
result in supply bottlenecks and eventually in inflationary
pressures – that is, it could backfire.
Oil prices provide ample external support
The very robust prices of the Venezuelan crude mix have
provided ample support for the country’s balance of
payments. During the first 11 months of the year, said
price averaged USD100/barrel, up 42% yoy. According to
our calculations, at current oil prices, Venezuela is to
generate a current account surplus equivalent to some
USD15bn this year, which should result in a notional
increase in international reserves of around USD22bn.
Such increase, however, is not reflected in the reserves
being held by the Central Bank, as the government’s
strategy continues to be the establishment of an
‚optimal‛ reserve level and the transfer of any excess to
other official entities, mainly the Fonden development
fund. During the first nine months of the year, the
government’s exchange bureau Cadivi authorized
USD22.9bn worth of imports at the official exchange rate
of VEF4.30/USD, a 7.2% yoy increase. The supply of
dollars was completed with what was processed via
Sitme and what provided by the Central Bank. It must be
noted that the implicit parity exchange rate that results
from the ration between M2 and reserves was over
VEF14/USD in November.
Venezuela: Nominal and real exchange rates
70
75
80
85
90
95
100
105
110
4.0
4.2
4.4
4.6
4.8
5.0
5.2
5.4
5.6
5.8
6.0
Official rate Sitme rate Real exchange rate (2000=100), rhs
Source: IIF, Deutsche Bank
New PDVSA issue
State owned oil Company PDVSA announced the issuance
of USD2.394bn worth of dollar denominated bonds
maturing on November 17, 2021. The bonds will pay a 9%
semi-annual coupon and will be amortized in three equal
installments on November 2019, November 2020 and
November 2021. The securities are not registered in the
US and are being offered outside the US only. The
6 December 2011 EM Monthly
Page 108 Deutsche Bank Securities Inc.
company reported that USD1.256bn will be exchanged for
the PDVSA bonds due 2013 currently being held by the
Central Bank. In addition, USD564m of the new bonds will
be placed directly with the Central Bank. The remaining
USD574m should in principle be sold to the market, but
the company did not provide any other specifics about the
transaction. The proceeds of the bond sale are to be used
for ‚general corporate purposes and for contributions to
social projects and programs‛. A few weeks ago, Energy
Minister and PDVSA head Rafael Ramirez had denied that
the company would issue new debt this year, but it could
well be the case that he was referring to issuance to the
market. Before the company’s announcement, there had
been market talk about PDVSA tapping the dollar market
with some USD3bn issue, so that the smaller amount,
coupled with the fact that a large portion of the securities
will be sold directly to the Central Bank, and then leak to
the market more gradually, provided some relief.
Cemex reaches accord with Venezuelan
government The Venezuelan government reached an agreement with
Mexican cement company Cemex to compensate the firm
for the nationalization of its assets in the country. The
local media reported that Cemex initially valued its
Venezuelan assets at USD1.3bn, but the accord was for
USD600m, of which USD240m will be paid immediately
and the rest in four USD90m installments in the form of
PDVSA securities. In August 2008, the government had
seized the three plants of the company in Venezuela, and
both parties were in the process of arbitration with the
World Bank’s ICSID since 2009. Cemex reported that the
agreement was subscribed by its subsidiaries in the
Netherlands and the Socialist Cement Corporation, which
represented the Venezuelan government. Since 2008, the
cement industry is under full government control. It is not
clear whether the agreement with Cemex represents a
blueprint for other agreements with companies currently
in arbitration with the Venezuelan government. If so,
future agreements could represent a marked increase in
PDVSA liabilities.
Electoral campaigns heating up
Last month, the leading opposition politicians held their
first televised debate ahead of February 2012’s primary
election to choose a coalition candidate to run against the
chavismo. The candidates were Miranda Governor
Henrique Capriles Radonski, currently at the top of the
opposition polls, former Chacao Mayor Leopoldo Lopez,
Zulia Governor Pablo Perez, former Caracas Mayor Diego
Arria and independent legislator Maria Corina Machado.
Polls conducted by the local media immediately after the
debate showed that Machado and Arria had the strongest
performances in the debate, although the event did not
feature any substantial crossfire among the candidates,
who instead wanted to convey a message of unity and
need for regime change. The debate was praised by the
local media as a successful democratic event in which the
opposition rallied around the ideas of the need for
institutional change, the fight against corruption, the
improvement of security and education, and the need to
reduce poverty.
The debate appears to have prompted multiple reactions
within the ruling chavista coalition. First, President Chavez
criticized the opposition leaders as elitist and hinted that
he may decide ‚to stay in office for much longer, until
2041‛. Later on, former education minister and chavista
coalition leader Aristobulo Isturiz announced a new
nationwide political strategy in support of Chavez
reelection. The coalition plans to create so called
‚vanguard patrols‛ to drum up support for Chavez,
starting in Caracas, then in Miranda and Aragua, and later
on in the western part of the country. Asturiz said the plan
is to put together, in this first stage, some 1,900 patrols in
Caracas, Miranda, Aragua and Vargas, which would
include 380,000 activists. We indeed expect the
government to implement a more aggressive electoral
campaign since the beginning of 2012, including not only
a very expansive fiscal policy but also targeted criticism at
the opposition candidates with the most robust showings
in the surveys.
The latest poll conducted by Alfredo Keller and Associates
showed that President Chavez’s popular support
recovered from the drop observed in the early part of the
year, reaching 57% versus the 37% of 2Q11, mainly
because of the positive reading of the population about
the Housing Mission and also because of sympathy
reaction prompted by Chavez’ illness. The survey was
conducted during July, August and September among
1,200 Venezuelans nationwide. The poll also shows that
the perception that the main problems of the country have
not been resolved still continues. 85% of the survey
participants believe that security was worsened, while
69% indicated that cost of living has increased, 68% said
drug trafficking has increased, 64% complained about
corruption, and 63% argued that unemployment has risen.
That is, while the poll suggests that Chavez has regained
popular backing, it also highlights that the population
wants policy changes, which leaves the door open for a
good showing of the opposition in the October 2012
elections. In the event that Chavez cannot run for
reelection next year, the poll shows that Vice President
Elias Jaua would be the strongest contender within the
chavismo, with 34% of the preferences, followed by
Barinas Governor (and the President’s brother) Adan
Chavez and Former Interior Minister Nicolas Maduro. On
the opposition front, Capriles and Lopez are at the top of
the preferences, followed by Perez and Machado, with
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 109
Arria trailing by a very large margin. Interestingly,
according this poll Chavez leads all opposition candidates
by at least 17 percentage points when he faces an
atomized opposition, but loses against a coalition
candidate by 51% to 39%.
Fernando Losada, New York, (1) 212 250-3162
Investment Strategy
Credit Markets: Increase to a small overweight.
Venezuela has been one of the best performers in terms
of cash bond total returns and the best performer in terms
of CDS total returns in EM in 2011, thanks in large part to
the hopes of a potential regime change down the road
and high level of carry.
While continued deterioration of the credit quality and
poor technicals due to massive amount of issuance will
undoubtedly continue to constrain spread performance of
Venezuelan assets, we believe market has been
underpricing the probability of a relatively peaceful
transition of power to the opposition at end of 2012. This,
together with attractive valuation and continued high oil
prices, form the main basis for our overweight
recommendation. However, due to potential risk of
political uncertainty, we would keep the size of
overweight relatively small.
The recent PDVSA 21s issuance was done in a less
disruptive fashion than expected. Consequently, PDVSA
has outperformed the sovereign in recent days. At current
levels, we are more in favor of the Sovereign curve,
where 10Y sector continue to offer the best value (24s
being currently the cheapest). Towards the longer end,
the 28s look attractive. We continue to recommend long
basis at the mid section of the curve, now favoring 24s vs.
10Y CDS. We have previously favored the 26s, which
have outperformed and now look expensive to the curve.
On PDVSA, while we continue to favor the 13s for carry-
oriented investors as there is little credit risk before the
maturity of this bond (the maturity of the 13s have also
been partially financed through the swap with the Central
bank in the issuance of the 21s), we would also
considering moving out to longer end of the curve where
we find the 22s attractive. Finally, we recommend PDVSA
22s vs. Venezuela 10Y CDS (notional ratio 1 x 0.85) at the
par-equivalent basis of almost -600bp, with excellent carry
of 47bp in 3M breakeven.
Hongtao Jiang, New York, (1) 212 250-2524
Venezuela: Deutsche Bank Forecasts 2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 328 436 522 597
Population (mn) 29 30 31 31
GDP per capita (USD) 11,312 14,640 17,103 19,573
Real GDP (YoY%) -1.4 3.9 4.0 3.0
Priv. consumption -1.7 3.5 3.5 3.0
Gov't consumption 1.0 6.0 6.5 4.0
Investment -6.0 1.0 1.0 1.0
Exports -12.4 13.0 8.0 6.0
Imports -4.6 10.0 11.0 6.0
Prices, Money and Banking
CPI (Dec YoY%) 27.2 28.0 27.0 25.0
Broad Money 26.0 46.0 40.0 18.0
Credit 18.0 35.0 30.0 10.0
Fiscal Accounts (% of GDP)
Consolidated budget balance -1.9 -2.4 -3.7 -3.2
Interest payments 2.6 3.0 3.2 3.3
Primary Balance 0.7 0.6 -0.5 0.1
External Accounts (USD bn)
Exports 65.8 94.0 85.0 85.0
Imports 38.6 45.0 58.0 55.0
Trade balance 27.2 49.0 27.0 30.0
% of GDP 8.3 11.2 5.2 5.0
Current account balance 15.0 30.0 13.0 14.0
% of GDP 4.6 6.9 2.5 2.3
FDI -2.0 2.0 0.0 0.0
FX reserves 30.3 30.0 30.0 30.0
VEF/USD (eop) 4.30 4.30 5.20 6.50
Debt Indicators (% of GDP)
Government debt 34.5 35.8 36.8 40.0
Domestic 11.0 14.6 16.5 18.0
External 23.5 21.2 20.3 22.0
Total external debt 25.9 23.2 21.7 20.1
in USDbn 84.9 101.0 113.0 120.0
Short-term (% of total) 22.0 22.0 22.0 22.0
General
Industrial production (YoY%) 25.5 30.0 30.0 10.0
Unemployment (%) 8.5 8.3 8.0 8.1
Financial Markets (end
period)
Current 3M 6M 12M
Overnight rate (%) 0.2 2.0 8.0 12.0
3-month rate (%) 14.5 15.0 15.5 17.0
VEB/USD 4.30 4.30 4.30 5.20 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 110 Deutsche Bank Securities Inc.
Czech Republic A1(stable)/AA-(stable)/A+(pos) Moody’s/S&P/Fitch
Economic Outlook: The combination of a weak
labour market, ongoing fiscal austerity and an
expected recession in Euroland leaves a significant
risk of recession in Czech Republic. But with the
public debt/GDP ratio sub 40% and C/A deficit
financing the most secure in the region, the medium-
term fundamentals remain strong.
Main Risks: Germany is by far Czech Republic’s
largest export partner accounting for 22% of GDP in
exports. A more protracted recession in Germany
leaves significant downside risk for the Czech
economy and could well push the CNB into a rate cut.
Strategy Recommendations: 2s10s IRS set to
steepen.Neutral on rates. Neutral on EUR/CZK
Macro View An imported recession in 2012. As the most open
economy in EMEA alongside Hungary, Czech Republic
faces a very difficult 2012. Growth stalled in Q3 in what
was the worst growth performance in CEE, and with little
room for fiscal or monetary stimulus and a deteriorating
growth outlook in Euroland the next several quarters are
also likely to report zero or negative growth. The currency
has also come under pressure from the stress in
European financial markets and the plans for a sovereign
Eurobond in H2 2011 did not materialize. But despite the
immediate spillover from European woes the
fundamentals of the Czech economy remain the most
solid in the region. Needed fiscal adjustment and debt
reduction is much less than elsewhere and the structure
of C/A financing the most secure. The medium-term
outlook remains robust.
The zero QoQ and 1.5% YoY reading (sa-wda basis) for
Q3 GDP compares with a consensus expectation of 0.2%
QoQ and 1.6% YoY and a CNB forecast of 1.7% YoY. It is
also disappointing given the only 0.1% QoQ reading in
Q2. Although full components are not yet released the
CZSO press release from the flash estimate noted that a
slowdown in domestic demand was compensated by
positive developments in external demand with net trade
remaining as the only component reporting positive
growth. We expect that some of the underperformance in
Q3 GDP versus the 0.5% QoQ reading for Hungary and
1.9% QoQ reading for Romania is due to the temporary
boost from agriculture which benefitted these economies
due to the larger agriculture sectors in these countries.
The level of the PMI remained the highest in CE3, trade
momentum held up better than elsewhere, albeit much
reduced from Q2, and households were not impacted by
a strong Swiss franc through the quarter. It is also the
case that direct banking sector linkages with the most
stressed European countries are smaller than in Hungary
or Poland and the sector-wide LTD ratio is at a
comfortable 80% so pressure on financing should also
have been much less.
The stalling in growth through Q3 came with a declining,
but still expansionary, PMI with a 53.0 average for Q3.
Nevertheless, this was a 3.7 point drop from Q2 and the
largest quarterly decline since Q1 2009 when the
economy reported its largest quarterly GDP contraction on
record (-3.6% QoQ). A decline in new orders was by far
the largest contributor to the drop in the PMI through Q3
with declines in output, inventories and employment
being much smaller factors during recent months. The
trend continued in the October and November PMI
readings and pushed the November PMI to a 27-month
low of 48.6 and the first sub 50 reading since October
2009. On the domestic demand side the worst quarterly
reading on retail sales since Q1 2010 combined with a
drop back in the pace of credit extension versus earlier in
the year will both have added to the negative domestic
demand contribution through the quarter. Confidence has
also continued to decline with consumer confidence now
back close to the Q1 2009 lows.
Czech Republic: Consumer confidence has dropped
back close to the Q1 2009 lows
-35
-30
-25
-20
-15
-10
-5
0
5
10
-40
-30
-20
-10
0
10
20
30
Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11
Industrial
confidenceConsumer
confidence (rhs)
% balance (seasonally adjusted)
Source: Haver Analytics, DB Global Markets Research
The January 2012 hike in the preferential VAT rate from
10% to 14% and ongoing fiscal consolidation efforts in an
attempt to achieve a sub 3% fiscal deficit by 2013 point to
further weakness in domestic demand for 2012.
Combined with our expectation of three quarters of
negative growth in Euroland (with our 2012 Euroland GDP
growth forecasts recently revised down to -0.5% from
+0.4% previously) we have now revised down our 2012
GDP forecasts for Czech Republic and also nudged down
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 111
2011 estimates due to the recent poor performance. We
now expect 2011 GDP growth at 1.8% (from 2.0%
previously) with a positive carryover and enough
momentum through H1 to produce a reasonable growth
reading despite a poor H2. For 2012 we now expect GDP
growth of zero (and therefore in line with our forecast for
Germany) versus 1.6% in our earlier forecasts with the
contribution to growth from external trade now much
reduced and most of the growth coming in the second
half of the year. The latest CNB forecast stands at 1.2%
and Ministry of Finance projection at 1.0%. Our revised
forecasts still see Czech Republic returning to pre-crisis
levels of output in 2012 but now in H2 (as of Q3 2011
output remained 0.6% below the peak compared with
5.3% in Hungary and 5.8% in Romania). Our baseline is
for a shallow recession through the first half of 2012 with
the risks to our forecasts remaining skewed to the
downside.
One complicating factor for our growth projections is the
upcoming release of the revised quarterly national
accounts data back to 1995. The annual revisions were
released in September and saw the level of nominal GDP
raised by around 4% relative to earlier estimates and 2010
real GDP growth revised up to 2.7% from 2.2%
previously. Depending on how the quarterly profile is
distributed this could push up our 2011 and 2012 growth
projections. Nevertheless, given the weak backdrop the
risks still remain skewed to the downside.
Fiscal deficit is narrowing slowly. The Finance Ministry
has recently revised down its 2012 GDP growth
assumption to 1.0% from 2.3% in its May Fiscal Outlook.
The earlier plans for a maximum 3.5% of GDP deficit in
2012 and 2.9% in 2013 have however been retained with
lower revenue estimates being offset by revisions to
spending plans (the point forecast is for a 3.2% fiscal
deficit forecast for 2012). With the lower growth outlook,
the planned narrowing in the headline deficit requires an
average 0.7pp improvement in the structural position in
each of the next several years to achieve the targeted
medium-term structural deficit of less than 1% of GDP.
The 2012 fiscal adjustment switches to the revenue side
after the spending side measures of 2011 which included
a 10% reduction in the public sector wage bill,
reduction/cancellation of benefits and reduction in current
and investment spending. 2012 will see a rise in the
preferential VAT rate from 10% to 14% (expected to
result in increased revenues of CZK27bn) with revenues
intended to plug the gap created by the establishing of a
second pillar pension system as of 2013. YTD
performance looks broadly on track with data through
November showing the state deficit at 93.2% of the
CZK135bn full-year target. This is however worse than the
86% in November 2010 and therefore leaves less of a
buffer going into year end. On the wider general
government deficit the government has initially targeted a
4.6% of GDP deficit for 2011 but has suggested this could
be as low as 3.7%. Assuming no overshoot on the state
budget this would still need a material improvement in the
local government budget to be realistic. We do not expect
the deficit targets to be achieved but nevertheless see
slow, steady consolidation.
Czech Republic: The EC expects only a small
improvement in the deficit in 2012
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
2007 2008 2009 2010 2011F 2012F
Autumn 2011
Sprine 2011
Headline budget balance (% GDP)
Source: European Commission
The Ministry of Finance has yet to release its Debt
Management Outlook for 2012 but the Finance Minister
has said the gross borrowing requirement would be
around CZK226bn (5.7% of GDP) and therefore up from
the CZK219.5bn for 2011 (and based on the planned
CZK105bn state budget deficit). Czech Republic does not
face any sovereign Eurobond redemptions in 2012 but we
expect the authorities will issue the Eurobond announced
for H2 2011 with the remainder of the financing from
domestic issuance.
C/A financing likely to remain comfortable. We do not
expect much change in the C/A dynamics in 2012 with the
income outflows from the high presence of foreign-
owned companies continuing to offset the trade surplus.
While we have modified our export assumption the very
high correlation between export and import growth in
Czech Republic (reflecting the high import content of
exports) points to a largely neutral impact on the trade
balance from a drop back in export demand. The C/A
deficit stands at an annualized 3.8% of GDP through
September with the trade surplus at 4.0% of GDP and the
deficit on the income line at 11.1% of GDP. A weaker
macro environment will likely reduce corporate profitability
and dividend outflows and potentially reduce the headline
C/A deficit. This will be offset by lower reinvested
earnings on the capital account (the main financing item of
6 December 2011 EM Monthly
Page 112 Deutsche Bank Securities Inc.
the Czech C/A) and leave a stable structure of C/A
financing.
While the weaker export demand is expected to neutralize
on a BoP basis it is not neutral on economic growth. The
export-oriented manufacturing sector will take a hit from
weaker end demand in Germany which accounts for
32.5% of total exports versus the next largest export
partners which are Slovakia at 8.8%, Poland at 6.3%,
France at 5.4% and the UK at 4.8%. As a share of GDP
exports to Euroland are the highest in CEE at 43.5% with
exports to Germany accounting for 22.3% of GDP. Our
chart below shows export ratio across CEE and Hungary
is the highest in the region but with a lower share to
Euroland (and Germany) than in Czech Republic.
Czech Republic: Exports to Euroland are around 43%
of GDP (versus 39.5% of GDP for Hungary)
0
10
20
30
40
50
60
70
80
HUF CZK LTL BGN LVL PLN RON
US
Rest of the world
Japan
Euroland
% GDP
Source: Haver Analytics, DB Global Markets Research
Policy rate likely to remain unchanged until 2013. In
line with the deteriorating domestic and external backdrop
the Czech National Bank (CNB) has sounded increasingly
dovish in recent policy meetings. Vice Governor Tomsik
voted for a 25bps rate cut to 0.5% at the November 3rd
CNB Board meeting and the previously more hawkish
Board members (Zamrazilova and Janacek) have recently
voted to leave rates unchanged. Governor Singer had said
even before the November ECB rate cut that CNB rates
could go down, as well as up, from there but we view rate
cuts as unlikely in practice. October inflation was reported
at a higher-than-expected 2.3% YoY versus a 2.1% CNB
forecasts and a 2% target. The CZK-denominated CRB
food index reported an average monthly increase of 1.0%
through July-September after an average decline of -0.9%
from March-June and given the lags through to headline
CPI there could be more bad news in the pipeline
particularly given a ~5% depreciation in the currency since
August. The CPI outlook is dominated by that January VAT
hike and will push up CPI to outside the 2% +/-1pp buffer.
While the CNB will probably concentrate on their measure
of monetary-policy-relevant inflation which should remain
close to the 2% target, the VAT hike should still be
enough to rule out any rate cut. That inflation expectations
remain above target on both a one- (2.8%) and three-year
(2.2%) horizon also decreases any change of a rate cut.
With Janacek, Rezabek and Zamrazilova stating their
preference for stable rates it is also unlikely that Tomsik
could gather enough support to push through a rate cut.
Czech Republic: One of the seven CNB Board
members voted for a rate cut in November
Nov-11 Sep-11 Aug-11 Jun-11 May-11 Mar-11
Policy ra te (%) 0.75 0.75 0.75 0.75 0.75 0.75
M. Singer H H H H H H
M. Hampl H H H H H H
V. Tomsik -25 H H H H H
K. Janacek H H +25 +25 +25 -
P. Rezabek H H H H H H
E. Zamrazilova H H +25 +25 +25 +25
L. Lízal H H H H H H Source: CNB
The November PMI points to the possibility of rate cuts
with the CNB reducing the policy rate in the past with the
PMI at a higher level. The difference now is the level of
rates as at 0.75% the CNB rate is at a historic low and it is
debatable whether another cut could stimulate growth.
Czech Republic: PMI points to scope for rate cuts
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
30
35
40
45
50
55
60
65
Nov-03 Nov-05 Nov-07 Nov-09 Nov-11
PMI (lhs)
change in policy rate
Source: Haver Analytics, DB Global Markets Research
As the CNB did not follow the ECB with its summer rate
hikes we do expect they will follow on the way down
either. Our Euroland economists expect the ECB rate back
at 1% by January and to remain there until 2013. This
would take the differential in the policy rates back to the -
25bp of mid 2010 – mid 2011 and with rate cuts from the
CNB unlikely we expect the differential will remain at -
25bps. Despite this negative interest rate differential the
solid medium-term fundamentals including a stronger
public sector balance sheet than elsewhere in CEE, an
absence of near-term downward pressure on the
sovereign rating and less concern over deleveraging from
foreign parent banks given the 80% LTD ratio and the
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 113
banking systems status as a net external creditor, our bias
remains for medium-term appreciation of the koruna.
Caroline Grady, London, (44) 207 545 9913
Investment Strategy
FX: Over the medium term, CZK is supported by relatively
sound fundamentals, a credible central bank and the fact
that real income convergence is well ahead of price
convergence (vs Germany). Given CNB's strong focus and
historical track record of controlling inflation, over the
longer term price convergence will continue to primarily
take place through a stronger koruna (and not through
higher inflation). The shorter term outlook is less
favourable. The short point is that the koruna lacks
meaningful catalysts and impetus to rally in the near term.
Given its location (next to the Eurozone), the CZK will,
rightly or wrongly, likely continue to be used as a 'cheap'
hedge against Eurozone worries (the market being paid
gamma in considerable size in late summer is telling in
this context). Depressed economic activity, lack of
inflation momentum and fears of a sharp Eurozone
slowdown mean that the CNB have little room to hike the
already low base rate to 0.75%. Remain sidelined for the
short term.
Henrik Gullberg, London, (44) 20 7545 4987
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Neutral on rates The IRS curve has steepened
slightly in the 2s10s part since our recommendation (from
87 to 94bp). The trade was linked to expectations of a
weaker CZK, causing an increase in inflation expectations.
However, we believe this trade has become consensus as
seen from the reduction in foreign holding of CZK bonds
and the build up of long gamma trades in EURCZK. We
prefer to close our trade recommendation, and await
better levels. We expect monetary policy to remain
accommodative throughout 2012, but the rates curve
could remain stable with very little scope for policy rates
to move either to the upside or downside.
Lamine Bougueroua, London, (44) 20 7545 2402
Czech Republic: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 190.4 191.9 151.9 160.6
Population (mn) 10.5 10.5 10.5 10.6
GDP per capita (USD) 18187 18266 14423 15214
Real GDP (%) -4.0 2.2 1.8 0.0
Priv. consumption -0.1 0.1 1.2 1.0
Govt consumption 2.6 -0.1 -1.3 0.2
Investment -15.6 5.4 3.1 1.5
Exports -11.4 17.8 6.4 5.1
Imports -10.5 17.6 5.8 5.8
Prices, Money and Banking (eop)
CPI (YoY%) 1.0 2.3 2.0 3.3
Broad money (M2) 4.2 3.3 4.4 5.6
Fiscal Accounts (% of GDP)
Consolidated budget balance -5.9 -4.8 -4.3 -3.8
Revenue 40.1 40.5 40.6 41.1
Spending 46.0 45.3 44.9 44.9
External Accounts (USDbn)
Exports 98.4 118.0 134.9 137.7
Imports 93.8 115.2 130.7 133.8
Trade balance 4.6 2.8 4.2 3.9
% of GDP 2.4 1.5 2.7 2.4
Current account balance -4.8 -6.2 -6.0 -6.0
% of GDP -2.5 -3.3 -4.0 -3.7
FDI (net) 1.9 5.1 3.5 3.9
FX reserves (USDbn) 37.7 38.0 34.2 35.7
CZK/USD (eop) 18.5 18.7 19.2 17.8
CZK/EUR (eop) 26.4 25.0 25.0 24.0
Debt Indicators (% of GDP)
Government debt 34.4 37.6 40.9 43.2
Domestic 23.9 24.7 27.4 29.2
External 10.5 12.9 13.5 14.0
Total external debt 46.9 49.7 64.5 62.3
in USD bn 89.2 95.4 98.0 100.1
General (% pavg)
Industrial production (% YoY) -14.6 10.2 6.2 3.5
Unemployment 8.1 9.0 8.6 8.6
Financial Markets (end
period)
Current 3M 6M 12M
CNB policy rate (%) 0.75 0.75 0.75 0.75
CZK/EUR 25.3 24.8 24.5 24.0
CZK/USD 18.8 19.0 19.6 17.8
Source: Haver Analytics, CEIC, DB Global Markets Research
6 December 2011 EM Monthly
Page 114 Deutsche Bank Securities Inc.
Egypt B1 (negative)/B+ (negative)/BB (negative) Moody’s / S&P / Fitch
Economic Outlook: The economy is likely to gain
strength in FY2011/12 with political transition, base
effects and greater access to external financing.
Main Risks: Occasional setbacks in political progress
and delay in implementation of a comprehensive
economic plan in coordination with and funding from
multi-lateral institutions could lead to a much weaker
growth performance.
Strategy Recommendations: Neutral EGP. Political
stability and resumption of talks with IMF will hold
the key.
Macro View
The revolutionary spirit is back and elections are
underway…
The revolutionary spirit has rejuvenated as again
reformists have gathered at and remained in Cairo’s Tahrir
square in thousands for several days pushing for
continued ‚change‛ demanding more democracy and
less military. While this could ultimately lead to more progress towards a more democratic regime, it has
resulted in bloodshed as the military regime cracked down
on the protestors with very little in the way of
concessions. The Supreme Council of the Armed Forces
(SCAF) accepted the resignation of the cabinet, promised
to speed up the presidential election (to mid 2012 versus
the widely anticipated year-end previously) and indicated
their reluctance to govern once the electoral cycle is
completed. Neither the promises nor the appointment of
yet another elderly political veteran, Kamal Ganzouri, who
served under Mubarak as PM for three years, as PM to
form a national salvation government prevented the
reformists from continuing with their demonstrations.
The SCAF committed to holding parliamentary elections
as originally scheduled and the process went relatively
smoothly in the first leg on November 28-29 with almost
no violence and strong voter participation expected to be
above 70%.
…but the reformists still have major concerns
And yet it seems, and as local and international media
report, the reformists are not as keen on parliamentary
elections being held on time as they are on ensuring free
elections and adopting of a fully democratic constitution
stripping the military of any supra-national powers.
Following a number of changes in the interim government
and occasional tension between the SCAF and the
reformists, the pace of political progress seemed to have
slowed down since March or so with the former
becoming more retrograde. The SCAF took a number of
steps that could allow the Moslem Brotherhood and the
remnants of the old regime to dominate the political
scene going forward (particularly the minimalist approach
to changing the electoral law – see below), alienating the
liberals. In the summer the SCAF did accept the liberal’s
proposal of a preliminary blueprint of basic rights and
principals and yet it added clauses giving it a permanent
political role.
The SCAF has refused to step down and cede power to a
civilian government as some reformists have demanded
and the police have responded to unrest with force as
over forty people have died. The events of the past couple
of weeks seem to be a replay of that several months ago
before the ousting of President Mubarak and yet we
understand that the opinion on the ground may be split
with some groups against protests viewed as being
destructive during the elections. The SCAF indicated that
it would be willing to let a national referendum decide on
whether the military regime should continue to lead the
political transition or not.
The economy is under greater pressure…
Political instability resulted in intense pressure on the
EGP, which fell to its weakest point against the USD in six
years. This and the downgrading of the sovereign to B+
by S&P while maintaining a negative outlook prompted
the CBE to hike its policy rate by 100bps (the overnight
deposit rate to 9.25% from 8.25%) to shore up
confidence. The CBE’s international reserves (inclusive of
FX deposits at commercial banks) have more than halved
since the start of the year to $20bn leading to a
significantly weaker reserve coverage of external
obligations (a SCAF official indicated that reserves may
decline to $15bn by end-January due to external
obligations). Talks with the IMF for a program have been
Egypt: Interest rate corridor and nominal exchange
rate
6.0
7.0
8.0
9.0
10.0
11.0
12.0
13.0
14.0
Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
6
6.1Deposit Rate (lhs)
Lending Rate (lhs)
EGP/USD (rhs)
%
Source: Haver Analytics and Deutsche Bank Global Markets Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 115
on and off, and only a fraction of the bilateral funds
previously pledged by some Arab nations (mainly Saudi
Arabia) has been received. External and budgetary
financing are the two fundamental pressure points for the
economy going forward and restoring growth will be
difficult in the absence of financial assistance in the
months ahead, particularly with continued weakness in
revenues from tourism and FDI, and limited non-resident
interest in EGP assets. Continued instability may also
weigh in on confidence of locals and escalation of
violence could have negative implications for growth in
the same manner it did in the period preceding the
military takeover early this year when the economy was
brought to a standstill would widespread supply
bottlenecks.
…the expected broad coalition government may have
difficulty in delivering reforms
Parliamentary elections started on November 28 in 9
provinces and the process will be finalized by early-
January with voting for the remaining states scheduled for
mid-December and early January. The parliamentary
elections are a relatively complex process. For the 498
seats in the Parliament, one-third of the candidates will be
elected based on a single district scheme (voters select
candidates with no party affiliation who must win a simple
majority to be elected) and two-thirds will be elected
according to proportional representation (voters pick
among party candidates and each party gains seats in
proportion to its share of votes). The former scheme
favors local strongholds of the Mubarak era and for the
latter the competition will be fierce with several parties
entering the race. And yet the system overall seems to
favor well-entrenched larger parties with well-established
networks across the country while marginalizing the
relatively new and small parties that have yet to have the
opportunity and the time to organize nationwide.
While the results are difficult to project as there is no
precedent or polls, the newly adopted system is unlikely
to yield a single-party majority government in the
upcoming elections. And yet the Moslem Brotherhood
(MB) is widely expected to win the largest number of
seats with the remnants of the old regime, the reformist
bloc and the old Wasd party being represented leading to
a rather fragmented parliament. This is expected to result
in the formation of a broad national unity coalition
government, which may not be so effective for
policymaking going forward. We reiterate our view that
Egypt is fundamentally different and there is much to
cheer about with public opinion now being important in
political decisions. And yet progress is likely to be slow
next year with a fragmented parliament, the preparation of
a new constitution and the presidential election now set
for mid-2012 (could be delayed in our opinion given that
formation of the government is likely to take us well into
the first half of the year).
The post election period may see rising tensions between
the SCAF and MB. There are a number of contentious
issues including the MB’s opposition to the military's
desire to prevent civilian oversight of the military budget.
Additionally splits in the MB and the conservative camp in
general may not be a surprise as there are several groups
with varying views on Islamic rule, and how it should
written into the constitution. The reformists and the
revolutionaries are also likely to be unsatisfied with the
election results, the continued strong presence of the
military and slow progress towards a free and democratic
state. Weakness in the economy in our opinion requires
external assistance and the implementation of a cohesive
economic plan in coordination with multi-lateral
institutions. Otherwise political backlash is likely and the
government must be able to prioritize politically painful
economic reforms, which may be a difficult task given its
likely fragmented make up.
Cem Akyurek, Istanbul, (90) 212 317 0138
Egypt: FX reserves
0
5
10
15
20
25
30
35
40
45
50
Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11
CBT deposits at
banks
CBT Official reserves
Source: Haver Analytics and Deutsche Bank Global Markets Research
Egypt: Non-resident T-bill holdings
Non-resident's share in outstabding T-bills
0
5
10
15
20
25
Jan-10 Jul-10 Jan-11 Jul-11
%
Source: Haver Analytics and Deutsche Bank Global Markets Research
6 December 2011 EM Monthly
Page 116 Deutsche Bank Securities Inc.
Investment Strategy
FX: Neutral on USD/EGP. Political stability will hold the
key to much of EGP's fate over the course of the next
year. The complex electoral system means it may be
difficult to predict the precise breakdown of parliament
until the end of staggered voting on January 11. Even if
the current elections (at the time of writing) proceed
smoothly, maintaining order and democracy will be key
for the country and the currency. Political instability will
also have implications for Egypt's sovereign rating - as
S&P downgraded Egypt's rating by one notch last week.
The domestic economy has also struggled - the budget
deficit has been widening, and foreign reserves have
continued to drop into November. Any resumption of talks
with the IMF for a $3bn loan would be a clear positive for
capital flows, and therefore for the pound.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Egypt: Deutsche Bank Forecasts
2008/09 2009/10 2010/11F 2011/12F
National Income
Nominal GDP (USD bn) 188.6 218.4 236.1 254.3
Population (mn) 76.8 78.6 80.5 82.3
GDP per capita (USD) 2456 2779 2933 3090
Real GDP (YoY%) 4.7 5.1 1.8 3.0
Priv. consumption 4.5 5.2 4.8 3.4
Gov't consumption 8.4 4.5 3.8 2.2
Gross capital formation -9.1 6.5 -3.9 7.6
Exports -12.8 -1.9 3.7 1.2
Imports -17.7 -1.7 7.5 4.9
Prices, Money and Banking
CPI (YoY%) 9.9 10.1 8.94 9.0
Broad money (M2Y) (YoY%) 8.4 10.4 10 12
Bank credit (YoY%) 5.1 8.2 3..0 15
Fiscal Accounts (% of GDP)
Consolidated budget balance -6.9 -8.1 -9.5 -9.0
Interest Payments 4.4 5.4 5.2 5.5
Primary balance -1.8 -2.7 -4.3 -3.5
External Accounts (USD bn)
Merchandise exports 25.2 23.9 23.4 24.4
Merchandise imports 50.3 49.0 51 52.0
Trade balance -25.2 -25.1 -27.6 -27.7
% of GDP -13.3 -11.5 -11.2 -10.5
Current account balance -4.4 -4.3 6.5 -4.5
% of GDP -2.3 -2.0 -2.6 -1.7
FDI (net) 6.8 5.8 6 10.0
FX reserves (USD bn) 29.5 33.5 22.5 38.0
FX rate (eop) EGP/USD 5.59 5.70 5.95 6.20
Debt Indicators (% of GDP)
Government debt 81.1 79.4 86 88.0
Domestic 67.4 67.4 76 76.0
External 13.7 12.0 10 12.0
Total external debt 16.7 15.4 13.7 14.9
In USD bn 31.5 33.7 34 36.0
Short-term (% of total) 6.7 12.1 6.7 6.7
General (YoY %)
Industrial production -2.0 5.0 0 7.0
Unemployment 9.4 9.4 10.5 8.1
Financial Markets (end)
period)
Current 3M 6M 12M
CBE deposit rate 8.25 8.25 8.25 9.25
CBE lending rate 10.25 10.25 10.25 10.25
EGP/USD 6.01 6.20 6.30 6.20
EGP/EUR 8.20 8.40 8.40 8.68 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 117
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6 December 2011 EM Monthly
Page 118 Deutsche Bank Securities Inc.
Hungary Ba1(neg)/BBB-(neg)/BBB-(neg) Moodys/S&P/Fitch
Economic Outlook: We expect Hungary to tip back
into recession in 2012. Fiscal drag is set to increase
in line with the government’s commitment to stick to
a 2.5% of GDP fiscal deficit while rate hikes, FX
weakness and rising deleveraging will all severely
constrain growth for some time ahead. With the
expected recession in Euroland net trade will be
unable to offset the negative domestic environment.
Main Risks: Likely policy conflicts between the
authorities and the IMF/EU risks prolonged program
negotiations which could mean continued pressure
on the currency, a larger hiking cycle and further
rating downgrades. It could also mean a very difficult
backdrop to meet external refinancing needs.
Strategy Recommendations: NBH to provide ceiling
in EUR/HUF. Sell vega neutral 3m/6m straddles in
EURHUF. Underweight sovereign credit.
Macro View
Recession now unavoidable. Hungary’s November U-
turn to request a precautionary assistance package from
the IMF/EU reflects the exceptionally fragile macro
outlook. Moody’s has now downgraded the sovereign to
sub investment grade and S&P/Fitch could well follow in
Q1 if the negotiations with the IMF/EU prove problematic.
The policy stance is not supportive of growth with the
NBH recently embarking on a hiking cycle despite the high
probability of a recession and the government’s
commitment to a 2.5% fiscal deficit target for next year
implying a now much tighter structural position than
originally expected. Accelerated deleveraging also leaves
a substantial downside risk to the growth outlook.
The higher-than-expected 0.5% QoQ and 1.4% YoY Q3
GDP reading was a rare piece of good news in Hungary.
Q2 GDP was also revised upwards to 0.2% QoQ from an
earlier reported zero reading and Q1 was revised up to
0.5% QoQ from 0.3% (which was previously revised
down from an initial 0.7% reading). KSH have yet to
publish the full components but said that the Q3
performance was mainly due to agriculture and industrial
exports. The bumper summer harvest is likely to be only a
temporary boost to growth however and it is very unlikely
that the 0.5% QoQ reading will be repeated in the coming
quarters. Domestic demand growth is likely to turn
negative from Q4 during an acceleration in deleveraging
following the September announcement of the
discounted early repayment option on mortgages and
protracted currency weakness through Q4 pushing
monthly mortgage repayments higher. A January VAT hike
and further benefit cuts will start to impact growth from
Q1. Any boost to growth from external demand is also
likely to be much reduced from earlier in 2011 given our
expectation of recession in Euroland from Q4. September
trade momentum showed some pick up (the 0.8%
reading for exports on a 3m/3m basis was the first
positive reading since May) after a very weak summer but
it is unlikely that this will be sustained. Latest data on new
orders show a modest improvement after the negative
readings during the summer but we the trend remains
downward. The combination of a high growth beta with
Euroland and deteriorating domestic conditions point
firmly to a Hungarian recession in 2012.
Hungary: Growth beta with Euroland is very high
y = 1.5593x + 3.6383
R² = 0.8763
-30
-20
-10
0
10
20
-27 -18 -9 0 9
Hungary
IP
(S
A, %
YoY)
Euroland IP (SA, % YoY)
Source: Haver Analytics, DB Global Markets Research
The extent of the domestic demand contraction next year
will partly depend on the take-up rate on the discounted
early repayment scheme and the resulting losses faced by
the banking sector. Our impression is that the banking
sector currently work with a maximum take-up
expectation of 20% and data released so far put this at
8% between application and repayments. The additional
measures still being discussed between the banking
association and the government could increase this
baseline however as the government has indicated on
various occasions that it would like to see the early
repayment option available to as many households as
possible. The very negative operating environment for
foreign banks in Hungary after the bank levy, pension
system reform, 3-year fix on mortgage payments and the
discounted early repayment scheme also leaves a risk that
foreign parents opt to significantly reduce exposure to
Hungary. There is no evidence of this so far but it leaves
substantial downside risks to our macro projections. Any
IMF/EU program could be an important policy anchor for
next year and combined with implementation of the Szell
Kalman plan would be supportive for the medium-term
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 119
growth outlook. However it is unlikely to materially change
the growth dynamics for 2012. We do not however
expect anything similar to the very deep recession of
2008/09 with the worst of the flow adjustment now done
and fundamentals undoubtedly improved.
We now expect GDP growth of -0.8% for 2012 after an
expected 1.4% outturn for 2011. The NBH is likely to
revise down its 0.6% projection for 2012 when the
updated Inflation Report is released in late December
while the Economy Ministry recently mention a 0.5-1%
expectation versus the 1.5% published in September. For
2013, a reduced pace of deleveraging, improvement in
household balance sheets from a stronger forint and a
more supportive external backdrop should all bring growth
back to positive territory but probably still lagging on any
regional comparisons.
IMF/EU negotiations likely to face significant conflicts
over policy. Hungary’s announcement that it is seeking a
precautionary financing package with the IMF/EU was a
surprise to us given recent statements by the government
to the contrary. The initial announcement from the
Hungarian authorities mentioned ‚a new type of
cooperation with the IMF‛ and subsequent comments by
Economy Minister Matolcsy suggested Hungary would
like a FCL (flexible credit line) but would probably have to
seek a PCL (precautionary credit line) or a precautionary
SBA (stand-by arrangement). The PCL facility was
replaced with the PLL (precautionary and liquidity line) on
November 23rd so we do not yet have any example of
countries using the facility. Nevertheless, as the
qualification criteria are similar to those for an FCL and
based on a track record of a sustainable external position,
favourable market access, sound fiscal and monetary
policy, financial sector soundness and supervision with
moderate vulnerabilities in ‚one or two‛ of these areas‛
we do not think Hungary would be eligible. Hungary’s
external and fiscal vulnerabilities are protracted in our view
which suggests a precautionary SBA is the most likely
option similar to that currently in place in Romania and
Serbia.
In terms of the potential EC component, we expect this
would also be similar to Romania with a precautionary
deal under the BoP assistance programme available to
non-Euro Area member states. Out of the EUR50bn funds
allocated to this program a total of EUR13.25bn has been
disbursed to Hungary, Latvia and Romania and the
EUR1.4bn committed in precautionary assistance to
Romania in March 2011 was the first time the EC had
been involved in providing precautionary financial
assistance.
Hungary: We see a precautionary SBA as the most
likely IMF program option for Hungary Program
typeCr iter ia Condit iona lit y Likelihood Count r ies
FCL
Very strong economic
fundamentals and
institutional policy
framework
No ex-post conditions and all
resources available under the credit
line can to tapped at any time,
disbursements not phased or
conditioned on particular policies
None
Poland,
Colombia,
Mexico
PLL/PCL
Sound fundamentals and
policies and good track
record of policy
implementation
Combines pre-qualification (similar to
FCL) with more focused ex-post
conditions that aim to address
moderate vulnerabilities (actual or
potential BoP needs). Access limited
to 500% of quota up front and
1000% after 12 months
Very low Macedonia
Precaution-
ary SBA
For countries facing
potential (very large)
financing needs subject
to relevant IMF policies
Specific conditionality with
quantitative conditions and structural
measures. Regular program reviews,
exceptional high access on a case-by-
case basis
HighRomania,
Serbia
Source: IMF, DB Global Markets Research (likelihood reflects DB view)
The difficulty for the authorities with a precautionary
SBA/BoP assistance programme is the likely strict
conditionality and adjustment program that would be
required. Recent policies such as the discounted early
repayment scheme on mortgages, the abolishing of the
2nd pillar pension system, the bank levy, the crisis taxes on
retail/telecoms/energy and the government’s leaning of
the independence of the NBH, constitutional court and
revamp of the fiscal council to leave it largely powerless
are all unlikely to sit well with the international lenders.
The ECB’s very negative published opinion in early
November that the discounted mortgage repayment
option will weaken banking sector stability and the sectors
ability to lend, have adverse spillovers to the economy, hit
banks capital positions at a time when ability to
recapitalize is much reduced, put pressure on the forint,
increase country risk premia, put upward pressure on
domestic interest rates, weaken growth and dent investor
confidence due to increased legal uncertainty is an
example of this unhappiness. It is not yet clear whether
the EC will challenge the legality of the policy although a
spokesperson for the EC reputedly announced that
Hungary has until February to respond to complaints from
European banks about the scheme. It is difficult to see
how the EC could agree to any precautionary assistance
with this law still in place and it would be politically
difficult for PM Orban to now reverse this. Some of the
temporary revenue raising measures are probably easier
to reach a compromise on provided the authorities
commit to phasing these out, but even this could take
time to negotiate.
Our understanding is that Hungary had penciled in
EUR4bn (euro equivalent) in external issuance for 2012
and therefore unchanged from 2011. This financing is
intended to cover EUR3.2bn to the IMF (total principal
repayments to the IMF are EUR3.8bn but the remainder is
6 December 2011 EM Monthly
Page 120 Deutsche Bank Securities Inc.
due from the NBH) and two Eurobonds totaling
EUR1.4bn. The government has some buffer from
EUR1bn in its account at the NBH plus any proceeds from
the sale of pension assets. Without drawing down FX
reserves Hungary cannot however avoid coming to the
Eurobond market. Should Fitch or S&P also cut Hungary’s
sovereign rating to sub investment grade (which would
become increasingly likely if IMF/EU negotiations are
prolonged) this could also impact the ability to issue.
Hungary: External financing for 2012 remains fairly
onerous
EURbn 2007 2008 2009 2010 2011F2012F
Gross Financ ing Req. 34.4 45.1 39.3 37.4 37.3 36.3
C/A (deficit = positive) 7.2 7.8 0.2 -1.1 -0.6 -0.3
Amortisation (MLT) 10.0 14.8 19.4 18.8 13.4 12.2
Amortisation (ST) 17.1 22.5 19.7 19.6 24.6 24.3
Financ ing 34.4 45.1 39.3 37.4 37.3 36.3
Non-debt creating 0.9 3.7 0.9 2.2 3.7 2.7
FDI (net) 0.2 2.7 -0.2 0.4 1.3 1.0
EU capital inflows 0.7 1.0 1.1 1.7 2.4 1.7
Debt creating 33.6 51.4 44.1 39.4 33.7 33.6
Sovereign Eurobonds 1.2 1.8 1.0 1.4 4.0 4.0
Multilateral financing 6.9 7.5
Foreign purchases of HGBs 4.1 0.2 -3.4 0.4 5.5 3.0
Banks + corporates 28.3 42.5 39.0 37.7 24.2 26.6
Errors & omissions -1.6 -2.9 -0.3 -1.2 0.0 0.0
Reserves (+ = decrease) 1.5 -7.0 -5.5 -3.0 0.0 0.0
Gross Financ ing Req.
% of GDP 34.1 42.4 42.3 38.0 36.0 34.1 Source: DB Global Markets Research
NBH could just as easily hike or cut rates. Success and
timing in securing even a precautionary multilateral
financing packing combined with developments in Europe
will both have an important bearing on the monetary
policy outlook. Three months of protracted currency
weakness combined with a widening of CDS back to all
time highs prompted a 50bps rate hike from the NBH at
the November policy meeting despite acknowledgement
by Governor Simor that the Bank’s 0.6% GDP growth
forecast for 2012 now looked too optimistic. The
statement said explicitly that further rate hikes may be
necessary if inflation and risk perceptions remain
‚persistently unfavourable‛ which suggests that it would
take a fairly significant turnaround in the currency and CDS
to prevent further hikes. The sharp turnaround in the forint
after the coordinated announcement by the major central
banks to address pressure on global money markets
could, if sustained, be enough to prevent another rate hike
but it remains to be seen whether this rally can last. The
policy anchor and likely improvement in confidence from a
successor IMF/EU package would likely have a positive
and probably more lasting impact on the currency and risk
appetite and could open the door for rate cuts. In a
scenario where the forint is trading back sub 300/EUR and
CDS drops back from the November highs the summer
discussion on the timing of rate cuts, rather than hikes,
should come back on to the agenda.
Hungary: The decision to hike by 50bps in November
was unanimous Nov-11 Oct-11 Sep-11 Aug-11 Jul-11 Jun-11 May-11 Apr-11 Mar-11
Policy ra te (%) 6.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0
András Simor +50 H H H H H H H H
Júlia Király +50 +25 +25 H H H H H H
Ferenc Karvalits +50 H H H H H H H H
Andrea Bártfai-Mager +50 H H H H H H H H
János Cinkotai +50 H H H H H H H H
Ferenc Gerhardt +50 H H H H H H H H
Gyorgy Koczizsky +50 H H H H H H H -
Source: NBH
Our call for the policy rate sees only another 50bps in
tightening to take the policy rate to 7%. We expect this
will be delivered in the December/January MPC meetings
with the peak in CPI to come in January following the
scheduled 2pp VAT hike. On the basis that Hungary does
not end up in a situation of very protracted IMF
negotiations we expect the combination of a reversal of
the recent forint weakness and confirmation of the
weaker growth backdrop to prompt a reversal of the
recent hikes. We see the policy rate back at 6% by late
2012.
Political commitment to fiscal consolidation is an
important MT positive. The government’s commitment
to fiscal consolidation has been an important positive in an
otherwise negative environment. The government plan for
a 2.5% of GDP fiscal deficit in 2012 could prove too
optimistic in a recession environment but we do not
expect that any overshoot would be large. The initial
budget calculations were based on a 1.5% GDP growth
assumption but with the inclusion of HUF300bn or 1% of
GDP in reserves (split between a general reserve, a
reserve to cover higher interest costs and an additional
safety reserve) to provide buffer room in a deteriorating
environment. The budget is a combination of revenue and
expenditure side measures and split between 1.56% of
GDP (HUF455bn) from projected savings in the structural
reform plan (83% of that announced in structural reforms
earlier in the year) and another HUF656bn or 2.25% of
GDP from the recently announced balance improving
measures (such as 2pp VAT hike and increase in
employee social security contributions). While fiscal
policy will prove to be a drag of growth in 2012 from the
direct impact of various measures progress on
implementation of the structural reform plan is
nevertheless an important medium-term positive.
Caroline Grady, London, (44) 207 545 9913
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 121
Investment Strategy
FX: We have highlighted Hungary's vulnerabilities to the
Eurozone through a number of channels such as the FX
loan stock, high external debt and substantial refinancing
needs, (EMEA Daily Compass 2nd and 3rd Nov). After
NBH's 50bp hike on 29th Nov, the key question for the
HUF remains the timing and magnitude of further hikes.
The rates markets are currently pricing in 50bp of hikes by
Mar '12. The risk remains that the NBH may be forced to
take more forceful measures (similar to the 300bp hike in
'08). Further rate hikes being currency constructive will
depend on a number of factors, such as further
downgrades (following the downgrade by Moody's to Ba1
on Nov 25th) and how that will impact on the huge foreign
holdings of domestic government debt. Providing some
protection, meanwhile, is the surplus in the C/A and the
fact that state finances compare well with the Eurozone.
However, given its vulnerabilities EUR/HUF's risk beta will
remain high. Expect aggressive rate hikes [if necessary] to
limit the upside in EUR/HUF to around 320.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Favour HUF to rates Trading the Hungarian curve
has become akin to trading a credit product, with little
correlation to growth and inflation dynamics. The NBH has
decided to counteract the impact of higher risk aversion
with higher policy rates, with the primary aim being to
reduce CHF/HUF volatility and maintain financial stability.
Negotiations with the IMF have added a level of
complexity to the outlook. Our long held view that HUF
would perform better than rates has held true, and we
expect this to be the case over 2012, particularly vs PLN.
One risk Hungary faces is that of more accelerated
outflows from its bond market, where foreigners
represent 40% and local pension funds are expected to
not roll-over their assets following the end of government
transfers. In that scenario ever more aggressive hikes
could materialize.
Lamine Bougueroua, London, (44) 20 7545 2402
Credit: Underweight. Among the Central European
credits, Hungary remains the most vulnerable to a further
deterioration in the external environment. 2012 is set to
be particularly challenging given the government’s need to
raise a substantial amount on the external bond market. If
this is not forthcoming, then an agreement with the IMF
seems critical. However, to secure such an agreement
would likely require a radical change of approach from the
government and we are not convinced that this
government would be willing to stomach such a change.
Marc Balston, London, (44) 20 7547 1484
Hungary: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 128.9 130.2 143.8 133.6
Population (mn) 10.0 10.0 10.0 10.0
GDP per capita (USD) 12855 13008 14386 13381
Real GDP (YoY%) -6.7 1.2 1.4 -0.8
Priv. consumption -5.8 -2.0 -0.3 -0.7
Gov’t consumption 2.2 -0.6 0.1 -0.1
Gross capital formation -8.0 -5.6 1.5 -2.8
Exports -9.6 14.1 6.2 3.9
Imports -14.6 12.0 6.0 3.5
Prices, Money and Banking
CPI (YoY%) 5.6 4.7 4.1 4.7
Broad money (M3) 3.4 3.0 7.5 4.5
Fiscal Accounts (% of GDP)
ESA 95 fiscal balance -4.5 -4.3 1.9 -3.2
Revenue 46.1 44.6 51.0 43.3
Expenditure 50.5 48.9 49.1 46.5
Primary balance 0.1 -0.1 5.8 0.6
External Accounts (USDbn)
bn)
Exports 79.4 92.3 105.3 106.3
Imports 76.2 88.0 100.1 101.8
Trade balance 3.2 4.3 5.1 4.5
% of GDP 2.5 3.3 3.6 3.4
Current account balance -0.3 1.4 0.9 0.4
% of GDP -0.2 1.1 0.6 0.3
FDI (net) -0.2 0.6 1.7 1.5
FX reserves (USD bn) 41.1 43.1 47.3 43.0
HUF/USD (eop) 189.0 208.2 230.8 216.8
HUF/EUR (eop) 270.7 278.6 300.0 280.0
Debt Indicators (% of GDP)
Government debt 78.4 80.2 76.3 74.6
Domestic 42.0 42.4 40.1 41.2
External 36.4 37.8 36.2 33.4
Total external debt 146.6 139.7 146.0 142.0
in USD bn 188.9 182.1 210.0 189.7
Short-term (% of total) 14.3
17.9 16.0 16.1
General (YoY%)
Industrial production -17.3 10.3 5.2 2.1
Unemployment 9.8 11.1 11.1 11.3
Financial Markets (eop) Current 3M 6M 12M
Policy rate (2-week depo) 6.5 7.0 6.5 6.0
HUF/EUR 304.7 295.0 290.0 280.0
HUF/USD 226.7 226.9 232.0 207.4
Source: NBH, Haver Analytics, DB Global Markets Research. Fiscal and debt forecasts reflect the
pension reform which will mean a one-off transfer of around 10% of GDP as of end May 2011.
6 December 2011 EM Monthly
Page 122 Deutsche Bank Securities Inc.
Israel A1(stable)/A+(stable)/A(stable) Moody’s/S&P/Fitch
Economic Outlook: The divergence between strong
domestic absorption and faltering net exports is set
to dwindle, pointing to a marked loss in growth
momentum. Inflation is expected to behave benignly,
providing room for further easing if needed, although
housing dynamics and ILS will also play an
increasingly important role. The C/A is set to turn
negative and remain in deficit throughout the forecast
horizon, while fiscal consolidation arrives with a delay.
Main Risks: The geopolitical risk premium is set to
remain elevated given multiple sources of concern. A
more rapid than needed deceleration in housing
prices may lead to financial stability risks and
complicate rate outlook.
Strategy Recommendations: Favour tactical shorts
in EUR/ILS above 5.10. Receive 2Y IRS
Macro View
2011 was another year of economic success. Israel has
been one of the best performing economies in 2011 with
growth remaining well above the trend for the second
year in a row. The labour market has improved markedly
as unemployment reached its historical nadir (5.5%)
following an acute 2pp leapt during the course of global
recession. 2011 also saw an unanticipated one-notch
upgrade by S&P (to A+) thanks to improved macro policy
flexibility/credibility, a healthy banking sector, robust
external performance and ongoing fiscal consolidation,
confirming strong fundamentals of Israeli economy vis-à-
vis the rest of EMEA. Event risks, however, were also on
the rise year-to-date. The geopolitical/security backdrop
deteriorated noticeably with ongoing unrest in neighboring
countries, strained relations with Turkey and an elevated
possibility of military action against Iran more recently.
Local sentiment also turned sour owing to social protests
over the high cost of living. The latter has complicated the
fiscal outlook but was conducive to improved inflationary
conditions in the second half of the year which prompted
a timely monetary response by the Bank of Israel (BoI).
Growth is set to moderate notably in 2012 although a
hard landing is not in the cards. Recent economic
activity data were still resilient but signals of a
forthcoming shift from ‘normalization’ to ‘a general
slowdown’ in headline growth have intensified.
Preliminary Q3 2011 GDP growth was higher-than-
expected at 3.4%QoQ (saar), following a revised down
3.5% previously and 4.7% in Q1. While the headline
number looks relatively resilient, composition of growth
insinuates a looming softening. Putting robust fixed
investments aside, stock-building was very strong at
5.2%QoQ (saar) while private consumption continued to
soften and accounted for only 0.1pp of 0.8% quarterly
gain.
Israel: Growth is set to moderate notably in 2012
-4
-3
-2
-1
0
1
2
3
4
5
6
-6
-4
-2
0
2
4
6
8
10
04 05 06 07 08 09 10 11F 12F 13F
GCFGovt cons.Pvt cons.Net exportsReal GDP (rhs)
pp contr. QoQ (saar)
F o recast
Source: Haver Analytics, CBS, DB GM Research
Israel: C/A turns sour with record high trade deficit
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
2005 2006 2007 2008 2009 2010 2011F 2012F 2013F
Merchandise trade IncomeTransfers ServicesC/A balance
% of GDP
Source: Haver Analytics, BoI, DB GM Research
The negative contribution of net exports accelerated to -
1.1% following -0.8% seen in the previous period. Both
exports and imports receded over the quarter but the
extent of contraction in the former (-16.9%QoQ (saar)
versus -7.6%) was considerably larger, reflecting impact
of weak external sector. The latter is likely to be an
overhang on growth in 2012 as well given that exports
destined to US and Europe account for c25% of GDP and
DB now expects a recession to the tune of -0.5% in
Euroland. The divergence between strong domestic
absorption and faltering net exports is also set to dwindle.
The BoI’s latest Companies Survey revealed a fairly
downbeat output growth expectations in most industries
already in the final quarter of 2011 with manufacturing
companies specifically mentioning weakening domestic
market as one of the causes. This insinuates growth in
private consumption and fixed investments will likely
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 123
decelerate in 2012 on the back of elevated uncertainty,
dented confidence and constrained funding supply. We
now expect headline GDP growth to moderate by around
1.8pp to 2.8%YoY next year before converging to its trend
of 3.8% in 2013. Risks are tilted to the downside given
the forthcoming global slowdown.
It is also worth noting that current account is likely to turn
negative – already by end-2011 and throughout the
forecast horizon – for the first time since 2002. This is
mainly due to a marked acceleration in the trade deficit
emanating from the combined impact of export
underperformance and strong import growth. While
higher commodity prices played a role behind the latter, a
46.2%YoY rise in investment good imports year-to-date
suggests resilient domestic absorption was also an
important contributor. The expected deterioration in the
current account is commensurate with empirical studies
showing that countries experiencing a natural resource
discovery (natural gas in Israeli case) are likely to
spend/borrow more in the near term (in anticipation of
higher future income) before the advent of initial receipts
(probably in mid-2013 although a delay is more likely than
not) while surplus C/A figures are set to arrive consistently
once major fields (Tamar and Leviathan) become fully
operational (probably by the middle of decade).
Inflation seems under control for now. Headline
inflation already receded below BoI’s upper band (3%) in
Q3 and seems likely to remain within target rate at least
until end-2012, barring any external/ geopolitical or
administrative price (such as higher electricity tariff)
shocks. Many factors are behind this favourable outlook.
On top of anchored real wages and stable global
commodity prices, mass public protests over high cost of
living seem to have paved the way for a welcome quasi-
structural change in private (and to some extent public)
pricing behavior, reflected mostly in retail cuts on basic
goods. Subsequently, market-derived 12-month inflation
expectations retreated significantly from 3.8% in February
to 1.7% in mid-November. Secondly, the housing
component, a main driver of headline CPI since late 2008
given its +20% weight in the basket, is expected to
moderate given improved supply and demand conditions.
Finally, weakened FX pass-through is likely to cap any
upward pressure stemming from weaker ILS. According
to the latest BoI calculations, a 1% rise in USD/ILS (i.e.
depreciation) is envisaged to lift up housing component by
only 0.1pp in the short term versus 0.7pp estimated in the
previous decade (as the share of rental contracts
denominated in USD has dropped to only 5% from over
85% previously).
Fiscal backdrop will be under close scrutiny. The 2-year
combined budget bill sets deficit ceilings of 3.0% (of
GDP) and 2.0% for 2011 and 2012, respectively. Yet, a
slippage in both cases seems highly likely. Although the
cumulative budget deficit (excluding net credit) in the first
ten months of 2011 stood at a somewhat manageable
ILS14.1bn (1.6% of GDP) compared to annual target set at
ILS25.2bn, domestic revenues were 2.7% lower than the
seasonal path consistent with 3.0% ceiling mainly owing
to a continued slowdown in indirect tax receipts. This
suggests Ministry of Finance’s working target estimated
at 2.9% (just below 3.0% ceiling) will likely be overshot by
c0.4pp. Possibility of higher spending in light of public
protests and moderating growth (4.0% penciled in budget
forecast against our and BoI’s estimates standing at 2.8%
Israel: …with better conditions in housing…
-15
-10
-5
0
5
10
15
20
254
6
8
10
12
14
16
18
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Months of supply (inverted, t-3, LHS)
House prices, YoY% (RHS)
Forecast
Source: Haver Analytics, CBS, DB GM Research
Israel: Inflation seems to be under control…
-2
-1
0
1
2
3
4
5
6
-2
-1
0
1
2
3
4
5
6
Jan-07 Mar-08 May-09 Jul-10 Sep-11 Nov-12
Transportation & Comm.HousingFood (excl, fruit & veg.)Headline CPI (YoY%, rhs)
pp contribution YoY%pp contribution YoY%
Forecast
Source: Haver Analytics, CBS, DB GM Research
Israel: …and low FX pass-through
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
1 2 4 6 8
%
pp
co
ntr
ibuti
on to
head
line
Quarters
Clothing T&C
Dwelling maintenance Housing
Total CPI (RHS)
Note: The chart exhibits cumulative response of CPI (and its components) to a 1% depreciation in ILS
(against the USD) ; Source: BoI calculations, DB GM Research
6 December 2011 EM Monthly
Page 124 Deutsche Bank Securities Inc.
and 3.2%, respectively) point to high likelihood of a
consecutive slippage in budgetary balances next year;
although - in absolute terms - fiscal deficit will remain fairly
manageable compared to developed world and many
other EM peers. Meanwhile, a meaningful drop in
government debt/GDP ratio is now likely to arrive in 2013
once revenue side resumes its strong growth with
improved economic activity (and also partially on the back
of arrival of gas receipts while impact may be felt more in
2014-15 given grace period in place). Separately,
Netanyahu government's earlier plans to trim
income/corporate taxes gradually by 2016 have been
shelved with approval Trajtenberg Committee’s long-
awaited recommendations which envisaged social
spending of around ILS30bn over the forthcoming five
years financed mainly through cuts in defense spending
(to the tune of ILS2.5bn in 2012) and tax changes/hikes
Monetary policy to remain focused on growth.The
newly formed 6-member Monetary Committee (MC)
delivered its first cut in November following its inception a
month earlier. This was the second cut in the last three
months as concerns over negative spillovers from a
faltering global backdrop intensified. As has been the case
throughout the hiking cycle (125bps) earlier in the year,
the Bank will continue to base its rate decisions on (i)
domestic inflation (including inflation expectations); (ii)
growth in Israel and globally; (iii) monetary policies of
major central banks; (iv) the trade weighted ILS; and (v)
housing prices while weight of these parameters will
continue to be dynamic. For now, growth concerns seem
to have taken precedence given ongoing (forthcoming)
global (domestic) slowdown, and will likely remain as the
main driver at least in the first quarter of 2012. Policy
action by major central banks comes next in terms of
importance as any additional monetary accommodation
will likely be perceived as a strong signal for further
downturn in global economy and also due to
repercussions for the shekel. This is followed by inflation
dynamics (and inflationary expectations) which seems
fairly tamed for now. Housing prices and ILS appear to be
placed to the very end of this implicit ranking although this
is subject to change in 2012. Accordingly, the penultimate
paragraph of BoI’s latest communiqué, which reads as
‘…lower rates, together with the recent weakening of the
effective exchange of ILS, are expected to help Israel’s
economy deal with the difficulties confronting it’, implicitly
signals, in our view, that further (and noticeable) ILS
weakening in the coming period could be seen as an
alternative to additional rate cuts. Additionally, Governor
Fischer has cited his concern about the possibility of a
more rapid than needed deceleration in residential prices
and underlining the necessity to slowdown the pace of
marketing of land for construction, particularly given that
banking system’s overall exposure to real estate/housing
sector (accounting c44% of total loan book) is significant.
Combined altogether and given slowly-bleeding nature of
sovereign debt crisis in the Euro zone), we expect the BoI
to reduce rates by another 25bps to 2.50% in early 2012
followed by steady rates until mid next-year. This will
mean that monetary conditions remain accommodative
for most of 2012 but a delicate balance will be maintained
in the housing market at the same time by not overly
stoking the demand side (or by letting housing prices drop
precipitously). The precarious external outlook
necessitates a data-dependent stance by the Bank more
than ever, hinting that rate risks are tilted to the downside.
Apart from a deeper global slowdown, downward risks
(on growth and the ILS) will again emanate from
geopolitical backdrop. Although some part of noticeable
ILS weakness seen in the shekel since September is due
to poor risk appetite, weaker external balances, and
(expectations of) lowered yield support; rising geopolitical
risks (i.e. ongoing turmoil in Syria, regime change in
Egypt, stalemate in peace talks with PA, strained relations
with Turkey and more recently possibility of military action
against Iran) also played a significant role. Geopolitical
strains are unlikely to soften in 2012 given elevated
uncertainty over the end-game in Syria and the positioning
of any new administration in Egypt. Any direct
Israel: Housing market will remain spotlight
Public
sector; 9.0%
Retail sector;
11.8%
Corporate
sector (ex-
commerical
real estate
loans);
35.3% Commercial
real estate
loans; 15.5%
Mortgages;
28.4%
Total
exposure to
real estate/
housing
sector;
43.9%
% in total bank credit
Source: Haver Analytics, BoI, DB GM Research
Israel: Fiscal consolidation is to arrive with a delay
60
67
74
81
88
95
102-6
-5
-4
-3
-2
-1
0
04 05 06 07 08 09 10 11F 12F 13F
Government debt (RHS)
Fiscal deficit [excluding net credit, inverted]
% of GDP
Source: Haver Analytics, BoI, DB GM Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 125
confrontation with Iran (which is not our main working
assumption) will likely be accompanied by notably easier
monetary conditions by BoI while record-high FX reserves
will provide some (limited) comfort. ILS is still expected to
strengthen, mainly in the second half of the year, thanks
to unscathed macro fundamentals (i.e. credible macro
policy mix, healthy banking system, net external asset
position). Yet, projected C/A deficits and a lower yield
support (than expected) could put a cap on any
meaningful appreciation cycle. Any adverse geopolitical
development has also a potential to reverse the envisaged
path for the shekel.
Kubilay Ozturk, London, (44) 207 547 8806
Investment Strategy
FX: Continuing tensions with Iran (and rising possibility of
military action), continued social unease over living costs,
the negative trade balance in October and the
outperformance in the ILS vs peer currencies over the
past 3-6 months mean we do not currently see
risk/reward strongly favouring long ILS positions.
However, it is worth noting that price action in EUR/ILS
has been remarkably resilient over the last few months,
with the pair largely back to pre-August levels. To put this
move in perspective, EUR/ZAR has rallied by over 18%
over the same period, EUR/HUF by 16% and EUR/PLN by
over 12%. This suggests that being short EUR/ILS is a
lower beta or ‘defensively bullish’ way to express a
constructive EM view. In terms of positioning, we have
seen a marked reduction in the ILS position on dbSelect -
the ILS position is, in fact, shorter than it has been for
more than 12 months. We prefer to be tactical sellers of
EUR/ILS above 5.10, for an eventual move down towards
the pre-August lows at around 4.80.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Receive 2Y IRS We take comfort from the latest
MPC meeting minutes and expect two further cuts. The
BoI inflation forecast of 1.6% y/y in 12m is consistent with
immediate cuts, but the BoI feels that waiting may give it
a better opportunity to act effectively. The current 2s10s
slope is fair to the level of Telbor, based on historical
regression, however the 10Y is rich to one of its key
macro drivers (US economic surprise index). For this
reason, we decide to take profit on our recommendation
to receive 10Y IRS and instead recommend receiving 2Y
with a target of 2.4 and s/l at 2.9 (current 2.72). The
carry/roll on this trade is positive by 4bp/3m
Lamine Bougueroua, London, (44) 207545 2402
Israel: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 194.6 217.8 245.5 246.9
Population (mn) 7.5 7.6 7.8 7.9
GDP per capita (USD) 26004 28571 31634 31315
Real GDP (%) 0.8 4.8 4.5 2.8
Priv. consumption 1.4 5.3 4.4 2.7
Govt consumption 2.4 2.5 2.9 2.5
Investment -4.1 13.6 15.3 4.0
Exports -12.6 13.4 4.6 3.6
Imports -14.0 12.6 10.6 5.2
Prices, Money and Banking (eop)
CPI (YoY%) 4.0 2.6 2.3 2.3
Broad money (M2) 13.5 3.6 2.9 1.2
Fiscal Accounts (% of GDP)
Budget balance (excl credit) -5.1 -3.7 -3.3 -3.5
Revenue (incl credit) 37.7 38.9 41.1 40.0
Spending (incl credit) 42.7 42.3 43.7 42.9
Primary balance (incl credit) -2.1 -0.5 -0.1 -0.4
External Accounts (USDbn)
Exports 46.3 56.1 60.3 63.3
Imports 46.0 58.0 68.8 74.6
Trade balance 0.3 -1.9 -8.5 -11.3
% of GDP 0.2 -0.9 -3.5 -4.6
Current account balance 7.0 6.3 -1.0 -3.6
% of GDP 3.6 2.9 -0.4 -1.4
FDI (net) 2.7 -2.8 2.3 1.0
FX reserves (USDbn) 60.6 70.9 76.5 77.5
ILS/USD (eop) 3.79 3.52 3.75 3.65
ILS/EUR (eop) 5.42 4.72 4.88 4.93
Debt Indicators (% of GDP)
Government debt 77.8 74.5 73.5 73.3
Domestic 63.4 61.8 61.3 61.0
Foreign 14.4 12.7 12.2 12.3
Total external debt 48.0 48.7 48.0 50.7
in USD bn 93.3 106.0 117.7 125.3
General (% pavg)
Industrial production (% YoY) -5.9 8.0 2.3 2.0
Unemployment 7.5 6.7 5.7 6.0
Financial Markets (eop) Current 3M 6M 12M
BoI policy rate (%) 2.75 2.50 2.50 3.00
ILS/USD (eop) 3.79 3.80 3.72 3.65
ILS/EUR (eop) 5.05 4.94 4.65 4.93
Source: DB Global Markets Research, BoI
6 December 2011 EM Monthly
Page 126 Deutsche Bank Securities Inc.
Kazakhstan Baa2(stable)/BBB+(stable)/BBB(positive) Moody’s/S&P/Fitch
Economic outlook: Growth is picking up and
inflationary pressures are on the rise.
Main risks: The key vulnerability remains in the
banking sector, with negative implications for
recovery in loan growth.
Strategy outlook: Maintaining a relative preference
for KZT NDFs vs their UAH counterparts. Neutral on
sovereign credit (CDS).
Macro outlook
The macroeconomic conditions in Kazakhstan remained
relatively favourable in 2011 despite global financial
volatility as evidenced in sovereign credit rating upgrades.
In November 2011 S&P upgraded Kazakhstan’s sovereign
credit rating to BBB+ (outlook stable), citing rising exports
and the sustainability of high growth rates of 6% until
2014. The agency referred to the combination of a strong
current surplus, prudent fiscal policy and high FDI inflows
among the factors underpinning the upgrade. At the same
time, the agency also pointed to vulnerabilities, centering
on the country’s banks’ holdings of foreign debt, which
remains significant at 24% of total liabilities of the
financial sector. Overall, the increase in the sovereign
credit rating should be supportive for capital inflows and
the currency, though in the short term these positive
factors may be dented by lingering uncertainty and risk-
aversion in global financial markets. The S&P upgrade was
shortly followed by an upgrade from Moody’s, also in
November 2011.
One of the key strengths of the Kazakh economy is the
attainment of high growth rates, which is projected by the
government to reach 7% in 2011 and to stay at 6-7% in
the medium term. At the same time, the government is
targeting inflation in the range of 6-8% in each of the next
five years, a target that lacks ambition on the disinflation
front. It also reflects the greater predilection of the
National bank of Kazakhstan to keeping the exchange rate
stable versus the dollar, with the head of the National
Bank, Grigory Marchenko declaring that the monetary
authorities would not allow the tenge to appreciate
beyond KZY/USD145 in 2011. The continued commitment
to exchange rate stability may harbor upside risks for
inflation in a high oil price environment, with 2011 inflation
likely to come towards the upper end of the 6-8% range
targeted by the monetary authorities.
One of the main points of vulnerability in Kazakhstan’s
economy remains the banking sector, which continues to
face the challenges of slow lending dynamics and weak
asset quality. The latter is exerting pressure on margins
and profitability, which is coming on top of the already
significant problems inherited by the sector from the
downturn experienced in 2007. The authorities are
targeting the sale of majority stakes held by Samruk-
Kazyna in BTA, Temirbank and Alliance under a debt
restructuring program, but in November 2011 the Head of
the National Bank of Kazakhstan, Grigory Marchenko,
declared that it may take longer (beyond 2013) to sell off
these banks due to the volatility in Europe’s financial
markets.
On the political front, Kazakhstan is to hold snap
parliamentary elections on January 15-16 which are likely
to result in a reduction of the monopoly of the ruling Nur
Otan party. We do not expect to see an escalation in
political risks in the near term, with the longer-term
vulnerability being the uncertainty over the succession to
the 71-old leader, Nursultan Nazarbayev.
Kazakhstan: Inflation and GDP growth
0
2
4
6
8
10
12
14
16
18
20
2003 2004 2005 2006 2007 2008 2009 2010 2011F 2012F 2013F
Real GDP (YoY%) CPI (Dec/Dec)
Source: National authorities, Deutsche Bank
In the fiscal sphere, expenditure restraint has helped to
lower the vulnerability of the budget to a downturn in oil
prices. In 2011 Kazakhstan’s fiscal surplus could reach
close to 2% of GDP compared to a surplus of 1.4% of
GDP in 2010. In November, the parliament adopted the
budget plan for 2012-2014, which is based on
conservative oil price assumptions and envisages a
budget deficit of 2.6% of GDP in 2012, which is to
progressively decline to 1.5% of GDP in 2013 and 1.3% of
GDP in 2014. Outlays are projected to rise by 6-7% in
nominal terms in 2012, with transfers to the budget from
the National Fund of Kazakhstan projected at KZT1.2tr. As
of September 2011 the assets of the National Fund
reached nearly USD40bn.
Yaroslav Lissovolik, Moscow, (7) 495 933 9247
Ilya Piterskiy, Moscow,( 7) 495 933 92 30
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 127
Investment strategy
FX: Correlation patterns suggest that the main drivers for
KZT NDFs are the ruble, equity sentiment and oil. While it
is difficult to be constructive on risk assets over the
coming year, it is worth pointing out that the domestic
backdrop of Kazakhstan seems to be improving. Firstly,
the Fitch upgrade to 'BBB' (positive outlook) was a plus
for the currency, combined with a strong government
GDP forecast for 2012 (to 6.9% from 7%), stabilization in
FX reserves (to $32.6bn) and the continuing current
account surplus in Q3 '11 (vs. a deficit in Q3 '10) and a
gradual decline of inflation to 5.4% YoY in October (vs.
5.9% in September) bode well for the currency. Further,
the latest assets of the National Oil fund show another
increase, suggesting that we are unlikely to see sharp
moves in the KZT. We recommend staying sidelined for
now, but express a relative preference for KZT NDFs vs
their UAH counterparts.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Credit markets: Little has changed regarding our
fundamental view on Kazakhstan that selling sovereign
CDS protection offers a good medium-term risk-reward.
However, the weaker global environment and increased
risks in the domestic banking sector argue that the risk-
reward profile of such a position is currently unattractive.
We recommend remaining on the sidelines for the time
being.
Marc Balston, London, (44) 20 7547 1484
Kazakhstan: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National income
Nominal GDP (USDbn) 139.9 161.3 183.5 210.0
Population (m) 16.1 16.4 16.6 16.8
GDP per capita (USD) 8 689 9 832 11 055 12 503
Real GDP (%) 7.3 6.6 5.5 6.0
Private consumption 11.8 6.4 6.0 6.0
Government consumption 2.7 8.6 4.6 5.1
Investment 2.0 9.0 10.0 10.0
Exports 1.9 12.9 2.5 11.2
Imports 0.9 25.4 5.6 -7.7
Prices, money and banking (eop)
CPI (YoY %) 7.8 8.0 7.0 6.5
Broad money (M3) 15.7 13.0 14.0 12.0
Private credit 0.0 9.0 9.0 11.0
Fiscal accounts (% of GDP)
State budget balance 1.5 2.0 2.5 3.1
Revenue 25.3 26.3 26.6 27.0
Spending 23.8 24.3 24.1 23.9
External accounts
(USDbn)
Exports 60.8 86.5 92.8 102.6
Imports 32.0 43.3 48.9 48.1
Trade balance 28.9 43.3 43.8 54.5
% of GDP 20.6 26.8 23.9 26.0
Current account balance 4.3 16.7 15.4 24.3
% of GDP 3.1 10.4 8.4 11.6
FDI (net) 2.8 8.0 8.0 8.0
FX reserves (USDbn)
OIL
28.3 38.0 54.0 70.0
KZT/USD (eop) 147.4 147.0 145.0 143.0
Debt indicators (% of
GDP)
Total public debt 15.7 19.0 14.7 10.1
Total external debt 78.6 84.3 80.6 80.6
in USD bn 110.0 136.0 148.0 169.4
General (% pavg)
Industrial production (%
YoY)
10.0 6.2 5.8 6.0
Financial markets (eop)
period)
Current 3M 6M 12M
NBK policy rate (%) 7.0 7.0 7.0 7.0
KZT/USD (eop) 147.6 147.0 146.6 146.5 Source: Official statistics, Deutsche Bank Global Markets Researc
6 December 2011 EM Monthly
Page 128 Deutsche Bank Securities Inc.
Poland A2(stable)/A-(stable)/A-(stable) Moodys/S&P/Fitch
Economic Outlook: A Poland’s larger and less
export-orientated economy compared with elsewhere
in CEE should outperform again in 2012. While
growth will undoubtedly slow there is little risk of
recession. The pace of slowdown alongside zloty
performance, the inflation outlook and the fiscal
stance will all determine the scope for rate cuts in
2012. We see this as unlikely before Q3.
Main Risks: Any evidence that the new government
lacks commitment to fiscal austerity could quickly put
pressure on yields and see the rating outlook revised
to negative. The discussed methodology changes to
calculation of the debt rule, if used as a substitute for
fiscal reform, would be a big negative in this regard.
Strategy Recommendations: We recommend a 1y
EUR/PLN put, with a and strike at 4.25 for 2% of EUR
notional.Receive 1Y XCCY basis as a hedge but
outright purchase of POLGBs will be attractive in H2
201. Overweight sovereign credit.
Macro View
Still one of the strongest economies in Europe. Donald
Tusk has now been sworn in for a second term as Polish
PM leading a successor PO-PSL coalition. In his first
speech to Parliament Tusk set out a fairly ambitious fiscal
reform agenda which includes various changes to the
pension system, elimination of tax breaks, healthcare
reform and a pledge to step up deregulation. The
commitment to fiscal reform comes as Poland feels the
impact of the financial stress in Western Europe via
ongoing depreciation of the zloty but has otherwise been
relatively immune despite its own still-high fiscal deficit.
The government’s new four-year mandate and a better
economic backdrop then elsewhere in Europe to
implement fiscal reform suggests market tolerance
towards any perceived lack of commitment in Poland is
likely to be limited.
Poland statistics office reported a robust 1.0% QoQ
reading for Q3 GDP (seasonally adjusted) and 4.2% YoY
(non-seasonally adjusted) versus a consensus expectation
of 4.0% YoY. This is down only slightly from the upwardly
revised 1.2% QoQ reading for Q2 (previously reported at
1.1%) and other than Romania’s agriculture-induced
bumper 1.9% QoQ reading is comfortably the strongest
growth reading in Europe. The detailed components show
a pretty robust composition of growth albeit with some
evidence of a slowing in the domestic momentum.
Domestic demand accounted for 3.2pp out of the 4.2%
YoY GDP reading with the contribution from restocking
the lowest since Q4 2009 at 0.4pp. The components
showed the quarterly pace of consumer spending slowing
to just 0.6% from 1.0% in Q2 with the YoY rate
moderating to a still-strong 3.0%. Fixed investment
slowed as expected given the lower public investment
spending with the quarterly pace of growth at 1.4% and
therefore the lowest since Q3 2009. On a YoY basis
growth in investment now stands at 8.5% and is the
highest in the post-crisis period but more reflective of
gains in previous quarters rather than in Q3 itself. On a
YoY basis the contributions to growth from private
consumption and investment were reported at 1.8pp and
1.6pp respectively which is the lowest contribution from
consumer spending since Q4 2009. On the external side
net trade added 1.0pp to growth, the highest contribution
since Q4 2009 and the only meaningful boost to growth
from net trade in recent quarters. This masks the fact that
exports reported a sluggish 0.4% QoQ gain while import
growth turned positive after a negative reading in Q2.
Poland: Growth has eased back but remains strong
and the composition is robust
0
1
2
3
4
5
6
7
8
-15
-10
-5
0
5
10
Q3-06 Q3-07 Q3-08 Q3-09 Q3-10 Q3-11
Inventories GFCF
Govt Cons Pvt Cons
Net Exports Real GDP (rhs)
pp contribution % YoY
Source: Haver Analytics, DB Global Markets
Going forward we continue to expect the pace of GDP
growth to moderate. Investment should continue to
decelerate on the back of reduced public investment and
an uncertain global backdrop while consumer spending
will start to reflect lower wage growth in both nominal
and real terms and deteriorating employment prospects.
The planned fiscal consolidation will also weigh down on
domestic demand components as benefits are cut further
and spending freezes are expanded while it is unlikely that
reform of retirement schemes will offset these measures
in the near term. While Poland has a much smaller export
sector compared with Hungary or Czech Republic, exports
will still feel the impact of further weakness across
Western Europe which currency weakness (and therefore
competitiveness gains) will not be able to offset. A
continued normalisation in the boost to growth from the
restocking cycle will also dampen growth in the coming
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 129
year. A better-than-expected Q3 GDP pushes our 2011
growth estimate to 4.2% but we have nudged down our
2012 forecast to 2.3% versus 2.6% previously. We now
expect a lower contribution from both domestic demand
and net trade with the high base from the very solid
performance in 2011 also making YoY comparisons now
more difficult. Our 2.3% forecast is lower than the 3.2%
NBP projection and the likely 2.5% Ministry of Finance
forecast but still leaves Poland as easily one of the
strongest economies in Europe.
Fiscal financing looks secure for 2012. The combination
of a VAT hike, introduction of a spending rule, reduction in
the contributions to the private pension funds and cuts to
various benefits are expected to produce a narrowing in
Poland’s general government budget deficit from -7.8% in
2010 to 5.5% in 2011. Data on the narrower state budget
through October show the deficit at PLN22.5bn and
therefore on track to come in considerably below the
planned PLN40.2bn with outperformance on both the
revenue and spending sides. The government continues
to target a sub 3% general government deficit for 2012
with PLN35bn or 2.3% of GDP on the state budget.
Savings from the deficit rule for local governments, the
spending rule, reduced pension contributions and
elimination of some early retirement options are all
assumed to achieve this. The state budget is still under
revision however given the earlier 4% GDP growth
assumption for 2012 and unlike Hungary there is no
explicit reserves buffer in the budget and there has not
been any real discussion of additional measures to keep
the budget on track. Budgetary space afforded by
outperformance on the state budget in 2011 could provide
some buffer but this is unlikely to be enough. A sub 3%
fiscal deficit by 2012 was too optimistic even in a better
macro environment and we continue to expect the deficit
outturn to be in excess of 4% of GDP.
Poland: Gross borrowing requirement larger in 2012
65.4
105.7
8.7
35.7
103
6.2
47.3*
114.3
13.9
0
20
40
60
80
100
120
140
Net Borrowing
Requirements
Repayment of
domestic debt
Repayment of
foreign debt
2010 (Total:
PLN 179.8bn)
2011 (Total:
PLN 144.9bn)
2012 (Total:
PLN 175.5bn)
PLN bn
Source: Ministry of Finance (*state budget deficit of up to PLN35bn)
Nevertheless, the fiscal financing outlook looks relatively
secure. The authorities have announced a PLN175.5bn
(EUR39bn) gross borrowing requirement for 2012 with
intended financing split between PLN146.1bn in domestic
financing and PLN29.4bn in foreign financing. Poland has
already started pre-financing for 2012 on both the
domestic and external side (Ministry of Finance officials
said this was 10% by end November) and the government
has a substantial cash buffer (EUR10.5bn) at its disposal.
The 2012 pre-financing also suggests comfort by the
Ministry of Finance that Poland is not in danger of
breaching its 55% debt/GDP limit despite the recent zloty
weakness. Some 27% of public debt is denominated in
foreign currency (and predominantly euros) and with
debt/GDP at 53.7% as of Q2 (4-quarter rolling basis) on a
PLN rate of 3.99/EUR there have been increasing
concerns about breaking 55%. But with debt issuance
front-loaded in H1 and the combination of a slower than
expected easing in GDP growth plus slightly higher
inflation, we do not expect the threshold will be breached.
Public debt data are only available through June but using
the recent Ministry of Finance projection of debt/GDP at
53.8% based on EUR/PLN at 4.35 we see the tipping
point at 4.75/EUR for 2011 (data will be released in May
2012).
Recent comments that Poland may look to change the
calculation method for public debt to use an annual
average, rather than year end, exchange rate should be
viewed with caution. That a single exchange rate point can
have an important bearing on future fiscal policy does not
make much economic sense (triggering the 55% limit
would mean a 1pp temporary VAT hike and unspecified
measures to ensure the fiscal deficit is on a declining path
and the debt/GDP ratio is expected to decline). But the
worry will be that Poland uses a methodology change as a
substitute for fiscal reform. The bigger risks in our view is
the accompanying comments that Poland would also like
to see the debt definition changed to net, rather than
gross, debt. The EUR10.5bn in PLN and FX liquidity held
by the Ministry of Finance as of end October is equivalent
to 2.8% of GDP and would therefore open up significant
room to manoeuvre on fiscal policy before the debt limit
was reached. The ratings agencies have yet to comment
on the proposals but we expect these will be viewed
decidedly negatively.
C/A financing more vulnerable. Despite the ongoing
worries on the fiscal side, Poland’s larger vulnerabilities
for the coming year are on the external side in our opinion.
At an expected 4.5% of GDP in 2011 the C/A deficit is the
largest in CEE and has the weakest financing mix. NBP
data show the deficit at EUR12.5bn through September,
of which EUR7.8bn stems from the trade deficit and
EUR11.8bn from deficit on investment income line with a
partial offset from services and transfers surpluses. Both
FDI and EU transfers components cover around 30% each
with the much larger source of financing coming from
inflows into debt securities. This stands at EUR8.75bn
6 December 2011 EM Monthly
Page 130 Deutsche Bank Securities Inc.
YTD, with another EUR1.6bn in foreign inflows into equity,
and covers 70% of the deficit YTD. The September BoP
data reported the first (small) monthly outflow on the debt
securities component which corresponds with the start of
the zloty weakness. The overall BoP reported a shortfall
for the month and a corresponding fall in reserves which
is not explained by foreign debt repayments. The
combined debt and equity inflow amounted to 5.6% of
GDP in 2010 versus a headline C/A deficit of 4.6% of
GDP. This is now down to 3.7% of GDP on an annualised
basis versus a C/A deficit at 4.5% of GDP. Should these
flows drop back further this could mean continued
pressure on the zloty as it is difficult to see where any
financing offset could come from. We view Poland’s
USD30bn precautionary flexible credit line arrangement as
only a tentative source of strength. The arrangement is in
place until January 2013 but Poland’s decision to treat the
FCL as precautionary means this is not included in the
NBP’s EUR64.1bn in FX reserves. Any request to trigger
the facility would therefore be a very public sign of
weakness and we see this as likely only in a very worst
case scenario where the sovereign cannot issue.
Rate cuts pushed out to Q3. Governor Belka recently
described the ongoing zloty weakness as a ‚temporary
headache‛ and the Bank, along with various other Polish
officials, have said the move is out of line with Poland’s
fundamentals. As our chart opposite shows, the
weakness has largely been in tandem with the stresses in
Western Europe and has come in the absence of any
negative developments on the macro side. The NBP have
confirmed direct intervention on four occasions now with
their public stance that they are not targeting a particular
level of the zloty but instead acting against destabilisation
in the FX market. FX reserves have dropped by
EUR240mn since the start of intervention to stand at
EUR64.15bn at end October but this is clouded by
valuation effects and public flows making it difficult to
disentangle exactly the intervention size. Nevertheless,
with reserves less than 100% of ST debt and one of the
lowest in EMEA as a share of GDP we reiterate our view
that intervention is likely to be contained.
With inflation currently way above the NBP’s 2.5% target
(4.3% YoY for October) pass-through from currency
weakness is an increasing concern. The monthly gains in
the October food and petrol price components were
higher than elsewhere in CEE pointing to some immediate
pass-through from the zloty weakness and given
continued depreciation through October and November
(albeit smaller than the 5% decline in September) upside
risks remain for the forthcoming inflation prints. The input
price component of the November PMI was unchanged
from October at a five-month high which may cap some
of the concerns on pass-through while the EC survey on
selling price expectations also dropped in November after
a sharp jump in October.
Poland: Zloty weakness has been in tandem with
stresses in Western Europe
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
3.8
3.9
4.0
4.1
4.2
4.3
4.4
4.5
4.6
Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11
EURPLN
Italy 10Y Government
Bond (%, rhs)
Source: Bloomberg Finance LP
The NBP’s November Inflation Report saw a 0.4pp
upward revision to the Bank’s inflation projections for both
2012 and 2013 and the GDP growth projections lowered
marginally. With CPI expected to remain above target
through the entire forecast horizon the NBP are likely to
maintain their relatively hawkish stance for some time
ahead. Further zloty weakness will also rule out any
change to a dovish stance and we expect the Bank will
also want to be sure of the government commitment to
fiscal consolidation before hinting at any easing in
monetary policy.
Poland: NBP now expects inflation to remain above
its 2.5% target through the entire forecast horizon
Previous Latest Change Previous Latest Change
2011 4.0 4.0 0.0 4.0 4.1 0.1
2012 2.7 3.1 0.4 3.2 3.1 -0.1
2013 2.4 2.8 0.4 2.9 2.8 -0.1
Inflation forecasts (% YoY) GDP forecasts (%)
Source: NBP
Despite the ongoing zloty weakness and recent
announcement of tax increases on diesel and tobacco the
inflation profile will still improve from January as the 2011
VAT hike drops from annual comparisons. CPI will move
back within the 2.5% +/-1pp buffer by Q2 but it will not
drop back to the 2.5% midpoint target 2013. The
combination of still-strong domestic momentum and a
higher inflation profile suggests our earlier expectation for
the NBP to move to a rate cutting cycle from March 2012
now looks too soon. We now expect the NBP will remain
firmly in wait-and-see mode for at least the next six
months with the first rate cut unlikely before Q3.
Caroline Grady, London, (44) 207 545 9913
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 131
Investment Strategy
FX: Strong momentum in the domestic economy
continued in Q3, with the GDP report showing that
currency weakness is not entirely negative, as it makes
exports more competitive (net exports added 1% to Q3
growth). Inflation has been sticky, and commentary from
NBP has remained hawkish, suggesting that the
aggressive re-pricing of policy seen in August is unlikely to
materialise. The consolidation plan following the elections
was well received by OECD - who expect the government
deficit to be cut to 2.9% of GDP in '12 (previously 3.8%).
Finally, valuation is attractive on our longer term valuation
metric and combined with credible fiscal consolidation
and continued support from official authorities to keep
EUR/PLN contained (also to keep debt/GDP below 55%)
we are cautiously constructive. Near-term there are still
substantial risks, with the PLN hostage to the Eurozone
crisis and also taking over as the default European risk-off
hedge to some extent if NBH starts hiking rates. On
balance, we recommend a 1y EUR/PLN put struck at 4.25
for an indicative cost of 2%.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Receive 1Y XCCY basis as a hedge but outright
purchase of POLGBs will be attractive in H2 2012 The
negative FX performance and robust economic growth
has led us to reduce our expectations for rate cuts in H1
2012. Real money funds have been consistently
underweight through the year, at least partly due to the
current stigma associated with European names. Any
further negative developments could lead to a tightening
of USD funding and a rise in the interbank fixing. At
present, we see more upside in bearish positions such as
receiving the 1Y EURPLN cross-currency basis. In H2, as
more progress is achieved in resolving the Eurozone issue
and the inflation outlook likely moderates, we would be
looking to increase exposure via bonds.
Lamine Bougueroua, London, (44) 20 7545 2402
Credit: Overweight. The next few months are a critical
period for Poland with respect to fiscal policy – likely the
key determinant for relative performance of the credit in
the near term. While we are cautious in our expectations
of what the re-elected government will deliver, we believe
the market reflects an even more cautious view and
hence we see the risks being skewed towards tighter
spreads. Certainly there are few credits in EMEA which
have such a potential to provide a positive surprise in the
near term. We change our recommend to overweight
from neutral.
Marc Balston, London, (44) 20 7547 1484
Poland: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 428.5 471.4 520.6 494.4
Population (mn) 38.1 38.1 38.1 38.1
GDP per capita (USD) 11243 12375 13673 12986
Real GDP (YoY%) 1.6 3.8 4.2 2.3
Priv. consumption 2.0 3.2 3.5 2.7
Gov't consumption 2.1 3.9 0.2 1.0
Gross capital formation -1.4 -2.2 6.2 4.0
Exports -6.8 10.2 7.0 6.4
Imports -12.4 11.6 6.2 6.0
Prices, Money and Banking
(eop
CPI (YoY%) 3.5 3.1 4.0 2.4
Broad money (M2) 8.1 7.8 10.2 10.0
Fiscal Accounts (% of GDP)
ESA 95 budget balance -7.3 -7.8 -5.5 -4.3
Revenue 37.2 37.5 39.5 39.6
Expenditure 44.5 45.3 45.0 43.9
Primary balance -4.7 -5.1 -2.7 -1.3
External Accounts (USD bn)
Exports 142.1 165.7 191.2 188.2
Imports 149.7 177.5 208.5 203.8
Trade balance -7.6 -11.8 -17.3 -15.6
% of GDP -1.8 -2.5 -3.3 -3.2
Current account balance -17.2 -21.9 -23.4 -21.6
% of GDP -4.0 -4.6 -4.5 -4.4
FDI (net) 8.5 3.6 2.8 2.7
FX reserves (USD bn) 69.7 81.4 89.8 87.8
PLN/USD (eop) 2.86 2.96 3.38 3.04
PLN/EUR (eop) 4.10 3.97 4.40 4.10
Debt Indicators (% of GDP)
Government debt 49.9 52.9 53.0 53.2
Domestic 36.8 38.4 38.6 38.5
External 13.1 14.4 14.4 14.7
Total external debt 65.6 66.2 63.0 67.4
in USD bn 281.1 312.2 327.8 333.3
Short-term (% of total) 24.9 23.4 25.0 24.4
General (YoY%)
Industrial production -3.6 11.1 5.7 4.2
Unemployment 11.0 12.1 12.1 12.0
Financial Markets (eop) Current 3M 6M 12M
Policy rate (14 day repo) 4.50 4.50 4.50 4.00
PLN/EUR 4.49 4.33 4.25 4.10
PLN/USD 3.33 3.33 3.40 3.04
Source: Haver Analytics, NBP, DB Global Markets Research.
6 December 2011 EM Monthly
Page 132 Deutsche Bank Securities Inc.
Romania Baa3(stable)/BB+(stable)/BBB-(stable) Moodys/S&P/Fitch
Economic Outlook: A precautionary IMF/EU SBA in
place until 2013 combined with the government’s
intention to increasingly tap the Eurobond market
ahead of large external redemptions in 2013/14
should help to ensure reform fatigue is avoided and
the structure of growth continues to improve.
Despite a very difficult external backdrop we see
upside risks to our growth projection from stepped
up absorption of EU funding and reform of loss-
making SOEs.
Main Risks: Fiscal slippage in the run up to the Q4
general election risks pushing the IMF/EU program
off track and would limit scope for further monetary
easing. It could also put pressure on the ratings.
Strategy Recommendations: Neutral FX.
Overweight sovereign external debt.
Macro View Domestic factors point to upside risks to the growth
outlook. We see Romania’s recovery as one of the most
secure in the region for the coming year. While growth is
likely to be relatively slow after a bumper Q3 and continue
to be reliant on exports, the composition of growth is
expected to be the most balanced for many years. That
the IMF/EU precautionary stand-by arrangement (SBA) is
active through Q1 2013 should also help to avoid any
policy slippage in the run up to the general election due by
November. Fundamentals have continued to improve,
reflected in the positive assessment by the IMF in its
recent program review which commended the authorities
for making ‚good progress in implementing program
policies in a very difficult external environment‛. That the
sharp fiscal policy adjustments are now in the past also
reduces the fiscal drag on the 2012 growth outlook
compared with the past two years. Despite our
expectation for a 2012 recession in Euroland we see the
risks to our growth forecasts for Romania to the upside
with the potential for a sizeable step-up in absorption of
EU funding and positive spillover from growth-enhancing
structural reforms. Romania’s smaller export share (35.8%
of GDP) compared with Czech Republic (79.3%) and
Hungary (86.5%) also helps while a public debt/GDP ratio
of sub 40% also limits spillover from European debt
worries.
At 1.9% QoQ and 4.4% YoY Romania’s Q3 GDP reading
was by far the strongest in CEE and is the fastest pace of
quarterly growth since seasonally-adjusted data are
available (Q1 2009). On a YoY basis the 4.4% reading is
the highest since Q3 2008 and up sharply from the 1.4%
YoY reading in Q2 with the July 2010 austerity measures
now out of annual comparisons. INSEE have yet to
publish the GDP components for Q3 but we expect
agriculture provided by far the largest contribution to
growth given the bumper harvest through the quarter. IP
growth picked up to 5.7% through Q3 following a sharp
deceleration in Q2 and we expect exports will also show a
move up after merchandise exports (value basis) reported
a return to positive territory at 4.2% for Q3 versus Q2
after a -5.1% reading for Q2. On the domestic side,
monthly retail sales data suggests a still weak consumer
with growth remaining in negative territory for almost
three years now (3mma YoY basis) albeit with the
September 2012 reading the strongest for a year. Credit
growth remains weak with net new credit extension to
the private sector largely unchanged YTD versus a year
ago although this should be neutral, rather than negative,
for domestic demand. On a FX-adjusted basis credit
growth stands at 6% YoY as of September and positive in
real terms for three consecutive months now. The outlook
for any meaningful revival in credit growth is severely
limited however given capital raising requirements faced
by foreign parent banks. But with the Vienna initiative for
Romania renewed in early 2011 we do not expect any
protracted reduction in exposure by the largest foreign-
owned banks in the coming year.
Romania: At 1.9% QoQ in Q3 GDP Romania reported
by far the strongest growth in CEE
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11
RomaniaEurolandCzechHungaryPoland
Real GDP (SA, % QoQ)
Source: Haver Analytics, DB Global Markets Research
As the boost from a strong harvest could continue to
support growth through Q4 on a QoQ basis and the
bumper Q3 has now lifted the base to ensure a strong
final quarter reading in YoY terms, our previous 0.9% GDP
expectation for 2011 now looks too low. We revise this up
to 1.8% while for 2012 we leave our 1.9% growth
expectation unchanged despite our now weaker Euroland
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 133
baseline (-0.5% from +0.4% previously). We have
however adjusted the composition of GDP for next year
with a lower export assumption and higher domestic
demand growth. Our revised forecasts see a gradual pick-
up in consumer spending with wage growth much
improved in both real and nominal terms and acceleration
in investment growth from efforts to improve absorption
of allocated EU funding (the EUR6bn or 4.7% of GDP
included in the budget for EU transfers is a record high).
To the extent that the fiscal dynamics allow for a further
reversal of the 2010 public sector wage and pension cuts
this would be another upside for growth in the coming
year. The continuation of regular program reviews by the
IMF/EU and the authorities desire to increasingly tap the
Eurobond market ahead of large IMF repayments in 2013
and 2014 should also help to ensure reform fatigue does
not set in and the impressive track record of policy
implementation during the past two years continues.
Targeting a sub 3% fiscal deficit in 2012. The
government’s commitment to a sub 3% fiscal deficit for
2012 (which would be the first such reading since 2007) is
impressive particularly given the election calendar. The
recently approved 2012 budget is based on an IMF-agreed
1.8% GDP growth assumption and sees the
expenditure/GDP ratio dropping for the third consecutive
year and the revenue/GDP ratio increasing. We do not see
a 3% deficit as unachievable. Romania has already passed
all the necessary legislation to ensure continued fiscal
consolidation (the fiscal responsibility law, the unitary
wage law, the public finance law and the pension reform
law) and is committed to reduce the overall wage bill to
below 7.2% of GDP from 9.2% in 2009. The EUR6bn
assumption on EU transfers looks optimistic at first glance
but with the EU budget period ending in 2013 time is
running out to absorb the remaining funding allocation and
with just a 5% co-financing requirement (versus 15%
normally) there is a large incentive to do so. The IMF/EU
focus on loss-making SOEs and clearing of arrears, if
achieved, should also prove to be a support to growth and
indirectly to the budget. The authorities have also set out
a timeline for IPOs and for new management structures at
the largest loss-making enterprises with the intention of
making the companies cash-flow positive. The success of
the IPO pipeline will however depend on the broader
macro environment with the unsuccessful sale of the
country’s largest energy company, Petrom, in July
evidence of this. With an expected pick-up in growth next
year and continued narrowing of the headline deficit the
structural budget deficit should also narrow again next
year. The latest EC projections see a 2.6% of GDP
structural budget deficit for 2012 which would amount to
a 6.5pp reduction in the structural deficit since the peak in
2009. This compares with 2.1pp for Czech Republic,
0.5pp for Hungary and 3.5pp for Poland. The ~1pp
improvement for next year is smaller than the adjustments
made during the past two years which also supports our
view on an improvement in domestic demand for the
coming year.
Modest rate cuts look likely. A moderate loosening in
the monetary policy stance is also expected to provide
some support to growth in 2012. The NBR announced an
earlier-than-expected move to an easing cycle with a
25bps rate cut in early November. The rate cut was the
first since May 2010 and came after a significant
improvement in headline inflation with the November CPI
reading at 3.5% YoY, versus 8.4% in May, the adjusted
CORE2 readings at 2.7% and 4.8% YoY for October and
May respectively (CORE2 excludes administered prices,
volatile prices and tobacco and alcohol). While some of
the improvement reflects a better base as the July 2010
VAT hike has now dropped out of annual comparisons the
5.7% decline in the food price component (37.5% of the
total index) between May and September was also a
significant factor. The sharp disinflation pushed real rates
sharply higher and was offset only partly by a weaker leu
according to our monetary conditions index.
Romania: Further cuts in the policy rate will reverse
some of the recent increase in real rates
-4
-2
0
2
4
6
8
110
120
130
140
150
Oct-05 Oct-07 Oct-09 Oct-11
%
Dec
2000=100dbREER (lhs)
Real policy rate (rhs)
Source: Haver Analytic, DB Global Markets Research
The NBR policy statement from November said that the
cut in the policy rate was intended to ensure adequate
real broad monetary conditions and that the NBR would
maintain a prudent approach to monetary policy. The NBR
statement also mentioned a ‚gradual reduction‛ in real
broad monetary conditions going forward and highlighted
the importance of domestic savings and ‚appropriate
remuneration of bank deposits‛. These comments
combined with the Bank’s acknowledgement that the
medium-term risks to the inflation outlook are to the
upside suggest 2012 rate cuts are likely to be modest and
we expect a total of 75bps in rate cuts through the next
twelve months. This would leave the policy rate at 5.25%
and real rates around 2%. We expect the timing of rate
hikes to be fairly spread out as the NBR assesses the
6 December 2011 EM Monthly
Page 134 Deutsche Bank Securities Inc.
impact of the recent cut in heating subsidies (estimated to
add up to 0.5pp to headline CPI) as well as any spillover
impact from the recent increase in industrial gas prices.
The updated Inflation Report from November sees the 3%
+/-1pp target being achieved for both 2011 and 2012 (the
NBR has only once met its target in the past) but with
three main risks around the outlook namely; a weaker
external environment leading to a currency depreciation,
possible upward pressure on public sector wages in 2012
due to the general election and administered price hikes.
Romania: Liquidity operations have been stepped up
in case of any funding squeeze
-40
-30
-20
-10
0
10
20
30
40
50
60
Nov-07 Nov-08 Nov-09 Nov-10 Nov-11
RON bn
Net OMO
Source: NBR, DB Global Markets Research (chart shows monthly aggregate)
Aside from the inflation trajectory, scope for rate cuts will
also be dependent on banking sector stability in the face
of further stress in European financial markets as well as
RON performance. The NBR has stepped up its weekly 7-
day repo operations during recent months with the
RON6.25bn repo tender on November 21st the largest
since early 2010. That commercial bank holdings of
government securities now stand at 10.4% of GDP versus
just 1.3% of GDP in September 2008 significantly
improves bank’s access to repo liquidity as government
securities are the bulk of eligible collateral. If banks facing
a liquidity squeeze do not have sufficient eligible collateral
to use the repo window the NBR also has an option to
extend emergency liquidity with a broader range of
collateral. The list is not made public however and would
be done on a case-by-case basis. These short-term
liquidity facilities are complemented by a deposit
guarantee fund which has the power to take over
distressed banks temporarily in order to avoid any fire sale
until a private sector buyer can be found. Despite the high
share of Greek parent banks in Romania and the move up
in NPLs to 14.2% as of September 2011 from 11.7% a
year earlier the banking system is nevertheless generally
viewed as resilient with a 13.4% capital adequacy ratio as
of end September, adequate provisioning and all banks
above the 10% regulatory minimum. In addition, there has
not been any obvious pressure on deposits.
External position looks comfortable, albeit with some
widening in the C/A deficit. Romania’s external position
should also continue to show improvement during the
coming year although made difficult by a very weak
backdrop in Europe and a likely pick-up in import demand
given the expected improvement in domestic demand.
Latest data on exports show a turnaround from the
summer lows but it is difficult to determine the extent this
will be sustained although data on new export orders have
also rebounded from the summer slump. A very strong
performance at the beginning of 2011 should mean that
annual growth in exports and imports is only marginally
down from the 28.5% and 20.4% of 2010 securing a
further reduction in the trade deficit to around 4.5% of
GDP from a high of 13.7% in 2008. Recent divestments
by two of Romania’s main exporters will also hurt export
growth next year although production increases by Ford
as well as investment announcements from other
multinational corporates could offset this to some extent.
Romania faces the problem that the only offset to the
trade deficit, namely the transfers surplus, could well
decline further in line with fiscal austerity and recession in
Italy, the main source of remittances. Nevertheless, at
around 5% of GDP the C/A deficit should be comfortably
financed and we do not foresee any BoP funding gap that
would put pressure on the RON.
Romania: External financing will increase in 2012 but
looks easily manageable
EURbn 2007 2008 2009 2010 2011F 2012F
Gross Financ ing Req. 36.0 45.1 39.2 31.3 35.7 38.5
C/A (deficit = positive) 17.0 16.2 4.9 5.0 4.7 5.5
Amortisation (MLT) 6.5 8.5 13.1 12.3 14.6 13.5
Amortisation (ST) 12.5 20.5 21.3 14.1 16.4 19.4
Financ ing 36.0 45.1 39.2 31.3 35.7 38.5
Non-debt creating 8.1 9.9 4.2 2.5 2.2 4.2
FDI (net) 7.3 9.3 3.6 2.2 1.6 2.2
EU capital inflows 0.8 0.6 0.6 0.2 0.6 2.0
Debt creating 32.6 33.5 35.2 31.5 33.4 34.3
Sovereign Eurobonds 0.8 1.0 1.5 3.0
Multilateral financing 10.9 6.2 2.1
Banks + corporates 32.6 32.7 24.3 24.3 29.9 31.3
Errors & omissions -0.2 1.7 1.0 0.9 0.0 0.0
Reserves (+ = decrease) -4.5 0.0 -1.1 -3.5 0.0 0.0
Gross Financ ing Req.
% of GDP 28.9 32.3 33.4 25.7 27.9 28.5 Source: DB Global Markets Research
Despite the expected move wider in the C/A deficit and
slightly higher amortization than in 2011 the overall gross
external financing requirement looks manageable. The
bulk of the financing remains with the private sector but
with the IMF/EU anchor remaining in place we expect
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 135
sufficient financing will be maintained. On the sovereign
side, the government faces a total of EUR2.6bn in
redemptions in 2012 with EUR1.9bn in repayments to the
IMF (with principal payments of EUR0.6bn, EUR0.6bn and
EUR0.2bn due in August, November and December
respectively) and a EUR700mn Eurobond due in May. The
authorities have a EUR7bn EMTN program in place and
have announced plans to issue their first USD-
denominated Eurobond soon. With EUR5bn due to the
IMF in 2013 and EUR4.6bn due in 2014, Romania’s
presence on the Eurobond market will likely increase in
2012 in order to pre-finance for later years. We see
potential for S&P to join Fitch in bringing Romania’s LT
foreign currency sovereign rating back to investment
grade during the coming year provided the government
sticks with its fiscal commitments.
Caroline Grady, London, (44) 207 545 9913
Investment Strategy
FX: Romania's macro outlook is improving. Domestic
factors are pointing towards upside risks to growth, the
C/A deficit at around 4% does not pose a material threat
to the RON and the government's sub 3% fiscal deficit
target does not look unachievable. It is worth noting that
with 35% of exports to Europe, Romania is not as
exposed to Europe as Czech Republic (around 80%) or
Hungary (87%). From a strategy point of view, however,
we see a lack of catalysts for RON volatility. In risk
positive scenarios we see investors preferring higher
yielding and more 'default' risk currencies such as the
ZAR. In risk negative scenarios we do not foresee the leu
getting hit as aggressively as for example HUF, and of
course of the threat of intervention from the NBH.
Henrik Gullberg, London, (44) 20 7545 4987
Siddharth Kapoor, London, (44) 20 7547 4241
Credit: Overweight. Risks to economic performance are
mounting, but the government’s commitment to fiscal
adjustment and its good relationship with the IMF should
stand the country in good stead to weather potential
storms ahead. At 430bp, Romania 5Y CDS exaggerates
the risks; we recommend an overweight exposure to the
credit. The main risk to this position is renewed pressure
on eurozone sovereigns. Romania spreads are already
20bp tighter than Italy and while this is arguably justified
given the country’s relative debt dynamics, it will likely
constrain how much Romania spreads could tighten.
Marc Balston, London, (44) 20 7547 1484
Romania: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 162.8 163.2 177.6 174.1
Population (mn) 21.4 21.4 21.4 21.4
GDP per capita (USD) 7602 7617 8305 8134
Real GDP (%) -7.1 -1.3 1.8 1.9
Priv. consumption -9.6 -1.8 2.3 4.0
Govt consumption 1.2 -3.2 1.5 3.5
Investment -25.3 -13.1 6.5 9.5
Exports -5.0 14.3 8.9 9.2
Imports -21.4 12.4 10.0 13.0
Prices, Money and Banking (eop)
CPI (YoY%) 4.8 8.0 3.5 3.2
Broad money (M2) 8.3 6.2 5.6 5.3
Fiscal Accounts (% of GDP)
General budget balance -8.5 -6.4 -4.4 -3.1
Revenue 32.1 34.4 34.6 35.1
Spending 40.6 40.8 39.0 38.2
Primary balance -6.9 -4.6 -2.6 -1.3
External Accounts (USDbn)
Exports 40.3 51.8 61.7 64.6
Imports 49.8 60.0 69.7 73.6
Trade balance -9.5 -8.2 -8.0 -9.0
% of GDP -5.8 -5.0 -4.5 -5.2
Current account balance -6.8 -6.9 -6.5 -7.1
% of GDP -4.2 -4.2 -3.6 -4.1
FDI (net) 4.9 3.1 2.3 2.9
FX reserves (USDbn) 40.5 43.4 45.0 46.5
RON/USD (eop) 2.95 3.20 3.31 3.07
RON/EUR (eop) 4.23 4.28 4.30 4.15
Debt Indicators (% of GDP)
Government debt 30.0 37.9 39.0 39.1
Domestic 18.4 22.7 21.8 22.0
External 11.6 15.2 17.2 17.1
Total external debt 69.1 75.8 75.2 80.2
in USD bn 112.5 123.7 133.5 139.6
General (% pavg)
Industrial production (% YoY) -6.1 5.6 8.7 8.8
Unemployment 7.8 6.9 5.5 5.2
Financial Markets (end
period)
Current 3M 6M 12M
NBR policy rate (%) 6.00 5.75 5.25 5.25
RON/EUR 4.36 4.26 4.23 4.15
RON/USD 3.24 3.28 3.38 3.07
Source: NBR, DB Global Markets Research. The NBR classifies the IMF lending under
monetary authorities rather than government external debt.
6 December 2011 EM Monthly
Page 136 Deutsche Bank Securities Inc.
Russia Baa1(stable)/BBB(stable)/BBB(positive) Moody’s/S&P/Fitch
Outlook: Growth accelerating on the back of high
consumption and fixed investment growth.
Main risks: Recurring capital outflows and a drop in
oil prices remain key risks.
Strategy recommendations: Short NOK/RUB, for a
move back down to 51 flat. OFZs likely to perform in
2012. Overweight sovereign credit.
Macro outlook
The outlook for 2012 is clouded by the volatility in global
financial markets, which impacts Russia through higher
capital outflows as well as elevated risks of a decline in oil
prices. To some degree the scale of capital outflows may
moderate in 2012 with a reduction in political uncertainty
and some of the positive developments in Russia’s
investment climate, most notably the accession to the
WTO. The latter is likely to be largely sealed by Russia at
the WTO Council on December 15, 2011, with the
approval of the accession package and full-fledged
accession taking place in mid-2012.
We believe that growth has scope to accelerate further in
2012 on the back of higher expansion in fixed investment.
At the same time there may be upside risks to inflation
due to the effects of rouble weakness in H2 2011 as well
as higher fiscal spending ahead of the presidential
elections. Given DB’s positive oil price outlook for 2012,
the current account is likely to continue to exhibit a strong
surplus, while in the fiscal sphere a moderate deficit may
emerge at the federal level. The escalation in fiscal
commitments (most notably in the defense sector) may
sustain the level of the non-oil budget deficit at high
levels, leaving the federal budget vulnerable to declines in
oil prices.
Growth outlook: investment likely to accelerate
The key economic indicators for October reveal the
persistence of high household consumption growth rates
and emphatic acceleration in fixed investment growth. In
October household consumption (as proxied by retail
sales) increased by 8.8% YoY, which is only moderately
lower than the 9.2% YoY reading registered in the
preceding month. The surge in household consumption
was mostly driven by higher outlays on non-food goods –
while in January-October 2011 food retail sales increased
by 2.5% YoY, the corresponding figure for non-food
goods amounted to 10.4%. The high rate of growth in
consumption took place despite the rise in unemployment
from 6% in September to 6.4% in October and real
disposable income rising by a moderate 0.4% YoY in
October. The volatility in the exchange rate sphere may
have still favoured spending on non-food goods as a way
to preserve rouble savings. The recent acceleration in
household consumption growth suggests that in 2011
growth could reach nearly 7%, which significantly
exceeds government projections.
Fixed investment growth reached 8.6% in October, which
is higher than the 8.5% and 6.5% seen in September and
August respectively. In January-October 2011 fixed
investment growth reached 5.3% and is on course to
reach or exceed the government’s 6% projection for
2011. One of the drivers behind the acceleration in fixed
investment growth is construction, which expanded by
8.2% YoY in October after posting a 4.8% YoY increase in
the preceding month. We continue to see construction as
one of the key potential drivers of higher fixed investment
in the remainder of this year as well as in 2012. Our view
is that fixed investment growth is likely to benefit in 2012
from a combination of lower capital outflows, further
recovery in construction as well as the implementation of
large-scale infrastructure projects associated with the
preparations for APEC summit in 2012 and Sochi Winter
Olympics in 2014. Starting from next year a notable
increase in infrastructure spending is also projected for
the 2018 Soccer World Cup.
Russia: fixed investment and household consumption
-20
-15
-10
-5
0
5
10
15
20
25
2003 2004 2005 2006 2007 2008 2009 2010 2011F 2012F 2013F
Consumption growth, %, real Investment growth, %, real
Source: Rosstat, Deutsche Bank
According to the Ministry of Economy, the government
could revise up its GDP growth estimate for 2011 from
4.1% to 4.2-4.5%. For 2012-2014, the ministry projects
the GDP growth would stabilize around 4% with inflation
gradually decelerating to 4–5%. Overall, the ministry’s
possible GDP growth outlook is in line with our projection
of 4.5% for 2011, given a significant acceleration in fixed
investment growth in recent months as well as the
resilience of high rates of growth in household
consumption. At the same time compared to the official
forecast of less than 4% GDP growth in 2012, we are
more optimistic in assessing the scope for growth in fixed
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 137
investment, while also expecting a relatively strong
increase in household consumption on the back of the
pre-electoral boost to social outlays.
Fiscal policy: medium-term concerns on the spending
front
According to the Ministry of Finance, Russia’s federal
budget posted a RUR269bn surplus in October, putting
YTD surplus at RUR1.4tr. The accelerating surplus was
mainly due to higher-than-YTD average revenues
(RUR1,028bn in October vs. monthly average of
RUR913bn in the first nine months of 2011), while
expenditures were slightly above average at RUR759bn.
For the first ten months of 2011, the federal surplus figure
stands at 3.2% of GDP, though this is likely to decline to
less than 1% of GDP by the end of the year due to a
seasonal surge in spending in December, which this year
is likely to be exacerbated by electoral pressures. The
Ministry of Finance estimates that Russia could post a
budget surplus of 0.2% of GDP in 2011, which is in line
with our projections for this year.
Russia: Federal budget parameters
Government forecast DB forecast
% of GDP 2011* 2012 2013 2011 2012 2013
State budget balance -1.3% -1.5% -1.6% 0.2% -0.4% 0.6%
Revenue 19.3% 20.1% 19.6% 21.9% 20.2% 20.0%
Expenditure 20.7% 21.6% 21.2% 21.7% 20.6% 19.4%
Urals oil price, USD/bbl 100 97 101 109 112 117
* - most recently the government forecasted a 0.5% federal budget surplus in 2011
Source: Minfin, Deutsche Bank
Despite the strong fiscal performance this year, there are
mounting concerns regarding to possibility of high fiscal
outlays in the medium-term due to the already high social
commitments assumed by the government ahead of the
2011-2012 elections, the rising outlays on defense as well
as the projected increases in spending on infrastructure.
In fact outlays as a share of GDP are projected to rise by
the Ministry of Finance from 20.8% of GDP in 2011 to
21.1% of GDP in 2012. The rise in spending commitments
will result in a further increase in the vulnerability of the
budget to a downturn in oil prices – current projections of
the Ministry of Finance assume an increase in the non-oil
budget deficit from 10.3% of GDP in 2011 to nearly 11%
of GDP in 2012.
Monetary policy: lower inflation prioritized
One of the main achievements in the macro sphere for
Russia in 2011 has been the attainment of the lowest
inflation rate since 1992, which by the end of the year
may reach around 7%. Greater focus on inflation the part
of the CBR, which was accompanied by greater exchange
rate flexibility, was a crucial factor in improving Russia’s
inflation track-record. Improved focus on inflation was also
complemented by the effects of capital outflows, which
served to lower the pace of growth in M2 money supply.
According to the CBR, Russia’s M2 money supply
declined by 0.5% after rising by 2% in September. Since
the beginning of the year the rise in M2 money supply
amounted to 6.8%, while the 12-month growth rate
decelerated to 20% by the end of October after reaching
31% at the end of last year. According to earlier
statements of the Head of the CBR Sergey Ignatiev the
deceleration in the money supply has been driven by the
sizeable budget surplus as well as the CBR’s tight
monetary policy. In the remainder of this year the growth
in the money supply will get a boost from the end of the
year budget spending increase, which may persist into Q1
2012 due to electoral factors. For 2012-2014 the CBR
expects growth in the money supply of 13-20%. Despite
the slowdown in the growth in the money supply,
inflationary pressures are building up in recent periods on
the back of the effects of rouble depreciation.
Russia: Main parameters of the monetary programme
In RUBbn unless
otherwise mentioned
Scenario 1
2011 2 012 2 013
Monetary base 7 099 7 713 8 672
Net international
reserves, USDbn 495 480 462
Net domestic assets (7 991) (6 922) (5 401)
Net credit to the broad
government (5 529) (5 202) (4 801)
Net credit to banks (90) 679 1 865
Scenario 2
2011 2 012 2 013
Monetary base 7 099 8 058 9 137
Net international
reserves, USDbn 495 521 545
Net domestic assets (7 991) (7 824) (7 471)
Net credit to the broad
government (5 529) (5 698) (6 159)
Net credit to banks (90) 250 1 092
Scenario 3
2011 2 012 2 013
Monetary base 7 099 8 264 9 452
Net international
reserves, USDbn 495 568 641
Net domestic assets (7 991) (9 036) (10 082)
Net credit to the broad
government
(5 529) (6 589) (7 864)
Net credit to banks (90) 116 565
Source: Deutsche Bank
We expect the rouble nominal rate next year to appreciate
versus the dollar towards Rb/USD28, given DB’s high oil
price forecast as well as the possibility of net capital
inflows in the second half of 2012 – in line with our and
6 December 2011 EM Monthly
Page 138 Deutsche Bank Securities Inc.
government’s expectations. Provided the CBR continues
to target low inflation and allow greater exchange rate
flexibility we believe that inflation may stabilize around 7%
in 2012, though upside risks associated with high fiscal
spending may be significant. Still, given that in 2012 we
expect both inflation and growth rates to remain close to
2011 levels, we do not expect significant swings in policy
rates. During its November meeting the CBR ruled to
keep key policy rates on hold and noted in its statement
that the current level of interest rates is consistent with
balancing inflationary and growth slowdown risks.
BOP: breaking the streak of capital outflows
One of the key negative developments in 2011 was the
persistence of net capital outflows from Russia, which
largely deprived the economy of the benefits of a
favourable high oil price environment. The government
projects net private capital outflows of 80 bn dollars in
2011, which implies that capital outflows in November -
December are projected to reach 16 bn dollars. According
to government estimates the scale of outflows in
November was significantly lower than in September-
October, possibly reaching around 10 bn dollars. For 2012
the government projects net outflows of 20 bn dollars,
while in 2013-2014 the Ministry of Economy expects net
inflows, with the trend towards inflows likely to emerge in
H2 2012 according to the Ministry. We share the view
that inflows are likely to materialize next year and believe
that there is scope for net inflows in 2012 on the back of
improvements in the investment climate, though much
will continue to depend on global factors.
As regards the current account, the high oil price
environment (as projected by DB for 2012) as well as the
moderation in the growth in imports (partly coming on the
back of a weaker rouble) are likely to result in the
persistence of a relatively high surplus of more than 4% of
GDP. In the medium-term the expansion in imports may
be given additional impetus by WTO accession as well as
imports of capital goods to support the efforts of the
authorities to develop infrastructure.
Politics: Putin to come back as President
The main political event of 2012 will be the presidential
elections scheduled for March 2012, though the main
intrigue regarding the outcome of the elections has largely
been resolved after earlier this year current President
Dmitry Medvedev called for Prime Minister Putin to run
for presidency. In November, support for Putin declined
remained at 67% compared to 66% in October, and
Medvedev’s remained stable at 62%. The new popularity
rating of Putin is close to an all-time low of 60% since the
start of his presidency in 2000-2001. The sizeable decline
in the popularity ratings of the ruling party and the Putin-
Medvedev tandem may be in part a pent-up demand for
greater changes with respect to improvements in
governance and the reduction in red tape. Despite the
notable decline in the popularity ratings of Vladimir Putin,
we expect Putin to secure his third presidential term in the
first round of the presidential elections with more than
50% of the vote.
Russia: : Putin and Medvedev approval ratings
50
55
60
65
70
75
80
85
90
2007 2008 2009 2010 2011
Percentage of Putin supporters, % Percentage of Medvedev supporters, %
Source: Levada Centre, Deutsche Bank
As regards the parliamentary elections scheduled for
December 4, the popularity of the ruling United Russia
party declined in November. The Levada-center poll
conducted at the end of November showed that support
for United Russia tumbled 7ppt to 53%, which is an all-
time low for the two past electoral cycles (in the fall of
2007, support for the party stood at nearly 70%). At the
same time, support for the communists increased from
17% to 20%, and for LDPR it grew from 11% to 12%,
with notable gains also observed for Yabloko and Justice
Russia. The eventual outcome of the elections is likely to
be a simple (rather than a constitutional) majority for the
ruling United Russia party, with the nationalistic LDPR
party possibly securing close to 15% of the vote, which
may enable the Kremlin to retain the possibility of
securing constitutional majority on key issues, since LDPR
tends to support the Kremlin in the Duma.
While the results of both parliamentary and presidential
elections are predictable and do not suggest a significant
departure from the current political framework, the decline
in the popularity ratings of Putin and the ruling United
Russia party may be of some concern with respect to the
commitment of the new government to pursuing reforms
in a post-electoral setting. In particular, further declines in
the popularity of the authorities may constrain the scope
for some of the more difficult reforms such as pension
reform or increases in regulated tariffs. There is also a risk
of greater proclivity towards higher fiscal spending in the
social sphere as a way to limit further declines in
popularity ratings.
Yaroslav Lissovolik, Moscow, (7) 495 933 9247
Ilya Piterskiy, Moscow, (7) 495 933 92 30
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 139
Investment strategy
FX: Economic uncertainty, lack of transparency, fears of a
Euro recession and political uncertainty point to outflows
of around $80bn. Capital flight is likely to diminish going
into the March elections and also likely to moderate in
response to the WTO finally approving Russian
membership after 18 years of negotiations - FinMin's
latest estimate is for outflows to slow to $20bn in 2012.
RUB will continue to be highly sensitive to oil prices, but
the budget plan for next year is based on crude at $95 on
average (Urals), which does not seem unrealistic (DB
Commodities forecasts Brent to average $115/barrel in
‘12). On balance, the outlook for capital flows, WTO
membership, oil price assumptions, the fact that FX
remains a key tool for the CBR to counter price pressures
as well as the fact that the RUB basket is still trading well
above not just pre-2008 crisis levels, but also 7% above
the levels prior to the Aug/Sep sell-off, imply there is
scope for RUB outperformance. Short 'oil' pair NOK/RUB,
for a move down to the around 51 with s/l at 54.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, (44) 20 7547 4241
Rates: OFZs likely to perform in 2012. Despite a strong
fiscal performance, record low inflation and high oil prices,
Russia was not immune to the effects of global risk
aversion. Large capital outflows caused a liquidity
tightening, despite a record increase in Repo funding by
the CBR. Russian rates are already pricing a sufficiently
cautious global scenario and we prefer to take profit on
our 2s5s flattener (initiated at 75bp, current 35bp). The
prospect of Euroclearability for OFZs as early as June
2012 is likely to lead to inflows from foreign investors (we
estimate this at about USD 9bln), since the only RUB
sovereign Eurobond, issued this year, is trading close to
90bp tight to OFZ. Therefore, we expect bonds to have a
positive performance in 2012. An easing of 3M Mosprime
levels would be a signal to receive rates
Lamine Bougueroua, London, (44) 20 7545 2402
Credit: Overweight. WTO accession and the passage of
elections make 2012 an important year for Russia. While
we are not very optimistic that the return of Putin to the
Kremlin will spur reform, we believe that the market
currently prices an excessive risk premium.
Marc Balston, London, (44) 20 7547 1484
Russia: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 1 480 1 757 2 027 2 282
Population (m) 141.9 141.8 141.7 141.6
GDP per capita (USD) 10 427 12 390 14 305 16 118
Real GDP (YoY %) 4.0 4.5 4.6 4.9
Priv. consumption 3.0 7.0 7.0 7.0
Govt consumption 1.4 2.7 -0.7 -1.2
Investment 6.0 7.0 8.0 7.0
Exports 11.1 0.2 4.0 4.0
Imports 25.4 6.1 9.0 10.0
Prices, Money and Banking (eop)
CPI (YoY %) 8.8 7.1 7.0 6.8
Broad money 28.5 20.0 20.0 20.0
Credit 13.0 21.0 17.0 18.0
Fiscal Accounts (% of GDP)
State budget balance -3.9 0.2 -0.4 0.6
Revenue 18.2 21.9 20.2 20.0
Expenditure 22.1 21.7 20.6 19.4
Primary surplus -3.5 0.7 0.1 1.1
External Accounts
(USDbn)
Exports 400 505 519 541
Imports 249 310 360 421
Trade balance 151 195 159 120
% of GDP 10.2 11.1 7.8 5.2
Current account balance 71.1 104.0 83.0 44.1
% of GDP 4.8 5.9 4.1 1.9
FDI (net) -10.5 10.0 12.0 12.0
FX reserves (USD bn) 479 520 590 654
RUR/USD (eop) 30.5 28.2 28.0 28.4
Debt Indicators (% of GDP)
Government debt 7.3 7.9 9.1 9.3
Domestic 4.6 5.9 7.1 7.3
External 2.8 2.0 2.0 2.0
Total external debt 32.6 27.3 25.2 25.0
in USD bn 483 480 510 570
General (% pavg)
Industrial production (% YoY) 8.2 5.2 5.4 5.4
Unemployment 7.5 6.8 6.8 6.8
Financial Markets (eop) Current 3M 6M 12M
Policy rate (refinancing rate) 8.25 8.00 8.00 8.00
RUR/USD 30.7 28..2 28.1 28.0 Source: Official statistics, Deutsche Bank Global Markets Research
6 December 2011 EM Monthly
Page 140 Deutsche Bank Securities Inc.
South Africa A3 (negative)/BBB+ (stable)/BBB+ (stable) Moodys/S&P/Fitch
Economic Outlook: The much weaker growth base
in Q2 and Q3 makes for encouraging rebound
potential in growth into 2012. We do not expect a
recession locally, as we estimate this probability
between 10-15%. Household demand is expected to
be the main growth driver in 2012.
Main Risks: Deteriorating global growth, negative
repercussions for terms of trade could severely harm
corporate profits. From these risks stem employment
losses, which will offset the benefit of lower
commodity prices on inflation.
Strategy Recommendations: Buy a 1y digital
EUR/ZAR put struck at 10 for roughly 25% of EUR
notional. ZAR curve set to steepen. Underweight
sovereign credit.
Macro View
Risks to global economic growth are tilted to the
downside, despite global efforts to limit deeper growth
contagion from the EU. Concerns have surfaced that the
domestic economy’s significantly weaker-than-expected
growth performance this year means that we could be a
lot closer to another recession. We believe these
concerns are misplaced. We do not foresee significant
risk of recession in the economy next year; indeed, we
estimate the likelihood to be between 10-15%. Our
reasons are outlined below. This analysis is supplemented
with base and bear case scenarios for those key business
cycle indicators that are considered to be timely signals of
recession risks. In short, substantial slippages need to
occur in global growth, commodity prices, and, by
extension, corporate profits, to raise the probability of
recession to higher levels of conviction.
A weaker global economy...: Our European colleagues
have cut near-term growth expectations to -0.5% from
0.4% for 2012, as downside risks to the sovereign debt
crisis are developing into the baseline view. Though we
acknowledge the risks, DB still remains of the view that a
euro break-up is not on the cards. The US is expected to
grow even if the euro area contracts. Asian growth should
remain generally resilient, though with some momentum
loss in the near term. We maintain a fairly robust outlook
for EM growth, but remain cautious of increasing
downside risks. Within this context we remain cautiously
optimistic on South Africa, expecting growth of 3.2% next
year from 3.1% in 2011 (revised from 3.3%).
Domestic growth artificially depressed in Q2 and Q3:
Economic growth improved in Q3 to 1.4% qoq saar but at
a more sluggish pace than we had expected (DBe 2.5%).
This mediocre growth performance is an extension of the
soft patch that had started in Q2 (1.3% from 4.6% in Q1)
and from unsustainable growth momentum in the
manufacturing sector late 2010. While there has been a
series of one-off events (eg. strikes and production
stoppages) that weighed more heavily on the mining,
manufacturing and agriculture sectors, the weakness was
not entirely due to local factors.
However, we expect positive growth momentum going
forward, and expect household demand to become the
dominant growth driver next year. That said, risks to this
view are likely to increase if global growth falls below 3%
next year. At global growth below 3%, the risks of weaker
commodity prices, which trigger potentially deeper
destocking in China, will have negative ramifications for
the economy. As it stands, our export exposure to Europe
leaves us vulnerable to a more meaningful slowdown next
year. This has raised several questions over the likelihood
of the economy falling into recession next year.
Before examining recession probabilities, below we briefly
discuss our main arguments against recession risks:
Financial conditions are less stringent for consumers
than during the crisis period: We explore the main
financial vulnerability metrics in the Figure below. The
heat map depicts the highest vulnerability in shades of
red, with yellow and greener shades showing neutral to
low levels of vulnerability. On average, the household
vulnerability index43 in 2Q11 was close to 2006 levels, the
midst of the previous boom period, but with the key
difference that employment, financial markets’
performance, house price growth and real disposable
income were much stronger in 2006 (one- to two standard
deviations above the long-term mean). Whereas
employment growth generally lags the economic cycle,
there has been very modest improvement in 2011, which
we believe could be sustained next year. The overall
financial position of households is also in a far healthier
state than in 2008, when most indicators were more than
two standard deviations away from the long-term mean
(negative). Therefore, the envisaged slowdown in
household demand to 3.3% next year, from DBe of 4.2%
in 2011, is mostly a result of high base effects,
consolidating net wealth, and rising inflation. We do not
believe that any of these key consumer metrics could
deteriorate significantly, without a new negative catalyst.
43 Scores are assigned based on the indicator’s deviation from its long-
term mean, with the highest score of 25 indicating extreme vulnerability,
and zero, low vulnerability. These scores are normalised to a total out of
100.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 141
South Africa: Household vulnerability heat map
Ave. Max Min LatestScore
2006
Score
2008
Score
20102Q11
Outlook
*
Debt-serivce-income
ratio (%)9.4 12.7 6.9 6.9 10 21 9 5 Stable
GDP growth
(qoq saar %) 3.1 6.7 -5.9 1.3 9 15 13 15 Positive
Employment
(non-farm - yoy %)2.9 13.9 -4.1 2.0 4 15 16 10 Stable
Financial assets
(yoy %)12.5 28.7 -12.9 15.5 5 18 10 10 Stable
House price (yoy %) 7.2 16.1 -3.5 1.9 5 15 14 15 Stable
Inflation (yoy %) 6.2 13.2 3.5 4.6 10 21 8 10 Negative
Insolvencies (yoy %) 22 137 -43 -36 10 21 6 5 Stable
Net wealth-to-debt ratio
(%)366 414 319 357 10 14 14 15 Stable
Household debt
(yoy %)13.7 27.3 2.0 6.7 20 13 8 10 Stable
Disposable income
(yoy %)3.6 8.3 -4.9 3.8 6 18 10 10 Stable
Savings-income ratio
(%)-0.6 -0.1 -1.3 -0.2 16 19 9 5 Stable
Average score (total
out of 100)38 69 42 40
Historical 2006-2011 Average
*The outlook is based on the expected movement in the score relative to the current quarter.
Source: Deutsche Bank, SARB, StatsSA, I-Net Bridge
Replacement needs exist for previously overextended
indebted households: We proxy pent-up demand as the
trough-to peak increase in the ratio of durable goods to
total HCE in the first two years after a recession. On this
basis, we saw the strongest increase in the durable goods
ratio to HCE on record between 2Q09 and 2Q11. Most of
this demand probably originated from higher income
earners supported by rising net wealth. In light of signs of
improving bad debt records, which we believe is mainly a
middle-to low income constraint; there is scope for more
replacement demand in our view. In addition, any upside
from modestly higher loan growth in the property market
should count as a bonus.
Several cyclical components of GDP are still
suppressed: The typical downward adjustments in
economic activity arise in the cyclical components of GDP
– eg investment in residential property, transport- and
machinery equipment and durable and semi-durable
goods, and business inventories. Of these indicators, only
spending on durable and semi-durable goods and
investment in transport has really recovered over the past
few years. Residential and machinery and equipment are
still at rock bottom levels44, which mean there is very little
downside pressure to growth that could arise from these
indicators
Strong corporate balance sheets: Robust corporate
profit growth in 2011, reaching 13.6% yoy in Q3 should
bring gross corporate savings to the best levels in thirty
years. Corporate profits usually slow sharply ahead of a
recession, which is typically the reason for a dramatic
downsizing of the workforce. But corporates are much
leaner in this cycle. Profit per private sector worker is
44 See EM Monthly: South Africa, 8 December 2010.
currently nearly one-and-a-half times the size at the start
of 2008. Barring much weaker global growth,
retrenchments should be light in comparison with the
2008 cycle, as corporates have not employed excessively
since then.
Monetary policy has room to manoeuvre: In the event
that recession risks do rise, the Bank has the option to cut
interest rates. Even in the absence of further monetary
policy relaxation, real rates are likely to decline further next
year to between -1 and -2%, which remains a tailwind for
consumer demand.
Export growth is more geared to EMs than before: A
point often missed in the context of export vulnerability is
that despite the importance of DMs in the export basket
(c. 55% of total rand exports), these economies only
account for 30-40% of export growth, versus 80-90%
eight years ago. Though quite cyclical at times, China’s
portion of the EM growth share has reached more than
50%. We remain constructive on the Chinese economy,
despite the modest momentum loss over the next few
quarters.
South Africa: EM a strong force behind export growth
-45
-30
-15
0
15
30
45
2003 2004 2005 2006 2007 2008 2009 2010 2011
Emerging markets ex China
China
Advanced economies ex Europe
Europe
% contribution to exports yoy
Source: Deutsche Bank, IMF
Downside risks remain: From these arguments, we view
downside risks to corporate profits, and commodity prices
(terms of trade) – which could scupper our growth call for
next year should these really disappoint. We believe that
terms of trade gains this past year-and-a half has been an
important cyclical driver of corporate profits, and do see
scope for moderation. However, as indicated below,
these indicators will have to fall dramatically in order to
materially weaken the growth dynamic. Should the global
economic recovery take a turn for the worse, in which
case corporates will battle to push rising costs through
the system, corporate profit margins will come under
pressure. The negative knock-on impact this will have on
employment should offset the benefit of lower
commodity prices on inflation, in our opinion.
6 December 2011 EM Monthly
Page 142 Deutsche Bank Securities Inc.
Turning to our recession probability gauge, we
estimate a very low probability of recession next year
of between 10-15%. These estimates (from models 2 and
3 in the Figure below) are based on the base view of
slowing, but not contracting growth, barring the G7
leading indicator. Using the benchmark leading indicator
of the SARB (model 1) we estimate a 45% probability of
recession in early 2012, if we assume the index level
remains stable next year. In defence, we have to say that
the SARB leading indicator has given three false signals of
recession risks over the last three decades, and hence
prefer models 1 and 2, which also have stronger
forecasting capabilities (second figure below). For the
leading indicator, we find firm levels of conviction at 70%
and above, which is worth monitoring closely.
South Africa: Recession probability model* inputs and
assumptions
2011
YTD Base Prob. Bear Prob.
1. SARB leading indicator (yoy %) 2.9 0 45% -5.5 85%
2. Model incorporating DM growth 15% 99%
Real money supply growth 1.8 0 -2
Insolvencies (number) 731 450 1050
Yield curve (10yr-jibar) 2.9 2.8 4.7
G7 leading indicator (yoy %) 2.9 -1 -4
3. Model incorporating corporate
profits/commodities 10% 95%
Real money supply growth 1.8 0 -2
Yield curve (10yr-jibar) 2.9 2.8 4.7
Real corporate profit growth (yoy %) 7.6 3.7 -1.1
Terms of trade (yoy %) 5.7 1.2 -4.5
2012 forecast assumptions
*Based on a binary response model using maximum likelihood techniques.
Source: Deutsche Bank, SARB, I-Net Bridge
South Africa: Estimated probabilities of recession
0%
50%
100%
1984 1989 1994 1999 2004 2009
Probability range from recession models
Downswing
Recession probability: leading indicator
Est.
Bear
Base
Source: Deutsche Bank
The bear case scenario, which we attach a low probability
to, is consistent with events linked to systemic contagion
in banking and financial markets, and a deeper downturn
in advanced economies. The bear case scenario provides
guidance of trends that have historically been associated
with economic downturns. We tweaked the yield curve to
incorporate a bearish scenario of stagflation, in which
case we think the SARB could react to by cutting interest
rates by 100 basis points, thus initiating a much steeper
yield curve than what would normally be the case for
economic downturns.
Implications for the C/A deficit: a function of savings:
All in, we expect a modest widening in the current
account deficit to 3.7% in 2012, from 3.1% this year. Only
part of this widening is attributed to a deteriorating trade
balance. This is in contrast to the string of surpluses this
year that had been supported by a widening in the savings
investment gap, stemming from healthy operating
surpluses and terms of trade gains. However the very
modest improvement in private investment spending of
late, coupled with a larger fiscal deficit has begun to
counter prospects of a sustained low C/A deficit.
... and private sector investment: While insufficient
demand and underlying political concerns, according to
the Bureau for Economic Research 4Q Manufacturing
survey, are amongst the main reasons for reduced
investment intentions, this sentiment is not evenly shared
amongst industries. An important feature from the survey
is that most manufactures, however, are not looking to
invest in additional capacity, replacement investment or
inventories over the next twelve months, which seem to
suggest that imports may not necessarily be buoyed.
Indeed, only retail-orientated industries seem somewhat
positive in for the next year, but their contribution to total
investment is less than 15% and they are smaller than the
larger capital-based industries. We therefore maintain our
view of fixed investment spending growth of c. 3% next
year.
Plus government dissaving: Our expectations of a fiscal
deficit of 5.4% of GDP (vs NT est. Of 5.2%) next year,
implies that corporate and households will have to save
more for the C/A to remain under control. We think this is
unlikely. On the public side, downside risks to the
Treasury’s existing growth forecasts of 3.4% in 2012
should mean that fiscal consolidation could be
challenging. These factors could be less constructive for
the bond and rand market.
With a weaker rand as the upshot: Our revised rand call
of 8.2, 8.4 and 7.9/USD in 3m, 6m and 12m time
incorporates our view of a weaker terms of trade dynamic
as discussed in this note. Though the rand will be
susceptible to risk events in either direction, our house
view of a stronger dollar in 1H12, coupled with the
potential underperformance in EM equities, implies that
the rand should be range-bound between 7.80 and 8.60
over this period. In times of risk on trades, the rand could
test 7.50/USD, in our view. Though balance of payments
risks should be largely contained, South Africa’s net
redemptions of R9.7bn worth of foreign bonds in 2012
could make the rand vulnerable during risk-off periods.
Monetary policy held hostage: Finally, our long-held
view of an inflation episode in 2012, which appears to
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 143
have become a consensus view, should mean lower rates
for longer and a slower adjustment when the need arises.
We expect the onset of a 150bps cycle starting in
November next year, in three 50bps increments.
Danelee Masia, South Africa, (27) 11 775 7267
Investment Strategy
FX: Has sold off 21% vs USD and 22% vs EUR YTD, and
is the worst performing currency in EM. It is worth
remembering that in 2009/10, ZAR was among the top
performing EMFX, and again was preceded in 2008 by
being one of the worst performing. Rand remains very
much the default risk-on/off choice, regardless of solid
fundamentals such as very limited gross external financing
requirements (less than 10% of GDP) and a relatively
attractive long-term valuation. This would suggest that the
fate of the rand will be determined by European rather
than domestic factors. Our preference remains to express
constructive ZAR views through RV, where the macro risk
component is reduced. More favourable geographic
location (vs Hungary) warrants a ZAR/HUF rate closer to
the upper 1SD band away from the mean over the past 10
years, suggesting scope for a 10% move towards 31.
Alternatively, buy a 1y digital EUR/ZAR put struck at 10 for
roughly 25% of EUR notional - giving a risk/reward of 4:1.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Curve set to steepen The SARB is unlikely to ease
monetary policy in the first half of the year despite the
ongoing slowdown in the global economy. At the same
time, the reliance on continuous non-resident interest to
absorb the heavy pace of issuance means that the back-
end performance has become linked to the unpredictable
developments in Europe. Our analysis suggests that the
curve is too flat to fair value. At times of risk-aversion, the
local bid for bonds became apparent only at levels
corresponding to 5Y5Y higher than 9%, while the same
point is unlikely to move lower than 8.40% without a
resumption of expectations for monetary easing.
Lamine Bougueroua, London, (44) 20 7545 402
Credit: Underweight. The combination of increased
gross issuance ahead, coupled with the fact that
dedicated investors are already relatively overweight the
credit persuades us to be cautious. Furthermore, as our
vulnerability indicators highlight, SA is not entirely immune
to the risks which characterise much of EMEA. In addition
to moving back to underweight from neutral, we also
close our recommendation to sell 5Y CDS protection, vs.
Brazil.
Marc Balston, London,( 44) 20 7547 1484
South Africa: Deutsche Bank Forecasts
2010 2011FF
2012F 2013F National Income
Nominal GDP (USD bn) 364.6 411 404 444
Population (mn) 50.0 50.5 51.0 51.5
GDP per capita (USD) 7293 8139 7913 8632
Real GDP (YoY%) 2.8 3.1 3.2 3.8
Priv. consumption 4.4 4.3 3.3 3.7
Gov't consumption 4.6 3.9 3.8 3.6
Gross capital formation -3.7 2.4 3.1 4.2
Exports 4.7 1.7 -2.4 8.5
Imports 9.6 5.3 0.9 6.9
Prices, Money and Banking
CPI (YoY%, eop) 3.5 6.4 6 6.4
Fiscal Accounts (% of GDP) (fiscal years)
Budget surplus -6.6 -5.5 -5.4 -5
Expenditures 33.8 32.6 32.1 31.4
Revenues 27.2 27.1 26.7 26.4
Primary surplus -4.3 -2.9 -2.7 -1.9
External Accounts (USD bn)
Exports 85.4 101.1 92.4 104.3
Imports 81.6 98.8 94.3 105.0
Trade balance 3.8 2.3 -1.9 -0.7
% of GDP 1.1 0.6 -0.5 -0.2
Current account balance -10.1 -12.7 -15.1 -16.3
% of GDP -2.8 -3.1 -3.7 -3.7
FDI(% of GDP) 0.3 1.5 0.5 1.5
FX reserves (USD bn) 43.8 50.5 55 58
USD/ZAR (eop) 6.6 8.0 7.9 8.3
EUR/ZAR (eop) 8.8 10.3 10.7 10.4
Debt Indicators (% of GDP) (fiscal years)
Government debt 37.1 40.3 41.8 42.5
Domestic debt 33.5 36.9 38.5 39.5
External debt 3.6 3.4 3.3 3
Total external debt 22.5 20.8 22.0 22.0
In USDbn 83 85.5 88.7 97.6
Financial Markets (eop) Current 3M 6M 12M
Policy rate 5.5 5.5 5.5 6
3-month rate (Jibar) 5.6 5.6 5.6 6.1
10-year rate 7.8 8.5 8.2 8.5
EUR/ZAR 10.8 10.4 10.5 10.7
USD/ZAR 8.1 8.2 8.4 7.9 Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 144 Deutsche Bank Securities Inc.
Turkey Ba2 (positive)/BB (positive)/BB+ (stable) Moody’s / S&P / Fitch
Economic Outlook: Rebalancing in the economy
continues with domestic demand slowing down
gradually and imports losing momentum. Inflation will
continue to rise in the short term due to FX pass-
through and higher food prices.
Main Risks: A harder landing is on the cards given
the large exposure to short-term funding from
international banks, balance sheet effects of a weaker
currency and volatility in capital inflows.
Strategy Recommendations: Having hit the target
on long TRY/HUF, we recommend playing the range
in USD/TRY. Buy a DnT with strikes at 1.70 and 1.90.
Add exposure to Jan-20 bonds if the economy
responds to the ongoing tightening. Overweight
sovereign external debt.
Macro View
Revising our growth outlook given that risks are much closer to becoming a reality
Since last month, conditions in Europe seem have
worsened and that has been reflected by the significant
downward revision of growth forecasts for the region for
next year. This will impact Turkey mainly through three
channels. First, exports to the region are likely to remain
weak, a hindrance to the already weak recovery in external
demand. The share of exports to the EU have declined
significantly over the past four years and continued
weakness in the area will be a drag on export recovery
unless exports to other markets gain strength (see chart
below). The expected sharp de-levering in EU banks will
have implications for local banks despite the relatively
limited organic ties between the local and European
banking sectors. Local banks’ exposure to short-term
financing from international banks had increased
significantly over the past two years reaching a total of
$57bn in September (including FX credits received and
deposits of international banks at local banks – showing
no signs of weakness yet). Arguably the size of this
exposure at 16% of the outstanding credit stock may be
not be extremely large, but nevertheless short term funds
received from international banks have played a greater
role in financing local credit expansion over the past two
years. While the rise in such exposure has increased
rapidly, deposit growth has remained relatively flat as the
loan to deposit ratio increased to about 100% from just
below 80% two years ago. Some large banks have rolled
over sizable syndication borrowings in November at
reasonable spreads (100bps) and yet conditions (price and
availability) are likely to deteriorate in the months ahead.
We also note that prolonged risk off sentiment is likely to
affect other sources of capital inflows. The vulnerability of
the capital account surfaced in August, as the balance
was close to zero with the current account deficit (CAD)
being financed entirely by decline in reserve assets. The
September figures showed a recovery with sizable
inflows from the usual suspects, the errors and omissions
component, short term borrowing and drawdown of FX
assets held abroad by local banks. Given that the CAD will
decline but remain elevated, its financing will continue to
be a source of vulnerability in the year ahead.
Finally, weakening expectations is likely to have some
negative impact on the economy. Confidence surveys are
showing some weakness although with some mixed
results as the PMI has climbed back to over the 50-mark
in September-October. And yet CBT and TUIK surveys are
showing a decline in export orders, consumer confidence
has taken a downturn over the past three months and
future demand for durable goods has declined sharply
following the strength seen during most of 2010-2011.
Turkey: Export growth and share of exports to EU
-50%
-30%
-10%
10%
30%
50%
70%
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
40%
42%
44%
46%
48%
50%
52%
54%
56%
58%
60%
Exports YoY (lhs)
Exports to EU as % of
to tal (rhs)
Source: Turkey Data Monitor and DB Global Markets Research
Turkey: Banking loans, deposits and ST external
financing
-60
-40
-20
0
20
40
60
80
100
120
Jan-05 Feb-06 Mar-07 Apr-08 May-09 Jun-10 Jul-11
ST External Financing (YoY)
Loans (YoY)
Deposits (YoY)
Source: Turkey Data Monitor and DB Global Markets Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 145
Looking at recent developments in the balance of FX
deposits of retail at domestic banks, we can argue that
confidence in TRY is also not so strong. Typically retail has
sold FX at times of pressure on the exchange rate working
as a stabilizer (particularly since 2007). Indeed during the
weakening of the currency in 1H2011 (partly driven by the
CBT’s policy mix), locals sold over $10bn and yet they
have hesitated to sell in the recent weakening episode (in
fact have re-built their FX deposits at times of occasional
limited appreciation).
Recent developments have led us to revise our growth
outlook. For the current year the pace of deceleration in
economic activity has been slower than our expectations.
Industrial production (IP) had more momentum than our
projections expanding by 7.5% YoY in 3Q following the
7.9% YoY 2Q number. Growth in imports of capital goods
declined in 3Q parallel to our expectations and yet
remained robust (30% YoY) indicating continued strength
in private sector investments. On the other hand, the
slowdown in consumption appears to in line with our view
based on the developments in leading indicators. We have
revised our current year GDP growth to 7% from 6%
previously.
For next year, we had emphasized the probability of a
harder landing compared to our original GDP growth
projection of 3.2% for some time. With risks now much
closer to becoming a reality and given the downward
revision to EU growth, we have reduced our 2012 GDP
growth projection to 2.3%. We expect that domestic
demand will slowdown significantly next year as
rebalancing in the economy will continue. We project the
contribution of domestic and external demand to growth
to be 3.1pp (9.5pp in 2011) and -0.8pp (-2.6pp in 2011),
respectively.
Credible policies are crucial for protection against risks, and while fiscal policy continues to provide an anchor…
In our opinion ultimately the severity of financial contagion
from the eurozone and the credibility of domestic policies
in maintaining investor confidence will be the key
determinants of the pace of growth deceleration going
forward. Fiscal policy remains to be Turkey’s strongest
anchor in this respect. The primary surplus and overall
budget deficit is projected to be close to 2% of GDP and
below 1% of GDP, respectively in 2011. The government
has done relatively well in constraining growth in non-
interest expenditure to about 10% YoY through October
while revenues have increased by a strong 18% YoY in
part due to collection of receivables (mainly tax arrears).
The government may revise the projections of its medium
term economic plan (MTP) released in October depending
on global developments as hinted by some authorities.
We reckon that the 4% GDP growth projection may be
reduced while noting that Deputy PM Babacan has
reiterated that fiscal policy will not be used to mitigate
downside risks to growth and that the budget targets will
remain as is. The pace of convergence in the current
account deficit (CAD) to more reasonable levels is also a
key factor in bolstering investor confidence. Following a
sharp recovery in September, momentum in import
growth declined in October as the YoY expansion was
halved to 15% compared to the average 31% in the
previous three-month period. The YoY expansion in capital
Turkey: Monthly balance of payments
-12000
-7000
-2000
3000
8000
13000
Jul-10 Nov-10 Mar-11 Jul-11
Current Account Balance
Capital Account Balance
$mn
Source: Turkey Data Monitor and DB Global Markets Research
Turkey: GDP and IP
-25
-20
-15
-10
-5
0
5
10
15
20
Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11
GDP YoY IP YoY
Source: CBT, Reuters and DB Global Markets Research
Turkey: Interest rate corridor and benchmark bond
0
2
4
6
8
10
12
14
May-10 Sep-10 Jan-11 May-11 Sep-11
ON Borrowing ON Lending
1-Week Repo Benchmark Bond
ON M arket
Source: CBT, Reuters and DB Global Markets Research
6 December 2011 EM Monthly
Page 146 Deutsche Bank Securities Inc.
goods and consumer goods fell slightly into the negative
territory (in part due to base effects), which is an early
indication of weakening private sector investment and
growth in 4Q as well as a more rapid pace of adjustment
in CAD in the next several months.
…monetary policy needs to be brought back to basics
Large capital inflows driven by monetary expansion in
developed economies, appreciation of the TRY (loss of
competitiveness), rapidly growing CAD and bank credit,
and to some extent tame inflation were the reasons
behind the CBT’s decision to lower its one-week repo
rate, widen the interest rate corridor (mainly by lowering
the overnight borrowing rate) and increase reserve
requirements back in December. The result was a
significant weakening of the TRY and gradual weakening
in loan growth with some help from measures by the
banking sector authority. The conditions have reversed
since October and monetary policy has responded but not
by a complete reversal of the policy tools used back in
December as the CBT logic would call for, but through the
initiation of yet another unorthodox dimension of an
already unorthodox monetary policy mix. Overnight
lending rate has been increased and reserve requirements
have been decreased while the one-week repo rate held
constant. Since then the CBT manages the volume of one
week repo funding to ensure that market overnight rates
are sufficiently high (closer to the 12.5% upper band of
the corridor) to stabilize the exchange rate. In the mean
time a number of changes on reserve requirement rules
(decline in TRY reserve requirements, allowing the banks
to hold a greater share of TRY requirements in FX and
gold) have increased liquidity and allowed the CBT to
decrease its total funding of the banks (see chart above).
The CBT has traded exchange rate stability for interest
rate volatility as the latter has fluctuated significantly
depending on the strength, or lack thereof, pressure on
the TRY (see chart above). We believe that adding more
durability to the policy stance by raising the repo rate
would go a long way in bolstering confidence in monetary
policy. Importantly, since loan rates have already
increased significantly due to higher and more volatile
cost of funds, adjusting the repo rate is unlikely to tighten
policy further but the return to basics and a more
transparent policy framework will enhance credibility and
provide better protection towards continued volatility in
markets.
In recent communication the CBT argued that the net
effect of accomodative repo rates, contractionary liquidty
and prudential measures, and neutral fiscal policy is
disinflationary. The CBT believes that they have already
done the necessary tightening to bring inflation down to
5% next year following the temporary rise. Governor
Basci recently argued that tighter liquidity conditions and
stability in the exchange rate (indicating that the 25%
depreciation will have caused close 4pp pass-through)
should facilitate the convergence in headline inflation to
the target also given that the CBT does not expect
consumption tax increases next year of the kind seen in
2011 (on tobacco and other selected items). While
inflation will continue to increase in the balance of the
year due to the expectation of a spike in unprocessed
food prices in November and lagged FX pass-through, the
CBT argues that CPI will start its decent in January next
year. We note that, and as acknowledged by the CBT, the
CBT’s year-end inflation is likely to be significantly higher
than the forecast presented in the October inflation report.
In our opinion continued monetary experimentation may
lead to greater risks in an environment of rising inflation,
persistent troubles in the EU and volatility in capital
inflows.
Cem Akyurek, Turkey, (90) 212 317 0138
Turkey: CBT funding mix of banks
-
10
20
30
40
50
60
70
80
Oct-11 Oct-11 Oct-11 Nov-11 Nov-11 Nov-11
O/N
1-w eek repos
Source: CBT and DB Global Markets Research
Turkey: Reserve Requirements and CBT funding of
banks
-90000
-70000
-50000
-30000
-10000
10000
30000
50000
70000
Nov-10 Mar-11 Jul-11 Nov-11
Required
Reserves
CBT Funding of
Banks
Increase in
CBT funding
TRY bn
Source: Turkey Data Monitor and DB Global Markets Research
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 147
Investment Strategy
FX: The lira is one of the worst performing currencies this
year, having lost 19% vs the USD and 21% vs EUR.
Despite the u-turn from the CBT on Oct 26th and their
subsequent attempt to beef up TRY the lira remains very
weak. We expect the lira to be broadly range-bound with
the upside limited at around 1.90 by CBT
intervention/policy and expectations (at least as expressed
by the CBT in the latest minutes) that the CA adjustment
will become more visible in the coming months due to
domestic demand weakening and loan growth
deceleration. At the same time the downside in USD/TRY
should be confined to around 1.75. Part of this stems
from the fact that downside risks to growth have
increased but also that any narrowing of the C/A deficit is
likely to be gradual and from high levels. Our long
TRY/HUF (14 Oct) trade has worked well (target hit Nov
14), returning 9%. At current levels we recommend
trading the ranges in USD/TRY. Otherwise, buy a DnT with
strikes at 1.70 and 1.90 costing roughly 30% of USD
notional - giving a risk reward of roughly 3:1.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, London, (44) 20 7547 4241
Rates: Add exposure to Jan-20 bonds if the economy
responds to the ongoing tightening. We estimate that
Turkey is real money manager’s largest underweight. This
is explained by the complex policy mix being pursued by
the CBT and the current rise in inflationary pressures. On
the other hand, a slowdown in the global economy could
help Turkey’s rebalancing and some leading indicators of
inflation have already slowed down. We expect that by
the end of Q1, some investors may be ready to increase
exposure to Turkey, particularly if longer dated bonds
continue to trade close to 10% and if oil levels do not rise
further than current levels.
Lamine Bougueroua, London, (44) 20 7545 2402
Credit: Overweight. While we remain concerned about
the direction of monetary policy and the risks of a hard
landing for the economy, it is undeniable that from a
sovereign credit perspective Turkey looks fairly positive.
Given the healthy primary surplus, moderate debt stock
and low real rates, the credit spreads on bonds of well
above 300bp seems incongruous. Certainly some
premium is warranted given the aforementioned risks, but
Turkey’s debt dynamics are considerably less vulnerable
than in the past. Relative to the EM sovereign market as a
whole Turkey credit is cheap on a historical basis. We
maintain an overweight recommendation.
Marc Balston, London, (44) 20 7547 1484
Turkey: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 615.1 734.9 759.5 764.4
Population (mn) 72 73.7 74.0 74.3
GDP per capita (USD) 8,519 9,968 10,263 10,288
Real GDP (YoY%) -4.7 8.9 7.0 2.3
Priv. consumption -2.3 6.5 7.2 2.4
Gov't consumption 7.8 1.9 3.6 1.0
Gross capital formation -19.2 30.0 17.4 5.2
Exports -5.4 3.7 7.2 11.1
Imports -14.4 20.7 14.9 11.5
Prices, Money and Banking
CPI (YoY%) 6.5 6.4 9.2 6.4
Broad money (M2Y) (YoY%) 11.8 21.9 18.5 13.0
Bank credit (YoY%) 10.8 39.0 25.0 10.0
Fiscal Accounts (% of GDP)
Consolidated budget balance -5.5 -3.6 -1.5 -1.5
Interest Payments 4.4 4.4 4.0 4.0
Primary balance -1.1 0.8 2.5 2.5
External Accounts (USD bn)
Merchandise exports 109.7 120.9 135.9 168.2
Merchandise imports 134.5 177.2 220.9 259.3
Trade balance -24.8 -56.4 -85.0 -91.1
% of GDP -4.0 -7.7 -11.2 -11.9
Current account balance -14.0 -48.6 -71.4 -64.1
% of GDP -2.3 -6.6 -9.4 -8.4
FDI (net) 6.1 7.2 9.5 13.0
FX reserves (USD bn) 67.0 80.7 85.0 85.0
FX rate (eop) USD/TRY 1.52 1.54 1.85 1.85
Debt Indicators (% of GDP)
Government debt 45.0 42.2 40.0 39.0
Domestic 32.9 30.1 27.9 27.0
External 12.1 12.1 12.1 12.0
Total external debt 42.9 35.4 40.8 39.2
In USD bn 271.1 265.0 309.6 300.0
Short-term (% of total) 19.2 23.4 27.5 25.1
General (YoY%)
Industrial production -8.9 13.2 6.0 4.0
Unemployment 13.5 11.9 9.9 9.9
Financial Markets (end)
period)
Current 3M 6M 12M
Policy rate 5.75 5.75 5.75 7.00
Benchmark bond rate (comp.) 10.95 10.75 10.50 11.50
USD/TRY 1.8500 1.8500 1.850 1.850
Source: DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 148 Deutsche Bank Securities Inc.
Ukraine B2(stable)/B+(stable)/B(stable) Moody’s/S&P/Fitch
Economic Outlook: Growth has been robust but is
set to soften on the back of rising macroeconomic
risks. Inflation pressure should also ease.
Main Risks: Hryvnia weakness on the back of the
deteriorating balance of payments remains a risk
Strategy Outlook: The negative skew of risks
warrant a bearish position in NDFs. Underweight
sovereign external debt.
Macro outlook
In the macroeconomic sphere the key vulnerability relates
to the widening current account deficit, which in January-
October 2011 reached USD 7 bn compared to USD 1.4 bn
in the same period of 2010. According to the NBU one of
the reasons for this apart from high fuel import costs is a
USD 6 bn YoY increase in imports of capital equipment
and machinery, partly due to the development of
infrastructure associated with Euro-2012. The rising capital
outflows amid a growing current account deficit led to a
USD 0.8 bn decline in the forex reserves to USD 34.2 bn
by the end of October as well as pressure on the Hryvnia.
According to the head of the NBU Sergey Arbuzov greater
exchange rate volatility could emerge in 2012 in case BoP
conditions were to deteriorate further. At the same time
Arbuzov noted that until the end of 2011 the Hryvnia
exchange rate would remain stable. At this stage we
retain our projection of a stable Hryvnia exchange rate for
2012, though we do note the intensification of downside
risks, which will be partly also a function of the volatility in
global financial markets and competitive pressures
coming from the dynamics in the rouble.
Despite the rising external accounts risks, Ukraine’s GDP
growth accelerated towards the end of the year boosted
by higher household spending, agricultural production and
fixed investment growth. According to preliminary figures
GDP growth accelerated to 6.6% YoY in Q3 2011
compared to 3.8% YoY in Q2 2011, and 5.5% YoY in the
first 10 months of 2011. The government is projecting
Ukraine’s GDP growth to reach 4.7% in 2011. For 2012
the government has downgraded its projection from 5.5%
to 4%. We have also downgraded our projection to 3.9%
for 2012 on the back of rising macroeconomic risks.
The key gateway to addressing the issue of
macroeconomic stability for Ukraine is the resuscitation of
the IMF stand-by programme, which is currently seen as
one of the key anchors for the country’s economy. One of
the key preconditions for this is the increase in regulated
tariffs on gas for households. The October IMF mission to
Kiev failed to reach an agreement, though consultations
continue. Most recently IMF officials signalled that the
main outstanding conditionality item related more to the
fiscal position of Ukraine and the budget for 2012 rather
than increases in gas tariffs per se. The line taken by
Ukraine’s government representatives is that the
necessity for increases in gas tariffs will be eliminated in
case Ukraine secures a gas tariff discount from Russia,
which would in itself be a significant factor in improving
the financial position of Naftogaz. While it is not clear
whether this creates scope for some concession to
Ukraine on the issue of gas tariff increases, we do see the
possibility of the IMF programme coming back on track in
the first half of 2012, especially if a deal with Russia on
lower gas prices is secured.
In this respect in November Ukraine's media reported that
Russia and Ukraine have agreed to reduce the gas price
by nearly half to USD220-230/mcm from USD355/mcm in
3Q11 and an estimated USD400/mcm in 4Q11 saving
USD500m per month for Ukraine according to PM Nikolai
Azarov. However, according to Russia’s PM
representative, the discussions were still ongoing. A
compromise on the price discount could be attained in
exchange for preferences to Russian investments into
Ukraine as well as the possibility that Ukraine would also
provide access to its gas transportation system. Most
recently Gazprom’s CEO Alexey Miller declared that the
talks could be completed in 2011.
On the political front there are signs of renewed instability
building up around the arrest of ex-PM and a prominent
member of the opposition Yulia Tymoshenko after the
parliament declined to decriminalize her abuse of power
offence. This put further pressure on Ukraine’s
relationships with the EU, with risks that an FTA
agreement between may not be concluded in December.
The tension with the West and the increasing domestic
opposition may further point the current administration
towards assistance from Russia. In this respect a possible
discount in the gas price for Ukraine would serve to
reduce the deficit of Naftogaz without hiking the gas
prices for the population. The latter would be an
unpopular measure ahead of the fall 2012 parliamentary
elections, while the reduction of Naftogaz deficit is
essential for putting the IMF stand-by program back on
track. Overall, political risks are likely to intensify next year
as Ukraine approaches the 2012 parliamentary elections,
which may entail economic costs in the form of elevated
pressure for higher fiscal spending.
Yaroslav Lissovolik, Moscow, (7) 495 933 9247
Ilya Piterskiy, Moscow, (7) 495 933 92 30
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 149
Investment strategy
FX: The three most important drivers of UAH NDFs are
gas price negotiations with Russia, risk appetite and
domestic developments. The risks to these three drivers
remain negative and warrant a bearish position. Press
reports and comments from Azarov on TV have alluded to
gas price reductions up to 40% (to $225/mcm from
$355/mcm in 3Q '11 - saving $500m/y). This would be a
positive, but risks are skewed towards disappointment if
there is no reduction in gas prices or the reduction is not
as high as expected. An announcement is expected by the
end of 2011, and a delay ahead of elections in 2012 it
adds to the negative skew of the risks. The strong
correlation between Russian equities, Oil, VIX and UAH
NDFs suggests that any devaluation pressure is likely to
stem from risk sentiment. Developments on the domestic
political front have worsened with Tymoshenko's arrest
increasingly looking like a political decision - souring
relations with the EU. Economic developments have
surprised to the downside: a worsening current account,
declining reserves and GDP forecasts to 4% (5%
previously) by Ukraine's government do not bode well.
Henrik Gullberg, London, (44) 20 7545 9847
Siddharth Kapoor, (44) 20 7547 4241
Credit strategy: Underweight Financing conditions
continue to tighten and with it the risks of credit problems
in the coming year. The treasury continues to struggle to
execute its domestic borrowing plan and is reliant on the
NBU for financing. Net claims of the NBU on the central
government have more than doubled since the end of
May, reaching approx. USD8bn.
All appears to hinge on Ukraine successfully extracting a
reduction in the price of gas charged by Gazprom, but the
history of such agreements suggest that we shouldn’t be
too optimistic for a generous reduction. External liabilities
in 2012 (principal and interest) will amount to USD 7.5bn.
On top of this will come the cost of gas imports. Given
the pressure, and the fact that it is only a remote
possibility that they are comprehensively eased, we
continue to recommend an underweight exposure.
Marc Balston, London, (44) 20 7547 1484
Ukraine: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National income
Nominal GDP (USDbn) 130.8 145.6 164.9 185.2
Population (m) 45.7 45.5 45.3 45.1
GDP per capita (USD) 2 862 3 200 3 640 4 106
Real GDP (YoY%) 4.2 4.5 3.9 4.0
Priv. Consumption 4.6 5.0 5.2 5.0
Govt Consumption 1.2 -3.2 8.1 -1.2
Investment -1.0 5.6 6.8 8.0
Exports 9.0 9.0 9.0 9.0
Imports 10.0 11.0 10.0 10.0
Prices, money and banking (% YoY, eop)
CPI (Dec YoY%) 9.1 6.5 9.0 8.0
Broad Money 23.1 16.0 14.0 13.0
Credit 8.0 20.0 18.0 16.0
Fiscal accounts (% of GDP)
Budget balance -5.0 -2.5 -2.5 -1.8
Revenues 22.0 22.5 23.5 22.9
Expenditures 27.0 25.0 26.0 24.7
External accounts
(USDbn)
Exports 52.1 52.6 57.1 64.1
Imports 60.5 61.0 66.6 66.3
Trade balance -8.4 -8.4 -9.5 -2.2
% of GDP -6.4 -5.8 -5.8 -1.2
Current account balance -2.6 -4.0 -5.1 2.2
% of GDP -2.0 -2.7 -3.1 1.2
FDI 5.7 6.5 7.0 7.0
FX reserves 34.6 32.0 38.0 42.7
UAH/USD (eop) 8.0 7.9 7.9 7.9
Debt indicators (% of GDP)
Government debt 40.0 43.0 46.2 2.2
Domestic 16.5 16.0 17.2 -26.8
External 23.5 27.0 29.0 29.0
Total external debt 82.9 81.1 74.0 74.0
in USDbn 108.5 118.0 122.0 137.0
General
Industrial production
(YoY%) 11.0 8.0 5.4 5.8
Unemployment (%) 9.2 8.5 7.8 7.4
Financial markets (eop) Current 3M 6M 12M
Short-term interest
rate(%) 7.75 7.75 7.75 7.75
UAH/USD 8.0 7.9 7.9 7.9 Source: Official statistics, DB Global Markets Research
6 December 2011 EM Monthly
Page 150 Deutsche Bank Securities Inc.
China Aa3(Pos)/AA-/A+ Moody’s/S&P/Fitch
Economic Outlook: For 2012, we expect the
economy to be featured by 1) disinflation, 2) initial
growth deceleration followed by a recovery, and 3)
policy easing in 1H followed by a more cautious
stance towards the end of the year. We maintain our
2012 GDP growth forecast at 8.3% (down from 9.1%
in 2011), with a qoq trough in Q1 (at 6.4% saar,
slightly deeper than our earlier projection of 6.8%)
and a sequential recovery from Q2. For 2013, we
expect GDP growth to recover to 8.6% largely on
stronger export growth. On policies, we expect 2-3
more RRR cuts in the coming 6-9 months, which
should permit average monthly RMB lending to
rebound to RMB800-900/month in 1H, and annual
lending to reach around RMB8.4tn in 2012. We
expect the fiscal deficit-to-GDP ratio to remain largely
unchanged at 2-2.2% in 2012. Fiscal priorities in
2012 should include public housing, completion of on-
going infrastructure projects, SMEs, services, and
consumption.
Main Risks: The two most important shocks to the
economy in the coming months are property FAI
deceleration and export slowdown. We expect
property FAI growth to slow from the current
25-30%yoy to 15%yoy in the first few months of
2012. We expect export growth to decelerate from
the current 15%yoy to 8-9% in 1Q 2012.
Strategy Recommendations: We favor Repo swap
NDIRS/IRS and Shibor swap 2x5 NDIRS/IRS
steepeners to express our view that interbank
liquidity will ease markedly in the coming 6-9 months.
We retain our bullish view on the CGB cash bonds.
Expect a slower pace of RMB appreciation in 2012.
Macro View
We maintain our 2012 GDP growth forecast at 8.3%,
but foresee a slightly deeper qoq trough in 1Q than
our earlier projection. We cut our 2012 GDP growth
forecast to 8.3% as early as in August 2011, and has since
maintained this forecast. Despite many changes in DB’s
global economic forecasts and recent developments in
China, we continue to believe our 8.3% annual forecast
remains reasonable.
DB’s European economists downgraded their 2012
Eurozone GDP forecast twice in the past four months.
The most recent revision reduced their 2012 Eurozone
GDP forecast from 0.4% to the current -0.5%. As we
(DB’s China economics team) took a more bearish view
on Europe as early as in August, the recent European
forecast changes only marginally worsened our annual
outlook for China’s export growth. The following table
produces our updated yoy and qoq (saar) GDP growth
forecasts for 2012. The slight change we made is to
further cut our qoq GDP growth forecast for 1Q 2012
to 6.4% from the previous 6.8%, on downward revision
of European GDP forecast in that quarter (we now expect
European GDP to contract 1.6% on qoq saar basis, vs the
previous 0.4% contraction).
China: yoy and qoq GDP growth forecast
yoy % qoq (saar) %
2011Q1 9.7% 8.7%
2011Q2 9.5% 9.1%
2011Q3 9.1% 9.5%
2011Q4F 8.5% 7.3%
2012Q1F 7.7% 6.4%
2012Q2F 7.5% 9.0%
2012Q3F 8.7% 10.0%
2012Q4F 8.7% 9.5%
Source: SSB and DB forecast
Three factors are behind our projection of a sequential
growth trough in 1Q 2012. First, we believe that the
European economy is already in recession and its
economic contraction will like to be worst in 1Q. This
implies that China’s export growth will suffer the most
from European demand weakness in 1Q. Second, China’s
real estate sales have slowed sharply since September
2011, and developers will thus likely rein in their
construction activities. Sequential slowdown in
construction should last until Q1 next year, before
property prices and sales may stabilize. Third, China’s
monetary easing, which began only at the end of
November (as marked by the RRR cut on November 30),
will likely become more visible in 1Q. With a one-quarter
lag, monetary easing should begin to support domestic
demand, especially investment activities, from 2Q.
Note that the qoq GDP growth rates before (and including)
3Q 2011 are estimates from the National Statistical
Bureau (NSB). Our estimates differ from theirs as we use
a different seasonal adjustment methodology. The NSB
uses its own methodology but the agency does not
release its details and original data, and therefore it not
possible to replicate its estimates. We believe its
estimates are problematic as their yoy and qoq growth
rates appear inconsistent. In particular, the NBS estimate
of a sequential acceleration of GDP growth in 3Q of 2011
is contradictory to most other indicators which became
visibly weaker in that quarter– these include the PMI,
monetary and loan growth rates, commodity prices, as
well as qoq change in power consumption. In particular,
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 151
the PMI fell to around only 50 in 3Q and during the quarter
monetary conditions appeared to be the tightest in two
years.
Given this difference in methodologies, we ask readers to
take our qoq GDP estimates as indicative (of our view of
the momentum of the economy), rather than something
that could be verified by NBS data releases in the future.
We expect GDP growth to accelerate to 8.6% in 2013.
In this monthly note, we for the first time publish our
forecasts of 2013 economic indicators. We expect GDP
growth to rise to 8.6% in 2013, up from 8.3% in 2012.
This is largely reflecting our view that US and Eurozone
GDP growth will be stronger in 2013 than 2012. The
rationales for this forecast include: 1) the worst part of
bank deleveraging, which causes the contraction of the
real economy, would be in 2012; 2) the fiscal contraction
(measured by the reduction in cyclically adjusted fiscal
deficit/GDP ratio) was as much as 1.4ppts in 2012, but
would improve in 2013. In other words, the impact of
fiscal contraction will become less of drag for the
Eurozone economy in 2013.
Stronger US and Eurozone growth would enhance
Chinese growth via stronger exports. So, for example,
based on historical correlations, a 1% increase in US&EU
growth would increase Chinese export growth by about
6ppts. We thus forecast acceleration of China export
growth from 8% in 2012 to 14% in 2013. In volume
terms, China’s export growth will likely accelerate by
about 3-4ppts. This should translate to a 0.5ppt increase
in China’s GDP growth. However, given that monetary
and fiscal policies will likely become a bit more restrained,
we expect GDP growth in 2013 to accelerate only by
0.3ppts to 8.6%.
Other changes to the key components on the Chinese
economy should largely offset each other in terms of
impact on GDP. For example, we expect some modest
deceleration in real gross capital formation (as the
corporate profit margin will drop due to the long-term
structural trend of higher wage growth), but real private
consumption will likely accelerate a bit on better income
growth and higher government spending on social
services and welfare.
On the latter point, the recent unfortunate school bus
accident in Gansu province is illustrative. This accident,
which killed 21 preschool students, provoked a massive
wave of public criticism (in the form of tens of thousands
of Internet and press commentaries) that put pressure for
the government to improve safety standards. A week
later, the State Council decided to allocate additional
budgetary resources for purchasing school buses that
meet safety standards on a nationwide basis. This case
demonstrates the significant rise in the role of public
opinions in influencing policy making in China, and that the
government will likely have no choice but to increasingly
steer its fiscal priority towards social spending.
China: Macroeconomic Forecasts
2010 2011F 2012F 2013F
Real GDP (YoY%) 10.3 9.1 8.3 8.6
CPI (YoY%) ann avg 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit (YoY%) 19.9 15.0 16.0 14.0
Budget surplus (% of GDP) -1.7 -2.0 -2.2 -1.5
FX rate (eop) CNY/USD 6.59 6.30 6.10 5.86
Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0
Retail sales (nominal) 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD nominal) 31.3 20.0 8.0 14.0
Merch imports (USD nominal) 38.7 24.0 9.0 16.0
1-year deposit rate (%) 3.50 3.50 3.50 3.50
Source: CEIC and DB forecasts
We expect property FAI growth to slow rapidly in the
first few months of the year. It appears that the
weakening of property investments by developers is
becoming the most serious challenge to the economy in
the coming few months, even more so than export
deceleration. This is because the average property price
in 35 major cities has declined by about 13% in the past
two months according to Soufun, and sales and floor
space started have both decelerated sharply. In terms of
floor space started – a leading indicator of real estate
FAI – its growth fell from 30%yoy in Jan-Aug to only
10%yoy in September and -1% in October. Based on
historical correlation, the deceleration in floor space
started will likely translate into a visible slowdown in real
estate FAI (correlation at 0.5-0.6). We thus expect real
estate FAI growth to decelerate from the 28%yoy in Jan-
September towards 15%yoy in 1Q next year.
Yoy% change in residential floor space started
-50%
0%
50%
100%
150%
200%
250%
Feb-0
8
May-0
8
Aug-0
8
Nov-0
8
Feb-0
9
May-0
9
Aug-0
9
Nov-0
9
Feb-1
0
May-1
0
Aug-1
0
Nov-1
0
Feb-1
1
May-1
1
Aug-1
1
Source: CEIC
Given that real estate sector’s capital formation accounts
for about 10% of GDP, we estimate that a 15ppt nominal
6 December 2011 EM Monthly
Page 152 Deutsche Bank Securities Inc.
deceleration (or 10% real deceleration) in real estate FAI
could contribute to 1ppt reduction in yoy GDP growth in
Q1 next year. This deceleration trend will only be partially
offset by a modest acceleration in infrastructure FAI.
Assuming that infrastructure FAI will accelerate by 7ppts
(from the current -2%yoy growth to 5%), it would reduce
the impact of real estate FAI slowdown on GDP by
0.3ppts. This results in a net reduction of yoy GDP
growth by about 0.7ppts for 1Q of 2011 (compared with
3Q of 2011).
Export growth will likely slow to 8%yoy in 1Q 2012.
Our European economists are projecting the Eurozone
economy will be in recession for the current quarter and
first half of next year. The trough is projected in 1Q of
2012. The driving forces for further deterioration of
sequential growth in Q1 include bank deleveraging, fiscal
contraction, as well as the negative wealth effect arising
from weaker consumer confidence. However, over the
coming months, we expect some progress of the
Eurozone towards fiscal consolidation, which will permit
the ECB to further loosen monetary policy and support the
debt market, and to help lift market and consumer
confidence. The benefits for the real economy are
expected to kick in from Q2 next year.
Given this European growth trajectory, and a relatively
steady pace of US economic growth (at around 2.5%
annualised rates for most quarters), we expect China’s
qoq and yoy export growth to look like the following:
China export growth forecast, yoy and qoq%
China export (yoy) China export (qoq) EU/US GDP
(qoq saar)
3Q 11 21% 2.5% 1.3%
4Q 11F 15% 1.5% 0.7%
1Q 12F 8% 0.5% 0.3%
2Q 12F 6% 0.7% 0.4%
3Q 12F 6% 2.9% 1.5%
4Q 12F 11% 3.5% 1.9%
Source: DB forecast
According to our estimates, China’s qoq (sa) export
growth will slow sharply to only 0.5% in 1Q next year,
down from 1.5% in 4Q this year. As a result, yoy export
growth will likely decelerate to 8% in 1Q, stay weak for
2Q and 3Q, before recovering in 4Q 2012. For the year as
a whole, we now forecast export growth at 8% (vs
previous expectation of 10%). We also revised down our
import growth forecast by 2ppts to 9%.
Ceteris paribus, the export deceleration will lead to a
reduction in yoy GDP growth by about 1.3ppts in 1Q of
2012 (compared with 3Q of 2011). We expect nearly half
of this deceleration to be offset by the benefits of policy
easing on other sectors.
CPI inflation to drop sharply to 3% in Q2 and 2.8% for
2012 as a whole. We continue to expect CPI inflation to
decline sharply to 4.2% in November and 3.8% yoy in
December, and to 3% in 2Q next year. This reflects the
significant decline in wholesale agriculture prices in the
past two months (by 7-8%) and its gradual pass-through
to retail food prices. Based on historical correlation, the
food component of CPI should fall by at least 5%
cumulatively between the peak September and the next
trough. Even if the power tariffs are raised by 5% and
refined oil prices are raised by 10%, their boost to CPI is
only 0.3ppts, a small fraction of CPI reduction (by 1.5%)
due to a 5% food price drop.
Based on normal seasonality, we assume a 5% rise in
food prices in January and February to reflect the Chinese
New Year effect. Even with this sequential rise in food
prices, yoy CPI inflation will still likely fall to 3% in 2Q and
the full year CPI inflation will likely be at 2.8% for 2012.
Other key assumptions we made in this CPI projection
include a modest decline in PPI in the coming few months,
with a recovery from Q2 next year. For the year as a
whole, we see PPI inflation at about 4%, significantly
lower than the recent peak of about 8%. This projection
is supported by the recent trend of declining input price
index in the PMI report.
Another important contributor to disinflation is the fall in
property prices, which will over time translate to a decline
in the housing component (which includes rents and
imputed rents) of CPI. We estimate that a 10% drop in
physical property prices (soufun property price index) will
eventually – after about 6 months – reduce the housing
component of CPI by 1%.
We expect M2 growth to accelerate to 15-16% for
2012. We expect M2 growth to accelerate marginally to
15-16% next year, up from the current 13%. Experience
tells us that M2 growth is typically set at 2-3ppts above
nominal GDP growth. This time, given the consensus
forecast of 8.5 for real GDP growth and about 3.5% for
CPI inflation, 14% will likely form the bottom for the
discussion for next year’s M2 growth range. However,
arguments for some additional monetary expansion will
likely be made in the coming months – even after the
National Economic Work Conference – to allow 1-2ppt
additional M2 growth in order to offset the global demand
shock and the weakness in the real estate sector. Thus,
the final outcome will likely be 15%-16% for M2 growth.
A M2 growth rate of 15% should be applicable if GDP
growth is running safely above 8%, but 16% is more likely
when yoy GDP growth slips below 8% for two quarters
(which is our forecast). Therefore, although the initial
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 153
target for M2 growth could be set at 15%, and eventual
outcome may be 16% next year.
At this moment, we do not see strong reasons why loan
growth will be much different from M2 growth in 2012.
This implies that new RMB lending will be around
RMB8.4tn next year, up from this year’s estimated
RMB7.4tn.
We expect very modest fiscal easing in 2012. Despite the
official rhetoric that fiscal policy will remain pro-active, we
think the reality is that there will be very limited fiscal
expansion in 2012 relative to 2011. Our baseline forecast
is that the deficit-GDP-ratio will rise only slightly to 2.2%
in 2012 (vs 2.0% in 2011). Specifically, we expect total
fiscal deficit to be RMB1.1tn (including RMB300bn for
local government deficit/bond financing) in 2012, vs
RMB900bn in 2011 (including RMB200bn for local
government deficit/bond financing).
Within the fiscal budget for 2012, we expect some
modest tax further cuts to support SMEs, exporters,
consumption, and services. On the expenditure side, we
expect priorities be given to support public housing,
infrastructure (e.g., resumption of railway projects, repair
of reservoirs and dams), social services, and consumption
(e.g., extension of the electronics trade-in policy).
Jun Ma, Hong Kong, (852) 2203 8308
Investment Strategy
Rates. With monetary policy having shifted towards
easing and likely will accelerate in the next 2-3 quarters,
we expect net liquidity inflow to the interbank market to
help bring money market rates to 50-100bps before mid
of 2012. However, in the near-term, the relative stickiness
of the 7D repo fixing rate given the year-end seasonal
liquidity demand, and the extent of liquidity easing being
priced in on the Repo IRS curve argues for the outright
level of CNY IRS curves to be relatively range bound
(within 10-15 bps range). As such we think the risk reward
of outright receiving Repo rates is unfavorable and costly
in carry. We believe Repo swap or Shibor swap curve
steepeners are more suitable for investors sharing our
view. We recommend building Repo IRS/NDIRS or Shibor
IRS/NDIRS 2x5 steepeners at the current market.
We retain our bullish view on CGB cash bonds and 10Y
CGB can rally by 20-30bps over the next quarter. Supply
risk is low in Q1 which should provide good technical
support.
We remain cautious on the onshore credit market and will
wait till credit outlook stabilizes before considering
increasing allocation.
FX. In our opinion, China regards FX as a monetary policy
tool – part of a broader policy toolkit that includes RRR,
interest rates, credit guidance and administrative
measures – for managing inflation. The inflation cycle has
turned in China, and downside risks to exports are
growing. While a major reversal of policy is unlikely, the
government is taking small steps to ease policy, which we
think include a slower pace of RMB appreciation early in
the sequencing of an easing response. We retain a
structurally bullish view on the RMB (tied in to its long
term plan for capital account liberalization, and the need to
reduce its undervaluation), but we expect a cyclical
slowdown in its appreciation path, to nearer 3% by H1
2012. USD/CNY NDFs could however squeeze higher as
the Chinese economy slows in coming months. Possible
overshoots in the NDFs in the coming months should be
seen as better opportunities to re-enter RMB longs.
Linan Liu, Hong Kong, (852) 2203 8709
Dennis Tan, Singapore, (65) 6423 5347
6 December 2011 EM Monthly
Page 154 Deutsche Bank Securities Inc.
China: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 5879 7031 8141 9516
Population (mn) 1374 1383 1389 1395
GDP per capita (USD) 4279 5084 5860 6819
Real GDP (YoY%)1 10.3 9.1 8.3 8.6
Private consumption 9.0 8.4 8.4 8.8
Government consumption 8.0 9.0 8.5 9.0
Gross capital formation 11.6 10.7 9.0 8.5
Export of goods & services 22.0 12.0 6.4 12.5
Import of goods & services 23.0 14.0 7.8 13.0
Prices, Money and Banking
CPI (YoY%) eop 4.6 3.8 2.8 3.5
CPI (YoY%) ann avg 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit (YoY%) 19.9 15.0 16.0 14.0
Fiscal Accounts (% of GDP)
Budget surplus -1.7 -2.0 -2.2 -1.5
Government revenue 21.3 22.7 22.5 22.5
Government expenditure 17.8 24.7 24.7 24.0
Primary surplus -1.2 -1.3 -1.5 -0.8
External Accounts (USD bn)
Merchandise exports 1578.0 1893.6 2045.1 2331.4
Merchandise imports 1395.0 1729.8 1885.5 2187.2
Trade balance 183.0 163.8 159.6 144.2
% of GDP 3.1 2.3 2.0 1.5
Current account balance 306.0 283.8 269.6 244.2
% of GDP 5.2 4.0 3.3 2.6
FDI (net) 124.9 100.0 70.0 50.0
FX reserves (USD bn) 2847.0 3270.0 3600.0 3900.0
FX rate (eop) CNY/USD 6.59 6.30 6.10 5.86
Debt Indicators (% of GDP)
Government debt2 20.3 19.4 19.1 18.3
Domestic 19.7 18.8 18.6 17.8
External 0.6 0.6 0.5 0.5
Total external debt 9.3 10.4 10.2 9.8
in USD bn 549.0 730.0 830.0 930.0
Short-term (% of total) 68.0 70.0 65.0 60.0
General (YoY%)
Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0
Retail sales (nominal) 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD nominal) 31.3 20.0 8.0 14.0
Merch imports (USD nominal) 38.7 24.0 9.0 16.0
Financial Markets Current 3M 6M 12M
1-year deposit rate 3.50 3.50 3.50 3.50
10-year yield (%) 3.63 3.40 3.30 3.30
CNY/USD 6.35 6.30 6.20 6.13
Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Growth rates of GDP components may not match overall GDP growth rates due to
inconsistency between historical data calculated from expenditure and product method. (2) Including
bank recapitalization and AMC bonds issued
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 155
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6 December 2011 EM Monthly
Page 156 Deutsche Bank Securities Inc.
Hong Kong Aa1(Pos)/AAA/AA+ Moody’s/S&P/Fitch
Economic Outlook: Growth in Hong Kong continues
to follow the lead of the US and EU economies. This
means markedly slower growth in 2012 but a likely
return to reasonably robust growth in 2013.
Main Risks: A disorderly resolution of the sovereign
debt crisis in Europe would likely be translated into a
deep recession in Hong Kong.
Strategy Recommendations: We see upside risk on
Hibor - Libor basis in Q1 next year driven by corporate
liability hedging demands.
Macro View
Slower US&EU growth means slower HK growth.
Hong Kong’s economy eked out 0.3%QoQ(saar) growth in
Q3 after contracting at a 1.4% rate in Q2. The key
message, though, is that when exports of goods and
services are 208% of GDP, external demand will always
be the main driver of growth. And it still seems to be that
US and European demand matters more than Mainland
Chinese demand.45 As exports have stagnated over the
past six months, so too has Hong Kong GDP. And having
downgraded our growth forecast for the US and EU
economies, we have done the same for Hong Kong,
cutting our 2012 forecast from 4.4% to 3.0%. In 2013,
though, as growth in the ‚G2‛ economies is expected to
recover we see Hong Kong’s growth rebounding to 4.5%.
GDP growth in Hong Kong and the G2 (US and EU)
HK = 1.6 x G2 + 1.9
R² = 0.68
-10
-5
0
5
10
15
-6 -4 -2 0 2 4 6
%
%
Sources: CEIC and Deutsche Bank
While export growth has plummeted in recent months –
from 15.1%yoy in Q1 to -0.4% in Q3 in real terms –
private consumption growth has held up surprisingly well,
slowing from 9.7%yoy in Q2 to 8.8% in Q3. But we don’t
45See ‚China is a Weak Engine of Growth for Asia,‛ Global Economic
Perspectives, Sept 10, 2011.
expect this will continue. Our analysis suggests that as
export growth slows and asset prices fall – we expect
Hong Kong property prices could fall 20% next year –
consumption growth is likely to slow significantly.
Private consumption expenditures
-10
-5
0
5
10
15
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
PCE Model%yoy
Sources: CEIC and Deutsche Bank. The “model” is a regression of real PCE growth on real merchandise
export growth, tourist arrivals, the real 3m Hibor yield and real equity price and property price inflation.
Since 1995 the model has an R2 of 0.70.
Inflation to fall gradually in 2012, more quickly in 2013
Because rental inflation only appears in the CPI index with
more than a one-year lag, falling property prices won’t
really show up in lower inflation until 2013. In the interim,
commodity price inflation will be more important. So,
falling food and fuel inflation will likely take inflation down
from 6% at the end of this year to below 4% by mid-
2012. But as food and fuel prices start to rise in the
second half of next year we see inflation rising above 4%
by year-end. But in 2013 even with higher commodity
prices we see the housing effect driving inflation below
1% and perhaps below zero in early 2014.
Expect modest fiscal stimulus The government’s
budget forecast a deficit of HKD32bn in the current fiscal
year. But in the first half of the fiscal year it has run a
deficit of only HKD5.4bn. Only once in the last thirteen
years has the government run a deficit during the Oct –
March period. In the last three years it has run surpluses
averaging HKD78bn during those months. The payout of
the HKD6,000 scheme will undoubtedly reduce the
surplus, but we project a surplus of HKD31bn for the
current fiscal year. Given our US and EU growth
forecasts, we expect only modest fiscal stimulus to be
applied in Hong Kong next year – perhaps a more targeted
cash handout scheme, increased support for those less
well off and possibly a cut in the corporate tax rate – but
we still project a surplus of nearly HKD30bn.
Michael Spencer, Hong Kong, (852) 2203 8305
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 157
Investment Strategy
Fixed Income Strategy: The dynamic of Hibor - Libor
basis likely will present interesting trading opportunities
next year. We think there are three relevant factors:
a) Q1 is typically seasonally strong funding season and
we expect demand for corporate liability hedging
purpose to push Hi-Li basis higher;
b) Funding activities in the offshore RMB bond market
by HK corporations which then have been swapped
back to HKD Libor, such flows are getting more
active in recent week and will grow if USD funding
market remains challenging next year.
c) The likely slowdown in RMB appreciation at least in
the next 1-2 quarters means less speculative
positioning on the USD/HKD forwards, which will
reduce the risk of further widening in Hi-Li basis.
Linan Liu, Hong Kong, (852) 2203 8709
FX: We think that market speculation of a HKD depeg is
likely to dissipate in 2012. This is because the reflation
tide which has driven a growing debate over the relevance
of the USD peg in recent years is likely to fade. A cyclical
slowdown in China, a more gradual pace of RMB
appreciation, falling inflation and possible property price
declines in both the mainland and in the SAR are factors
that will likely drive speculators to pare back their bets on
a near-term depeg..
HK officials have also repeatedly emphasized that
convertibility of the Chinese currency is a critical
precondition for a repeg to the RMB. While Chinese
authorities are likely to take further steps to allow capital
backflows from the CNH market, China is unlikely to
achieve full convertibility next year. As such the chances
of HKD depeg in 2012 are quite low in our view. We like
buying the 12M USD/HKD outrights, which is trading right
very close to the bottom of its policy band. We also like
buying 1Y risk reversals which are still trading near the
lower end of its historical ranges.
Dennis Tan, Singapore, (65) 6423 5347
Hong Kong: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 224.5 243.1 256.0 274.8
Population (mn) 7.1 7.1 7.2 7.2
GDP per capita (USD) 31628 34053 35662 38091
Real GDP (YoY%) 7.0 5.3 3.0 4.5
Private consumption 6.2 8.8 5.2 5.9
Government consumption 2.7 1.9 1.8 1.8
Gross fixed investment 7.8 4.3 1.2 5.5
Exports 16.8 3.2 2.1 8.8
Imports 17.3 3.3 2.1 9.5
Prices, Money and Banking
CPI (YoY%) eop 2.9 6.0 4.3 -0.1
CPI (YoY%) ann avg 2.3 5.3 4.6 2.1
Broad money (M3) 7.6 12.2 4.3 4.4
HKD Bank credit (YoY%) -0.4 15.1 6.9 3.9
Fiscal Accounts (% of GDP)1
Fiscal balance 4.2 1.6 1.2 1.5
Government revenue 21.1 21.5 21.3 21.0
Government expenditure 16.9 19.9 20.1 19.4
Primary surplus 4.3 1.7 1.3 1.5
External Accounts (USD bn)
Merchandise exports 394.0 431.6 439.5 477.0
Merchandise imports 437.0 487.9 498.5 544.3
Trade balance -43.0 -56.2 -58.9 -67.3
% of GDP -19.1 -23.1 -23.0 -24.5
Current account balance 13.9 13.5 12.2 10.3
% of GDP 6.2 5.5 4.8 3.8
FDI (net) -7.2 -2.7 -2.5 -3.5
FX reserves (USD bn) 268.7 271.8 253.6 242.4
FX rate (eop) HKD/USD 7.76 7.79 7.80 7.80
Debt Indicators (% of GDP)
Government debt1 2.2 2.5 2.9 3.2
Domestic 1.6 2.0 2.3 2.7
External 0.6 0.6 0.5 0.5
Total external debt 357.9 349.7 302.8 291.1
in USD bn 803.5 850.0 775.0 800.0
Short-term (% of total) 78.0 75.0 75.0 76.0
General
Unemployment (ann. avg, %) 4.4 3.5 3.7 3.7
Financial Markets Current 3M 6M 12M
Discount base rate 0.50 0.50 0.50 0.50
3-month interbank rate 0.30 0.30 0.30 0.30
10-year yield (%) 1.35 1.30 1.35 1.35
HKD/USD 7.78 7.80 7.80 7.80
Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Fiscal year data.
6 December 2011 EM Monthly
Page 158 Deutsche Bank Securities Inc.
India Baa2/BBB-/BBB- Moody’s/S&P/Fitch
Economic Outlook: Assuming no big collapse in
global financial markets, the Indian economy ought to
grow by 7-7.5% in 2012, supported by rate cuts from
RBI around mid-2012
Main Risks: Worsening of twin deficits could prevent
inflation from moderating to mid single-digit levels,
which could complicate RBI’s monetary policy
decision, especially if growth were to slow sharply at
about the same time
Strategy Recommendations: Pay steepeners on
the OIS curve (1Y/2Y) to position for the turn in the
cycle. Risk to INR gets more digital next year, with
policy intervention a key factor.
Questions for 2012
With the current and challenging year almost behind us,
focus now shifts to 2012:
When will the economy trough?
When will the RBI start reversing its current anti-
inflationary stance?
Will the government manage to carry out some
degree of fiscal consolidation?
What is the outlook for the rupee?
What is in the structural reform agenda?
Growth in 2012
For years, one of the appealing characteristics of India for
investors has been its resilient internal growth dynamic,
driven by domestic demand in a somewhat insulated
economy. Our analysis shows that before 2006, the
relationship between India’s growth and that of the US
and Euro Area (G2) was not statistically significant; i.e. the
growth dynamic appeared to be impervious of the G2
cycle. In this regard India used to mimic China.
But as the economy has opened up, it is no longer
shielded from global cyclical movements. The adjoining
chart shows that India’s growth trajectory is not just
mirroring capital flows, but G2 growth as well. The
coefficient estimate on a growth regression with G2
growth on the right hand side is statistically significant in
the post 2005 period, and the explanatory power of the
regression equation is considerable.
India’s economic growth : high correlation with G2
-6
-4
-2
0
2
4
6
5
6
7
8
9
10
11
2005 2006 2007 2008 2009 2010 2011
India, left G2, right%yoy %yoy
Note: A quarterly data regression of India’s real growth against ppp-weighted G2 growth, for the sample
period 2006Q1 to 2011Q2, obtains a beta coefficient of 0.4, estimated with a statistical significance at
1% level and an adjusted R-squared of 0.61.
Source: CEIC, Deutsche Bank Global Market Research
Through the first three quarters of 2011, GDP growth in
India has decelerated, averaging 7.5% as compared to
8.9% growth in the corresponding period in 2010. The
slowdown has been concentrated in the industrial sector,
with growth averaging 4.9%, as against 10.2% in the first
nine months of 2010. Services sector slowdown in
comparison has been relatively modest (8.7% vs. 9.8%),
though downside risks have increased in recent months.
Agricultural sector growth momentum has gained some
traction in 2011 over 2010 (4.9% vs. 2.9%). From the
expenditure side GDP, we note that investment growth
continues to be anemic, while private consumption
growth has also been trending lower. The main supportive
factor to growth has been higher public spending and,
more crucially, net exports.
Given the latest data, we have revised down our FY11/12
growth estimate to 7.0% (from 8.0% earlier), as we see
further intensification of global macro headwinds and
slowdown in domestic demand in the days ahead. We
have also revised down our FY12/13 growth estimate to
7.5% (from 8.0% earlier), which however reflects a
modest recovery relative to the likely 2011 outturn. This is
based on our view that growth momentum would likely
improve from the second half of 2012, helped by (i) a
supportive base effect; (ii) expected rate cuts from RBI
starting from mid-2012; and (iii) a likely improvement in
global market sentiments, helped by belated but
ultimately market stabilizing resolution of the present
Eurozone crisis. However, as the analysis of India’s
growth relationship with G2 shows, our baseline growth
forecast could face downside risks if the US/Euro area
economic growth were to slow appreciably in 2012 than
currently anticipated.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 159
When will RBI start cutting policy rates?
India’s clear and present danger is inflation, which has
been on a trend rise over the past five years or so.
Stubbornly high inflation is a reflection of a number of dis-
functionalities in the economy, which are also some of the
key impediments to India’s stability and prosperity. On the
demand side, high growth rates of GDP (200bps higher in
the past decade than any other period in India’s history)
and real per capita income (rising by 8% annually since
2001) have kept the economy operating at or above its
potential growth rate. Case in point is the dairy industry;
despite production rising by double digit rates in recent
years, milk prices have risen by an annual average of 13%
since 2006 as demand has been outpacing supply. On the
back of strong growth, wages have risen sharply in the
past decade, adding sizeable purchasing power to millions
of Indian households. As household income has risen,
consumption has evolved from basic food items to more
protein-rich items, but the ensuing demand surge has not
been met with an adequate supply response.
CPI and WPI inflation trend
0
2
4
6
8
10
12
14
16
2005 2006 2007 2008 2009 2010 2011
WPI CPI%yoy
Source: CEIC, Deutsche Bank Global Market Research
On the supply side, key impediments lie in the agriculture
sector, where production growth has been less than 1% a
year in the past decade. There are also substantial
distributional and infrastructure inefficiencies that cause
prices of goods to jump in a disorderly manner in the
event of weather or transportation related shocks. Rising
fiscal deficit and the recent sharp depreciation of the
rupee are also potential threat for inflation going forward.
Despite these concerns, we expect WPI inflation to
moderate to 8% by Dec 2011 from the current 9.7%,
thanks to a favorable base effect in food inflation. Barring
any further food price spike or fuel price hike, WPI
inflation should be down to around 7-7.5% by March and
to 6.5% by June 2012. This should allow RBI to start
cutting interest rates from mid-2012, by a cumulative
100bps through the year (taking repo rate down to
7.50%), in our view. However, the inflation trajectory may
not look as benign as our base case scenario suggests if
supply shocks were to materialize. In such a scenario,
inflation may stay in the 8-8.5% range in the second half
of 2012, instead of the 6-6.5% forecast in our base case
scenario. Given that this would take place amidst a
slowing growth environment and heightened global
uncertainty, the RBI’s monetary management would
clearly become highly challenging, in such a scenario.
Recent depreciation of the rupee is yet another risk to
inflation in the coming months.
WPI inflation forecast – two scenarios
5
6
7
8
9
10
11
2010 2011 2012 2013
Baseline Alternate% yoy
Source: CEIC, Deutsche Bank Global Market Research. Note: Alternate inflation scenario builds in a food
price spike (+3%mom) and a diesel price hike of 5-6%.
Could a CRR cut precede repo rate cut?
In recent months, money market liquidity has tightened
severely, with the existing deficit in the LAF (INR1.2trillion)
being almost twice that of what the RBI would like the
systemic liquidity deficit to be (1% of net demand and
time liabilities, which works out to about INR600bn).
Rupee liquidity conditions could tighten further, if the RBI
were to resort to unsterilized FX intervention to prevent
further sharp depreciation of the rupee.
Net LAF against 1% (+/-) NDTL band, WPI inflation
and cash reserve ratio rate
-2
0
2
4
6
8
10
12
-1500
-1000
-500
0
500
1000
15001 % of NDTL (+)1 % of NDTL (-)Net LAFCRR, rhs
%INR bn
Source: CEIC, Deutsche Bank Global Market Research
6 December 2011 EM Monthly
Page 160 Deutsche Bank Securities Inc.
While the RBI could resort to doing more and more open
market operations (OMO) to ease the pressure on rupee
liquidity, we note that the OMO route to improve rupee
liquidity (especially in an environment where FX
intervention could further complicate matters) may prove
to be a time consuming process. A speedier way to infuse
rupee liquidity, thereby creating more flexibility for the
central bank to intervene in the FX market (if the situation
demands), would be to cut the cash reserve ratio (CRR)
rate which currently stands at 6%. Every 1% point cut in
the CRR will increase primary liquidity immediately by
about INR600bn. Indeed, this was the case in the fourth
quarter of 2008, when after the Lehman Brothers
collapse, RBI decided to cut the CRR sharply, while also
intervening aggressively in the FX market.
There are however two main differences with respect to
the 2008-09 period; first, the CRR was at 9%, before the
RBI cut it by 250bps in October 2008 to 6.5% and then by
another 150bps to 5.0% by January 2009. With the CRR
standing at 6% today, the flexibility to cut it is clearly less
(although there is no guideline to stop the RBI from
cutting it). Second, inflation continues to be near double-
digit with little chance of it to moderate to the RBI’s
comfort range of 5-5.5% anytime soon, as compared to
2008/09, when inflation collapsed post 2008, led by a
sharp decline in commodity prices.
Given that inflation and inflation expectations remain high,
RBI therefore may find it difficult to cut the CRR rate
before inflation shows a clear downward trajectory, which
we expect to see only from January onward. Another
possibility could be that the RBI cuts the CRR, justifying
that its move is directed only towards liquidity
management, while its anti-inflationary stance remains
unchanged. This again appears unlikely in the immediate
near-term, though one cannot rule out the possibility of a
100bps cut in CRR, sometime in the first half of 2012.
Is there scope for fiscal consolidation?
The government has not succeeded in reducing the fiscal
deficit since the onset of the 2008 global financial crisis.
While the fiscal stimulus put in place in 2008 helped the
economy, spending has become stickier since then,
making normalization of fiscal policy difficult. Several
social programs have been introduced in recent years,
particularly the rural employment guarantee program (that
gives 100 days of minimum wage to the rural
unemployed), providing substantial impulse to rural
demand while making the fiscal position worse. The
government’s large subsidy programs for food, fuel, and
fertilizer (amounting to about 20% of total spending,
nearly 2.5% of GDP) also add to the adverse fiscal
position and inflated demand.
Expenditure on various subsidies as a % of GDP
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
0.0
0.3
0.6
0.9
1.2
1.5
1.8
FY05 FY07 FY09 FY11
Petroleum, lhs
Fertilizer,lhs
Food, lhs
Total, rhs
% of GDP % of GDP
Source: CEIC, Deutsche Bank Global Market Research
Building on the slippage of 2011, it is difficult to see
much scope for substantial fiscal consolidation in
2012. The expenditure side of the budget will likely
remain sticky owing to welfare programs such as NREGA
and rising subsidy bill on account of food, fertilizer and oil
(unless global oil prices fall sharply, which is not our base
case scenario). Further, if the Food Security Act is
implemented next year then our estimates suggest that
the food subsidy bill could rise by an additional INR200bn
from the current level.
The revenue side of the budget is likely be weak despite
the slated implementation of the Direct Tax Code, given
likely persistence of weak growth momentum in the next
few quarters. To support the revenue base, excise duties
could be raised on certain items while the services tax net
could be broadened, but this could affect economic
growth adversely on the margin.
The government would clearly like to revive its
disinvestment program to ease financing pressure, but
as the experience of 2011 shows the associated
difficulties; the government has been able to raise only
7% of the budgeted disinvestment target so far in the
current fiscal year.
Despite this, we think that the government will factor in
INR250-300bn proceeds from disinvestment, with an
intention of bringing fiscal deficit down to 4.8% of GDP in
FY12/13 (though upside risks will remain), from a likely
5.2-5.5% of GDP outturn in FY11/12 (as against the
budget estimate of 4.6% of GDP). Consistent with past
trend, this fiscal deficit will be financed primarily through
sizable market borrowings, which will continue to weigh
on bond market sentiments.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 161
Fiscal deficit & market borrowing of the central govt.
0
1
2
3
4
5
2
3
4
5
6
7Gross market borrowing, rhs
Fiscal deficit, lhs
% of GDP INR trn.
Source: CEIC, Deutsche Bank Global Market Research
Rupee correction: overdue or overdone?
India’s impressive track record with respect to growth and
market potential has brought in foreign capital in recent
years, crucial to the financing of its current account deficit.
This is an important issue, as India’s domestic savings
rate remains in the 32-33% of GDP range, whereas
investment demand has been around 35% of GDP. As a
result a current account of deficit of 2-3% of GDP has
become the norm. It was generally regarded that given
the economy’s high potential rate of growth, there would
be no shortage of foreign flows, and therefore financing of
the current account would continue unimpeded, allowing
even for reserves accumulation and some appreciation of
the exchange rate.
Current and capital accounts
0
2
4
6
8
10
FY07 FY08 FY09 FY10 FY11 FY12F
Current account deficit
Capital account surplus
% of GDP
Source: CEIC, Deutsche Bank Global Market Research
This thesis is however being challenged. Global risk
sentiments have been poor since 2008, with little respite
in sight. India’s current account deficit has steadily
worsened, primarily owing to high cost of commodity
imports, and financing difficulties were experienced in
2008/09 and again this year. The rupee has come under
pressure lately as the oil import bill has mounted and
portfolio flows have weakened.
Clearly the exchange rate will be vulnerable as the balance
of payments is likely to remain under pressure until
commodity prices correct (we forecast current account
deficit of 3.1% of GDP in 2012, with capital account
surplus just about managing to finance it). Persistent
inflation is yet another complicating factor, reducing the
competiveness of the currency through real exchange rate
appreciation. The rupee therefore has cyclical and
structural headwinds.
Rupee and external flows
-8%
-4%
0%
4%
8%-20
-15
-10
-5
0
2007 2008 2009 2010 2011
(trade balance + net portfolio), lhs
INR/USD (inverted), rhs
USD bn % ch,
mom
Source: CEIC, Deutsche Bank Global Market Research
Since a large part of the recent rupee depreciation has
been due to India specific issues such as rising trade
deficit and shrinking capital account surplus, an
improvement in those areas could therefore help the
exchange rate stabilize. The central bank and the
government have recently announced some measures to
increase foreign capital flows into the country, which
ought to be helpful on the margin.
The limit for foreign institutional investor’s investment
in government and corporate debt was increased by
USD5bn each.
External commercial borrowing norms were modified
to allow greater capital inflow through this route. i)
All-in-cost ceiling of 3-5 year loans were raised to
350bps above libor (from 300bps earlier); and ii) ECB
raised for rupee expenditure i.e. foreign borrowings
for local activities as opposed to external purchases,
will be required to brought in immediately.
Interest rates on new Non-Resident (External) Rupee
(NRE) term deposits for 1-3 year maturity enhanced
to libor + 275bps (from libor +175bps earlier) while
interest rate of fresh FCNR (B) deposits of all
maturities enhanced to libor + 125bps (from libor
+100bps earlier).
6 December 2011 EM Monthly
Page 162 Deutsche Bank Securities Inc.
The recent spate of capital liberalization measures
however is unlikely to have an immediate positive impact
on the rupee, especially as global risk aversion and USD
strength continues. The RBI, which has been virtually
absent from the foreign exchange rate market in the last
two years (marking a change in long-standing strategy),
could however play a bigger role. Recent statements of
key RBI officials indicate unwillingness on the part of the
central bank to intervene, but we believe that if markets
were to become disorderly, the RBI would take action,
and indeed, it has a few operational tools to intervene
effectively and credibly.
RBI intervention in FX market vs. USD/INR
-20
-15
-10
-5
0
5
10
15
38
42
46
50
54
2001 2003 2005 2007 2009 2011
USD bnNet purchase (+)/ sale (-) of USD
by RBI, rhsUSD/INR, lhs
Source: CEIC, RBI, Deutsche Bank Global Market Research
We stress that some of the correction of rupee seen in
the past three months was warranted, and further stress
in the global markets could add renewed pressures. But
we are not worried about India seeing some sort of a
balance of payments crisis. Reserves are ample, imports
cannot remain high if exports are slowing, and external
financing markets are functioning better than in 2008.
India’s reserves are ample to prevent a balance of
payments crisis
0
50
100
150
200
250
300
350
400
450
Adequate
coverage
Source: CEIC, Deutsche Bank. Risk weighted liabilities include short term external debt, current account
balance, broad money, portfolio investment, and exports.
Structural agenda
With economic momentum having slowed appreciably in
2011, the pressure on the government has risen to
implement growth-critical reforms. We provide a list
below of some of the important agenda of the
government in the next year, aimed at strengthening the
structural dynamic of the Indian economy.
National Food Security Bill: The Bill proposes free
food grain for the very vulnerable sections of the
society, and food grain at subsidized rates for
households categorized as 'priority' and 'general'
under the targeted public distribution system. While
this will likely increase the food subsidy bill by an
additional INR200bn, thereby straining the fiscal
position, it is also expected to have a positive effect
by supporting private consumption.
Tax reforms: The Direct Tax Code (DTC) is slated to
be implemented from FY12/13 onward. This would
broaden the tax base, while improving incentives for
tax compliance. The Goods and Services Tax (GST) is
unlikely to be fully implemented next year, but some
initial steps toward bringing retail taxes across states
under one common market system will be taken.
Land Acquisition and Rehabilitation Bill: As this bill
becomes an Act next year, land acquisition for
industrial purposes will likely become relatively easy
and less controversial, though it could increase the
overall cost. The benefits are however likely to
outweigh the costs, giving much needed boost to
industrialization and urbanization.
Capital account liberalization: Further liberalization
of the capital account could be expected as the
government is keen to attract capital flows to support
the orderly financing of the current account deficit.
FDI in the aviation sector could be allowed, external
commercial borrowing guidelines could be further
modified, and FII limit for investment in government
and corporate debt could be enhanced further.
Infrastructure investment: To meet its ambitious
goal of investing USD1trillion on infrastructure
between 2012 and 2017, the government would very
likely announce supportive measures (tax benefits,
deregulation, and privatization) that seek to attract
and enhance private investment in the sector.
Taimur Baig, Singapore, (65) 6423 8681
Kaushik Das, Mumbai, (91) 22 6658 4909
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 163
Investment Strategy
2012 should present interesting opportunities in India
as RBI starts to unwind part of its liquidity and rates
tightening from the last couple of years, and as INR
likely displays a high beta character to global risk. We
remain of the view that it will be a slow grind on the
former, with the central bank likely to ease its grip in
liquidity before it starts to cut interest rates. The start of
open market operations last week we see as a signal for
the same, and we believe the process would be
supplemented and/or expedited via CRR cuts at some
stage possibly in Q1 2012. While the market has started
to price in a turn in the cycle, the actual overnight fixing is
likely to lag till such time as the liquidity deficit gets
overturned. As such, the carry and timing of a long rates
position is very important. We have thus preferred to
position via 1Y/2Y NDOIS steepeners (and short dated
bonds), with minimal bleed, and with some (arguably less
than optimal) exposure to the likely eventual collapse of
yields in the front end of the curve. We initiated this trade
on 18 November at -55bp mid (current: -44), and believe
the spread will eventually revert towards parity.
INR has been the worst performer in Asia this year, and
among the worst in EMFX as a whole. As the only
significant economy suffering from twin deficits in the
region, it is not surprising that the currency has been
under pressure; though inelasticity of commodity imports
(gold and oil), and a sense of policy paralysis in
government affairs (which has impacted FDI) has
worsened the situation by opening up a gap on the
financing of the current account. From a valuation
perspective, we would note that the drawdown in real
terms on INR (both on bilateral basis vs. USD and in terms
of a broader REER) is still short of the experience in 2008-
09, given India’s high inflation; and that on this metric, an
overshoot in USD/INR to 57-59 levels under conditions of
further global stress is not impossible.
In the short run, we think INR is oversold. The threat of
systemic stability given the sharp recent move in the
currency has forced the authorities into action with policy
measures, which should have a near term positive impact.
However, whether it can sustainably reverse its direction
will depend to a large extent on the state of global risk,
and the ability of policymakers to show consistent
progress on issues which impact business and
investment sentiment. We suspect INR will have
significant digital risk in 2012, and to that effect will need
more active policy intervention.
Sameer Goel, Singapore, (65) 6423 6973
India: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 1643 1877 2054 2458
Population (mn) 1175 1200 1218 1236
GDP per capita (USD) 1399 1564 1686 1988
FY10/11 FY11/12 FY12/13 FY13/14
Real GDP (YoY %), FY 8.6 7.0 7.5 8.0
Real GDP (YoY %), CY 9.9 7.3 7.3 8.0
Private consumption 8.4 6.5 6.5 7.1
Government consumption 5.1 4.1 5.0 5.0
Gross fixed investment 12.2 2.5 7.4 8.5
Exports 13.9 23.2 16.3 16.2
Imports 11.5 14.1 13.0 14.3
Prices, Money and Banking
WPI (YoY%) eop 9.4 7.5 6.0 7.5
WPI (YoY%) avg 9.6 9.4 6.3 6.9
Broad money (M3) eop 16.5 16.3 19.0 18.3
Bank credit (YoY%) eop 23.2 15.7 18.7 18.9
Fiscal Accounts (% of GDP)1
Central government balance -4.7 -5.5 -4.8 -4.5
Government revenue 10.5 9.5 10.1 10.5
Government expenditure 15.2 15.0 14.9 15.0
Central primary balance -1.7 -2.5 -1.8 -1.5
Consolidated deficit -7.6 -8.1 -7.4 -7.0
External Accounts (USD bn)
Merchandise exports 225.7 268.2 303.0 348.5
Merchandise imports 357.9 418.8 473.2 544.2
Trade balance -132.2 -150.6 -170.2 -195.7
% of GDP -8.0 -8.0 -8.3 -8.0
Current account balance -51.7 -54.6 -63.5 -78.2
% of GDP -3.1 -2.9 -3.1 -3.2
FDI (net) 10.0 25.0 32.5 35.0
FX reserves (USD bn) 296.5 286.9 292.9 302.7
FX rate (eop) INR/USD 44.8
44.8
51.5
51.5
48.0
48.0
47.0
47.0
Debt Indicators (% of GDP)
Government debt 65.0 62.1 61.7 61.4
Domestic 61.4 59.0 58.8 58.7
External 3.6 3.2 2.9 2.7
Total external debt 15.0 14.1 14.6 13.0
in USD bn 247.0 265.0 300.0 320.0
Short-term (% of total) 17.0 17.0 18.0 18.0
General
Industrial production (YoY %) 8.1 0.7 8.5 6.5
Financial Markets Current 3M 6M 12M
Repo rate 8.50 8.50 8.50 7.50
3-month treasury bill 8.73 8.00 7.80 7.00
10-year yield (%) 8.71 9.00 8.50 8.00
INR/USD 51.3 50.5 49.5 48.0 Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Fiscal year ending March of following year, consolidated deficit includes state and central
government finances, as well as bonds issued as payments to oil and fertilizer companies on account of
the losses incurred from the provision of subsidies..
6 December 2011 EM Monthly
Page 164 Deutsche Bank Securities Inc.
Indonesia Ba1/BB+(Pos)/BB+(Pos) Moody’s/S&P/Fitch
Economic Outlook: Building on the momentum built
over the past couple of years, Indonesia steps into
2012 with well-anchored consumer and business
confidence, which could allow the economy to grow
by over 6% at a year when global growth will likely
slow sharply.
Main Risks: Inflation could rise sharply on the back of
electricity and fuel price adjustments, and as demand
remains strong. Rupiah could come under pressure if
global liquidity crunch and risk aversion continue.
Bond yields could rise for the same reason.
Strategy Recommendations: Increase underweight
as 10Y yields close in on 6%.
Sustained growth in a more challenging
environment
It has been a landmark year for Indonesia, characterized
by strong growth, robust investor sentiments, and below
trend inflation. Aided by a buoyant commodity market that
saw earnings from exports rise sharply, Indonesia’s
economic performance in 2011 has been particularly
striking as it has taken place when growth momentum
worldwide has been waning.
Growth will face some headwinds in 2012 if the
commodity markets weaken, but we believe that the
economy could continue to motor ahead, keeping most of
its growth momentum intact, as a virtuous cycle of strong
sentiments fuelling consumption and investment, which in
turn creates employment and income that further
supports sentiments appears to be in place for the time
being. We, therefore, expect growth to exceed 6% in the
coming year, helped by private and public consumption
and investment. Net exports contribution to growth will
likely decline, but that should not constitute more than
0.5% downside to GDP growth, in our view. On the
investment side, we expect continued activities in mining,
transportation, infrastructure, and retail sectors. If land and
labor laws become more transparent and effective, there
would be upside to our investment forecast.
Inflation has been remarkably benign through the course
of 2011 due to (i) about 20% of CPI has been kept fixed as
there have been no upward adjustment in administrative
prices of electricity, fuel, toll road usage, and
transportation, (ii) food prices have been mostly flat or
declining owing to favorable weather and well executed
public procurement and disbursement programs, and (iii)
the stability of food and fuel prices have kept inflation
expectations in core prices in check. Inflation could be 4%
or less at the beginning of 2012.
We however don’t see this trend persisting for long.
Capacities are stretched, wage pressure has risen, and
demand is likely outpacing supply. Against this backdrop,
the government’s policy to keep interest rates ultra-low
encourages a bank lending boom (much of it will likely go
toward financing consumption). The practice of leaving
administrative prices unadjusted is bound to fuel demand-
push inflation. Also, we understand that some electricity
tariff adjustment and fuel price hike are on the cards,
which could unleash an unfavourable inflation dynamic.
Our forecasts see inflation heading above 6% next year.
Bank Indonesia has been unambiguously dovish through
the course of the year and will likely remain so in the first
half of 2012. Our official call is for no further rate cuts, but
if inflation surprises on the downside and global
conditions deteriorate, the central bank will not hesitate to
cut rates, given its track record.
This approach toward supporting growth as first
default could be problematic for the medium term.
The dovish approach to monetary policy pre-supposes
limited feedback from interest rate policy to inflation and
inflation expectations. We don’t subscribe to this idea,
and believe that inflation expectations could readily get
adjusted upward if rate cuts continue while growth
remains relatively strong.
The policy framework of the central bank is also an
important determinant of the exchange rate and bond
yields. This should be a moment for the rupiah and
Indonesia bonds to readily outperform the region, given
the economy’s comfortable external financing position. A
highly interventionist policy, however, has undermined
external investor sentiment by strenuously moderating the
moves in the exchange rate and bond yields.
We expect much of the external financial market
difficulties of 2011 to spill over to 2012. This means
periods of heightened risk aversion and dollar funding
shortage cannot be ruled out. The authorities would likely
need to intervene periodically to ensure that asset price
overshooting does not happen (in either direction) and
payments and settlements take place in an orderly
manner. But the interventions need to be market based,
transparent, and constructive. Some progress in this
direction would ensure financial market stability for years
to come, in our view.
Taimur Baig, Singapore, (65) 6423 8681
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 165
Investment Strategy
Indonesia offers little value at these levels, particularly
on vol adjusted basis, and we stay defensive in our
exposure. But given the breakeven costs, and active
intervention by authorities (both in spot and bond markets),
it is also tough to carry anything more than a small
underweight position in this market. We see it therefore
more as a tail risk trade on both rates and FX, with the
possibility of gapping out in the event global conditions
worsen significantly, and/or policy errors get magnified.
Let’s have a look at the positives to start with, though –
the biggest one being the resilience of the economy’s
growth momentum as highlighted in the section above.
We would also count in this list a disciplined fiscal
strategy (though arguably more a reflection of lack of
spending); a strong cash position for the MOF (which
forms a part of the bond stabilization framework);
improved credit metrics; and a strong probability of
upgrade for sovereign ratings to investment grade by one
or possibly two agencies in 2012.
But with 10Y yields moving again towards 6%, and IDR
hugging 9000, the risk reward is hardly compelling. What
we don’t like in particular is, 1) the timing and quantum of
recent rate cuts by Bank Indonesia, given the backdrop of
a cyclically insensitive economy and possible increase in
inflationary risks again next year; 2) the concentration of
offshore ownership in the bond markets, and possible lack
of a similar level of sponsorship as in previous years; 3)
the dominance of BI as the main buyer of duration in this
market in the last couple of months; and 4) the failure of
BI’s spot intervention in calming market nerves.
Foreign investors own $24bn of government bonds,
equivalent to 30% of outstanding (and arguably double
the proportion of ‘floating stock’), and in the first eight
months of this year, had bought 82% of all net issuance.
They have in the last three months offloaded $3.6bn of
their holdings, 90% of which was picked up by Bank
Indonesia (which now carries a portfolio of $7.2bn). Local
banks picked up another $2.5bn, while other domestic
real money (insurers, pension funds, mutual funds) have
all been net sellers. With the pressure of issuance starting
again in January, the extent of offshore support for this
market will get severely tested again.
Inspite of a rapid build up in its reserves since 2008, we
note that Indonesia’s BOP sensitivity to stress situations
has not necessarily gotten any better. This is because
most of these reserves have been built on the back of a
growing concentration of offshore ownership of
Indonesia’s capital markets. See our Asia FX Strategy
Notes from 27th October for details.
Sameer Goel, Singapore, (65) 6423 6973
Indonesia: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 707.8 837.0 907.7 1040.8
Population (mn) 240.8 243.7 246.6 249.6
GDP per capita (USD) 2939 3435 3680 4170
Real GDP (YoY%) 6.1 6.5 6.3 6.5
Private consumption 4.6 4.7 5.0 5.0
Government consumption 0.3 3.0 4.4 4.5
Gross fixed investment 8.5 8.3 8.0 8.7
Exports 14.9 13.9 8.5 8.5
Imports 17.3 12.8 7.9 7.9
Prices, Money and Banking
CPI (YoY%) eop 7.0 4.0 6.5 6.6
CPI (YoY%) ann avg 5.1 5.4 5.7 6.5
Core CPI (YoY%) 4.3 4.5 5.5 6.0
Broad money (M2) 15.4 16.0 15.0 15.0
Bank credit (YoY%) 13.0 22.0 20.0 22.0
Fiscal Accounts (% of GDP)
Budget surplus -0.6 -1.1 -1.4 -1.9
Government revenue 15.8 15.4 15.8 16.0
Government expenditure 16.4 16.5 17.3 18.0
Primary surplus 1.4 0.9 0.6 0.1
External Accounts (USD bn)
Merchandise exports 158.1 199.6 216.0 226.9
Merchandise imports 127.4 164.5 184.9 199.8
Trade balance 30.6 36.7 31.1 27.1
% of GDP 4.3 4.4 3.4 2.6
Current account balance 5.6 4.0 -1.5 -5.1
% of GDP 0.8 0.5 -0.2 -0.5
FDI (net) 10.7 9.1 9.6 12.0
FX reserves (USD bn) 95.0 116.8 123.7 123.0
FX rate (eop) IDR/USD 8991 9100 8950 8700
Debt Indicators (% of GDP)
Government debt 27.0 26.0 24.9 24.5
Domestic 14.7 15.0 14.1 13.5
External 12.3 11.0 10.8 11.0
Total external debt 25.4 23.9 24.2 23.1
in USD bn 180.0 200.0 220.0 240.0
Short term (% of total) 18.6 18.5 20.5 20.8
General
Industrial production (YoY%) 4.0 7.0 8.0 8.0
Unemployment (%) 7.1 7.0 6.8 6.5
Financial Markets Current 3M 6M 12M
BI rate 6.00 6.00 6.00 6.50
10-year yield (%) 6.25 6.50 6.70 7.00
IDR/USD 9100 9050 9010 8950
Source: CEIC, DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 166 Deutsche Bank Securities Inc.
Malaysia A3/A-/A- Moody’s/S&P/Fitch
Economic outlook: Slower export growth will weigh
on investment spending and consumption cushioned
by continued easy monetary and fiscal policies.
Main risks: The main risks lie abroad, especially the
possibility of a deeper recession in Europe.
Strategy recommendations: Vulnerability to bond
market outflows keeps us cautious on rates (with a
steepening bias) and neutral on MYR.
Macro view
Surprising strength in Q3, but GDP growth will slow.
We estimate that GDP expanded 3.8%QoQ(saar) in Q3 up
from 2.4% in Q2. Compared to a year ago, growth rose
to 5.8% from 4.3% in Q2. We estimate that exports fell
3.8%QoQ(saar) in the quarter, but this was offset by
surprising growth in private and government consumption
and in investment. Broadly, our expectation is that as
exports continue to decline over the next few months,
domestic demand growth will suffer. While we are far
from forecasting a return to the extreme contractions of
2001 or 2008/09 we think export growth will start 2012 in
negative YoY territory and with a gradual recovery
thereafter the likelihood is that growth will be slightly
negative for the year as a whole. In such an environment,
we expect consumption growth – which has been running
well above long-run average recently – to slow down next
year. Private capital expenditures have historically been
heavily influenced by export growth will almost certainly
slow down in 2012.
Domestic and external demand in GDP
-20
-15
-10
-5
0
5
10
15
20
25
00 01 02 03 04 05 06 07 08 09 10 11
Dom demand Exports%yoy
Sources: CEIC and Deutsche Bank
Still, our forecast of 4.3% growth seems to us to be a
relatively positive one. Note that a backward-looking
estimate of Malaysia’s potential growth rate would put it
at about 4% although Bank Negara’s estimate is about
5%. With US and EU combined growth rising to about
2% in 2012 from about 1% in 2012 we see Malaysia’s
economy growing significantly faster in 2013.
Policies to remain supportive but not very stimulative
In the October budget, the government announced a
mildly contractionary policy – forecasting a deficit next
year of 4.7% of GDP versus 5.4% this year. While there
were lots of measures aimed at boosting demand, the
overall target for government expenditures is slightly
lower than the expected outcome this year. Our forecast
is for expenditures to come in slightly above target,
resulting in a deficit mildly higher than what was budgeted
but more importantly higher than this year’s forecast
deficit. So in that sense we think fiscal policy will be
slightly expansionary in 2012 but not aggressively so. We
think the government is committed to reducing its debt
burden in the medium term.
On the monetary side, while the risks are increasingly
weighted in the direction of rate cuts as inflation falls, we
don’t at this point think the central bank will cut rates. The
real policy rate is still negative today but we expect that
with subsidy cuts likely deferred to the second half of next
year inflation will fall to about 2% by mid-2012 from 3.4%
currently (3.3% excluding price-controlled items). Rate
cuts become possible, in our view, once real interest rates
turn significantly positive but our forecast is that by then
growth will have bottomed out obviating the need for rate
cuts. Clearly, some combination of slower growth and/or
lower inflation relative to our forecasts could change the
interest rate outlook.
Inflation and interest rate forecasts
-4
-2
0
2
4
6
8
10
06 07 08 09 10 11 12
CPI o/n policy rate%
Sources: CEIC and Deutsche Bank
Michael Spencer, Hong Kong, (852) 2203 8305
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 167
Investment strategy
Rates: In FY12, we expect gross and net issuance of
bonds (MGS/GII) to be MYR89bn and MYR43.5bn
respectively. This is marginally lower compared to FY11.
We continue to be cautious in the MGS market due to its
vulnerability to capital outflows. As of end September,
foreigners had bought over 230% YTD of the net issuance
of MGS on the back of continuous inflows into EM local
currency debt funds. Even though our base case remains
that offshore inflows will continue to support the market
in 2012, systemic risks from Europe could result in these
inflows turning weaker. Given that net supply is roughly
the same next year; the onus will be on local players to
pick up the slack. At such rich levels, locals have not
shown a strong appetite for bonds despite ample liquidity
onshore and growing AUM of pension funds.
The upside risks to yield is mitigated by the dovish outlook
on monetary policy and weak growth prospects, which
could result in the domestic players allocating more
towards bonds compared to risky assets. Therefore, we
think sustained and sharp spike in back end yields are
unlikely even though curves could continue to steepen on
underperformance of the long end of the curve.
FX: We see the MYR as one of the more vulnerable
currencies to a deepening of the European crisis. First, the
ringgit is trading as a high beta currency to global risk
sentiment and the broad USD, in part because the central
bank is less active in smoothing FX volatility. Second, FX-
implied USD funding costs in the local market are at
exceptionally high levels, as asset swapping activities by
MYR bond issuers and investment outflows by locals have
picked up at a time when USD funding has tightened
globally. Third, foreign bond holdings remain at high
levels, and a pickup in EM fund redemptions could drive
further fixed income outflows from Malaysia.
That said, we note quite a couple of positive factors for
the MYR. Malaysia has one of the largest current account
surpluses in the region. Currency valuations are not
stretched, and the MYR REER is trading furthest below
the pre-97 crisis peaks. Exports are likely to slow as
external demand weakens, but the drag to growth from
exports would also be partly offset by the government’s
initiatives to kick start a few mega projects domestically.
Nominal rates differentials should remain in favour of MYR
assets, as BNM does appear to be in a hurry to ease
policy. In sum, our preference is to stay neutral the MYR
until external headwinds subside.
Arjun Shetty, Singapore, (65) 6423 5925
Dennis Tan, Singapore, (65) 6423 5347
Malaysia: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 238.4 275.9 285.9 310.6
Population (mn) 28.3 28.6 29.0 29.4
GDP per capita (USD) 8438 9643 9863 10580
Real GDP (YoY%) 7.2 5.0 4.3 5.5
Private consumption 6.5 7.0 5.5 6.3
Government consumption 0.5 12.5 4.9 6.3
Gross fixed investment 9.8 4.9 1.3 6.1
Exports 9.9 2.8 -0.2 5.2
Imports 15.1 4.1 -0.9 6.2
Prices, Money and Banking
CPI (YoY%) eop 2.1 3.4 2.1 2.6
CPI (YoY%) ann avg 1.7 3.2 2.4 2.3
Broad money (M3) 8.3 10.8 11.1 9.3
Bank credit (YoY%) 10.7 10.6 9.7 8.6
Fiscal Accounts (% of GDP)
Federal government surplus -5.6 -4.2 -5.0 -5.0
Government revenue 20.8 22.3 21.0 20.0
Government expenditure 26.5 26.4 26.0 25.0
Primary fed. gov't fiscal
surplus -3.6 -2.0 -2.8 -2.7
External Accounts (USD bn)
Merchandise exports 199.4 226.2 237.9 261.7
Merchandise imports 157.7 180.5 196.8 218.4
Trade balance 41.8 45.7 41.2 43.3
% of GDP 17.5 16.6 14.4 14.0
Current account balance 27.4 31.5 28.4 28.8
% of GDP 11.5 11.4 9.9 9.3
FDI (net) -4.4 -4.0 -3.0 -3.0
FX reserves (USD bn) 106.5 124.6 125.0 126.1
FX rate (eop) MYR/USD 3.13 3.15 3.10 3.07
Debt Indicators (% of GDP)
Government debt 53.1 52.2 54.0 55.1
Domestic 51.0 50.3 52.3 53.6
External 2.2 1.9 1.7 1.5
Total external debt 29.5 27.6 24.3 22.4
in USD bn 73.4 74.0 70.0 69.8
Short-term (% of total) 35.1 40.5 40.0 43.0
General
Industrial production (YoY%) 8.9 1.7 0.6 3.1
Unemployment (%) 3.3 3.2 3.3 3.3
Financial Markets Current 3M 6M 12M
Overnight call rate 3.00 3.00 3.00 3.00
3-month interbank rate 3.2 3.2 3.2 3.2
10-year yield (%) 3.75 3.80 3.80 3.90
MYR/USD 3.13 3.15 3.13 3.10
Source: CEIC, DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 168 Deutsche Bank Securities Inc.
Philippines Ba2/BB/BB+ Moody’s/S&P/Fitch
Economic Outlook: Growth has slowed owing to a
weakening of external demand, but domestic demand
is likely to hold up as inflation declines, while
consumer and business sentiment remains resilient.
Main Risks: External demand could be weaker than
expected if the crisis in Europe deepens further.
Strategy Recommendations: Modest overweight
on duration into 2012. Peso to be more resilient than
regional FX.
More resilient to face external
headwinds
As expected, the ongoing global slowdown is pulling
down the Philippine economy. The key question is if the
economy could head toward near-zero growth in 2012
due to the drag from the Euro area, and possibly from
China, or if it would display a more resilient outcome. We
think that short of a severe exacerbation of the global
economy and markets, the Philippines should come
across as more resilient in 2012 relative to 2008.
The recently published third-quarter national accounts data
could be an apt illustration of the economy’s
vulnerabilities and strengths. Reflecting a sharp
contraction in trade and poor weather, the economy grew
by 3.2%yoy in Q3 (3.1% in Q2), in line with our forecast
(3.3%). The authorities have estimated that poor weather
subtracted 0.3% from growth in Q3 (agriculture sector
growth moderated to 1.8%yoy in Q3 vs. 8.2% in Q2). The
biggest drag was from the external sector, with exports
(which represent over 50% of GDP) declining by
13.1%yoy, a sharp deterioration from growth of 1.4% in
the previous quarter. With a view to 2012, the outlook will
remain grim for exports, with the Euro area expected to
undergo a recession and China’s domestic economy
slowing.
On the bright side, industrial production appears to have
stabilized owing to strong domestic demand. More
corroboration is found in the expenditure side data, which
show consumption rising by 7.1%yoy, up from 5.5% in
Q2. Investment rebounded strongly during the quarter,
rising by 24.5%yoy (vs. -7.7% in Q2). Within the segment,
growth in durable equipment rose sharply by 9.9% (up
from 1.0% in Q2) and the pace of decline in construction
investment eased to 10.6% in Q3 vs.-21.0% in Q2. With
remittances remaining resilient, the outsourcing sector
gaining momentum, domestic money and credit
conditions highly comfortable, and the government’s
public infrastructure spending program beginning to take
traction, the outlook for domestic demand is considerably
better than was the case in 2008/09.
Our growth forecasts for 2011 and 2012 (3.5% and 3%,
respectively) would have been at least 100bps lower if we
did not take solace from the resiliency of domestic
demand, driven by the factors discussed above. We also
think that public spending would be more supportive
next year as public-private infrastructure spending picks
up and the central bank takes monetary policy easing
measures (at least 50bps in rate cuts in Q1 2012, in our
view). BSP will be comfortable with the money and credit
situation in the economy due to ample liquidity, and hence
is unlikely to pursue policy measures aggressively.
We also expect inflation to ease next year as commodity
prices flatten out and growth falls below the potential
rate. We see considerable base-effect led disinflation in
Q1 2012, which could take inflation down by 100bps
during the quarter. BSP’s 3-5% inflation target is
comfortably achievable, in our view.
We expect remittances to be impacted only mildly in
2012, growing perhaps by 3-4%. Demand for overseas
Filipinos remains strong worldwide, and the 2008 crisis
showed that deployment of workers was not particularly
pro-cyclical. The marginal demand for overseas Filipinos
come from Asia and the Middle-East, where growth
would slow much less than in the industrial countries,
which would likely help.
The peso should be well supported. At a time when
rising risk aversion has caused a tightness in USD liquidity
worldwide, squeezing systems of payments and
settlements, the Philippines is an outlier, with an
exceptionally flush dollar liquidity position (thanks to
steady and sizeable remittance flows). Reserves are
ample to the extent of making the Philippines a net
creditor nation, so the currency is among the least
vulnerable in Asia, in our view.
We think that there are risks to the upside with
respect to our growth forecasts. If agriculture rebounds,
domestic consumption and investment sentiments remain
stable, and public spending gains traction, growth could
well surprise on the upside. By focusing on fiscal
consolidation, pursuing prudent monetary policy, the
Philippine authorities have established a strong macro
framework to deal with adverse economic shocks, and
2012 may well be a year when the economy’s improved
resiliency catches investor attention.
Taimur Baig, Singapore, (65) 6423 8681
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 169
Investment Strategy
Rates: The key differentiating factor this year for the
Philippines was the improvement in fiscal performance.
While we would expect some payback to what was at
least in part a result of postponement of spending, we
should nonetheless see a gradual reduction in the fiscal
risk premium priced into the interest rate curve. Except for
its legacy EM-like nature, characterized mostly by the lack
of depth in the bond market which makes it vulnerable to
global risk sell offs, there is little else to fault in the rates
backdrop for the Philippines as we head into 2012. The
inflation outlook is comfortably benign; with BSP itself
forecasting average CPI in mid to low 3% range for the
next couple of years (food prices arguably are the biggest
risk to this outlook). BSP will likely be early within the
region to cut rates, while the currency remains less
sensitive to interest rate differentials, and more a function
of current account surpluses. The financing picture is
robust – ample domestic liquidity, tapped this year in part
also by two very successful retail issuances. We project
net issuance of FXTBs and retail bonds to in fact dip by
close to 20% year-on-year, with larger redemptions in the
pipeline. And very importantly, there is little immediate
vulnerability to the volatility in capital flows, except in the
case of GPNs. We think yields will grind lower towards
5.5% eventually, with the possibility of an overshoot in
response to BSP rate cuts. We suggest being positioned
modestly overweight on this market going into next year.
FX: The Philippine peso has weathered this year’s market
turmoil better than most Asian currencies – it is one of
only two Asian currencies which are trading up against the
USD year to date (the other being the RMB). Reasons for
the peso’s outperformance include stable growth in
remittances and outsourcing sector inflows, as well as
relatively more resilient portfolio inflows. We think these
factors should help the peso outperform in 2012 as well,
particularly if the Europe-related volatility continues. Our
recent BoP stress test reveals that the peso is one of the
least vulnerable currencies should market conditions turn
more adverse. We also see chances of a pick up in FDI if
the government manages to kick start the Public-Private
Partnership (PPP) infrastructure, given strong interests in
the scheme by foreign investors. Should capital inflows
pick up next year, the BSP may face constrains in FX
intervention, not least because of flush domestic liquidity.
Note that the BSP is the only Asian central bank talking
about relaxing outflows measures and tightening control
measures on inflows at this point. The main risk to this
view is if supply constraints cause commodity prices to
start heading higher again.
Sameer Goel, Singapore, (65) 6423 6973
Dennis Tan, Singapore, (65) 6423 5347
Philippines: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 199.5 226.9 245.9 274.3
Population (mn) 92.5 94.8 97.1 99.6
GDP per capita (USD) 2158 2394 2531 2755
Real GDP (YoY%) 7.6 3.5 3.0 4.5
Private consumption 3.4 5.0 4.5 4.5
Government consumption 4.0 1.0 3.0 3.0
Gross fixed investment 31.6 8.0 4.0 10.0
Exports 21.0 -2.0 2.0 9.0
Imports 22.5 1.4 4.5 10.8
Prices, Money and Banking CPI (YoY%) eop 3.1 4.7 4.0 4.0
CPI (YoY%) ann avg 3.8 4.8 3.8 4.0
Core CPI (YoY%) 3.7 4.2 3.5 4.0
Broad money (M3) 9.8 9.0 9.5 10.0
Bank credit1 (YoY%) 8.9 13.9 12.5 13.0
Fiscal Accounts (% of GDP) National government surplus -3.5 -2.9 -3.2 -3.2
Government revenue 13.4 14.4 14.3 14.5
Government expenditure 16.9 17.3 17.5 17.7
Primary surplus -0.2 0.6 0.1 0.3
External Accounts (USD bn) Merchandise exports 50.7 52.2 51.5 56.1
Merchandise imports 61.1 67.7 69.1 76.0
Trade balance -10.4 -15.5 -17.6 -19.9
% of GDP -5.2 -6.8 -7.2 -7.2
Current account balance 8.5 10.3 8.3 9.0
% of GDP 4.2 4.5 3.4 3.3
FDI (net) 1.2 1.3 0.1 0.5
FX reserves (USD bn) 58.4 77.7 84.5 89.0
FX rate (eop) PHP/USD 43.9 43.5 42.5 41.5
Debt Indicators (% of GDP) Government debt2 57.6 56.4 55.2 54.0
Domestic 30.4 30.0 30.1 29.8
External 27.3 26.4 25.2 24.2
Total external debt 34.1 31.9 30.6 28.8
in USD bn 70.0 72.0 76.0 80.0
Short-term (% of total) 16.8 16.5 16.0 18.0
General Industrial production (YoY%) 15.6 3.0 6.0 6.0
Unemployment (ILO) (%) 8.1 7.9 7.7 7.7
Financial Markets Current 3M 6M 12M
BSP o/n repo 6.50 6.00 6.00 6.00
BSP o/n reverse repo 4.50 4.00 4.00 4.00
3-month treasury bill 2.89 3.50 4.00 4.55
10-year yield (%) 5.88 5.70 5.50 5.50
PHP/USD 43.8 43.4 43.1 42.5
Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Deposit money bank credit to the private sector. (2) Incl. guarantees on SOE debt.
6 December 2011 EM Monthly
Page 170 Deutsche Bank Securities Inc.
Singapore Aaa/AAA/AAA Moody’s/S&P/Fitch
Economic Outlook: Slower global growth means
much slower growth in Singapore in 2012, but
sharply lower inflation as well.
Main Risks: Singapore is Asia’s most export-
sensitive economy, so macro risk derives mainly from
the US and Europe.
Strategy Recommendations: SGS has strong
technicals but rich valuations. Expect the yield curve
to flatten in 2012. Trade SGD NEER in a range.
Macro View
Asia’s highest-‚beta‛ economy. As export volumes
have stagnated in recent months so too has the economy.
We estimate that exports of goods and services fell
4.5%QoQ(saar) in Q3 after falling 5.3% in Q2 – more than
enough to offsetting the previous two quarters’ growth.
So, not surprising given that exports are more than double
the size of GDP, GDP growth has essentially stalled as
well. While GDP did expand at a 1.9% annualized rate in
Q3, this followed a 6.4% rate of decline in Q2. Given the
volatility of economic data in Singapore even quarterly
forecasts are difficult but we can with great confidence
say that the economy will simply follow where exports
lead. Over the past 15 years the correlation between
growth in (gross) exports and goods and services and
GDP has been 0.87.
Exports of goods and services and GDP
-20
-15
-10
-5
0
5
10
15
20
25
30
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
GDP Exports%yoy
Sources: CEIC and Deutsche Bank
So the key question for Singapore is: what drives
exports? As we argued recently1 it does not appear that
China is yet an important source of final demand for
Singapore’s exports – at least compared with the US and
1See ‚China is a weak engine of growth for Asia,‛ in Global Economic
Perspectives, September 10, 2011.
Europe. So, with Euroland in recession and the US
growing at a stable 2.0% - 2.5% rate we expect to see
slower export growth next year compared with this year
and therefore slower GDP growth. But similarly, the
recovery in Euroland and possibly faster US growth in
2013 should see the Singapore economy bounce back
sharply.
Inflation to fall rapidly in 2012/13 With slower global
growth will come lower inflation. Indeed, the inflation
impulse has already weakened. The 3m/3m seasonally
adjusted rate of change in the CPI is 1.2% versus a YoY
rate of inflation of 5.4%. Global wholesale food prices
have broadly been in decline since April – the YoY change
in the IMF’s food price index has fallen from 33.4% to
1.4% over the past six months. Similarly, crude oil prices
have essentially been stable for the past seven months,
taking the YoY rate of change down from above 50% in
July to about 30% currently. If, as we expect, oil prices
remain stable for the next six months then of course oil
price inflation will vanish.
We are confident that we’ve seen the worst of property
price inflation and that prices may actually decline next
year. However, that won’t necessarily translate into the
CPI. We think the CPI lags market prices by at least six
months, but when property prices fell 24%yoy in mid-
2009 the accommodation component of the CPI for 2009
recorded at most a 3%yoy fall. So, we assume the CPI
measure of accommodation costs stops rising after mid-
2012 but doesn’t decline.
Inflation and interest rates
-2
0
2
4
6
8
06 07 08 09 10 11 12
Inflation 3m SGD Sibor%
Sources: CEIC and Deutsche Bank
Still, as inflation falls – and the risks to our forecast are,
we think, to the downside – real interest rates will rise
sharply, adding further downward momentum to GDP.
Michael Spencer, Hong Kong, (852) 2203 8305
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 171
Investment Strategy
Rates: For 2012, we estimate a gross issuance of
SGD24.7bn for SGS and 1Y T-bills. Accounting for the
maturities of SGD20.4bn; we expect the net issuance to
be SGD4.3bn which is more or less in line with previous
years. The technicals in this market are very healthy
however valuations do appear rich. Any sustained
improvement in risk sentiment could cause a significant
back up in yields from current levels. However, we still
think that there are factors which lend some degree of
comfort on this front. 1) With over EUR600bn of
refinancing needs for Italy and Spain in 2012, and ECB
reluctant to finance state deficits, systemic risks from
Europe will continue to dampen risk sentiments and keep
a bid on save haven assets 2) Most of the foreign holdings
in SGS are concentrated at the front end of the curve
which means that FX exposure dominates duration
exposure. With SGD NEER close to the bottom of the
band, downside on the currency is ultimately capped by
MAS. 3) Liquidity ratio of banks is close to all time lows
which mean that despite the rich yield levels, banks are
likely to continue buying SGS/T-bills. The risk to this view
could come from a strong rebound in growth in US and/or
a change in stance by ECB on financing state deficits.
Arjun Shetty, Singapore, (65) 6423 5925
FX: The SGD was the top currency pick for the macro
community earlier this year, but it has fallen from grace to
become the worst performing Asian currency after the
INR lately. We think there are a few reasons for SGD’s
underperformance: 1) investors paring back bullish bets
on policy expectations, 2) impact of deleveraging by
European banks, and 3) less active MAS intervention
within a relatively wide band (+/-3% around mid-point).
While the initial weakness in the SGD can be explained by
a washout of speculative positions in late September, we
suspect that deleveraging by European banks have started
to impact the SGD more significantly, given Singapore’s
status as a financial centre. Currencies of countries with a
higher exposure to European banks (i.e. SGD, KRW, PHP,
IDR and MYR) have underperformed this month, while
currencies of countries with a lower exposure (CNY, TWD,
THB) have been more insulated from the European
contagion. This could limit SGD's recent bounce, even
though it is still trading in the lower half of the policy band
(about 1.5% above the bottom band). A slowdown in
global growth and inflation would also increase the
chances of another round of policy easing by MAS in
April. We favor a more range-trading approach to SGD
NEER (within the lower band).
Dennis Tan, Singapore, (65) 6423 5347
Singapore: Deutsche Bank Forecasts
2009 2010 2011F 2012F
National Income
Nominal GDP (USD bn) 222.7 257.2 265.4 291.6
Population (mn) 5.2 5.3 5.4 5.5
GDP per capita (USD) 43007 48800 49602 53436
Real GDP (YoY%) 14.5 5.0 2.5 4.8
Private consumption 4.2 5.9 4.7 5.4
Government consumption 11.0 3.4 6.7 4.1
Gross fixed investment 5.1 0.7 -7.1 -0.1
Exports 19.2 1.4 0.0 6.4
Imports 16.6 1.4 -0.9 6.2
Prices, Money and Banking
CPI (YoY%) eop 4.6 5.3 1.2 1.0
CPI (YoY%) ann avg 2.8 5.2 2.6 0.9
Broad money (M2) 8.5 10.4 10.6 9.8
Bank credit (YoY%) 9.6 24.7 10.9 1.6
Fiscal Accounts (% of GDP)
Fiscal balance 5.1 8.0 6.6 7.3
Government revenue 21.1 24.6 22.2 21.0
Government expenditure 16.0 16.6 15.6 13.7
External Accounts (USD bn)
Merchandise exports 358.5 415.9 442.5 495.6
Merchandise imports 311.7 365.1 390.7 438.5
Trade balance 46.8 50.8 51.8 57.1
% of GDP 21.0 19.7 19.5 19.6
Current account balance 49.5 49.1 49.0 59.3
% of GDP 22.2 19.1 18.5 20.3
FDI (net) 19.1 19.8 10.0 8.0
FX reserves (USD bn) 225.8 244.4 271.1 313.4
FX rate (eop) SGD/USD 1.31 1.30 1.25 1.20
Debt Indicators (% of GDP)
Government debt 105.8 107.2 110.4 113.3
Domestic 105.8 107.2 110.4 113.3
External 0.0 0.0 0.0 1.0
Total external debt 169.1 233.2 218.5 188.6
in USD bn 513.6 600.0 580.0 550.0
Short-term (% of total) 74.8 75.0 75.0 76.0
General
Industrial production (YoY%) 29.7 8.1 0.0 4.1
Unemployment (%) (eop) 2.2 2.1 2.6 2.8
Financial Markets Current 3M 6M 12M
3-month interbank rate 0.4 0.4 0.4 0.4
10-year yield (%) 1.70 1.75 1.80 1.90
SGD/USD 1.28 1.28 1.27 1.25
Source: CEIC, DB Global Markets Research, National Sources
Note: includes external liabilities of ACU banks.
6 December 2011 EM Monthly
Page 172 Deutsche Bank Securities Inc.
South Korea A1/A/A+ Moody’s/S&P/Fitch
Economic Outlook: We see South Korea’s growth to
follow the G2 cycle, reporting a below trend growth
of 3.4% in 2012, followed by a notable rebound to
4% in 2013.
Main Risks: The sovereign debt crisis in Euroland
pose serious downside risks to growth.
Strategy Recommendations: We look for further
steepening on the KTB curve. Concerns about lack of
reinvestment demand from offshore fund investors
should reduce, which is supportive of 2Y-3Y segment.
Macro View
Growth thus far this year has been broadly in line with
expectations, driven by exports… Performance of the
South Korean economy was broadly in line with our
forecast in terms of the headline numbers. A year ago, we
forecasted that the economy would grow by 4.0% in 2011
and it expanded 3.7%yoy ytd in Q3 2011. On the other
hand, there were some notable differences in detail, with
exports outperforming our expectations and domestic
demand proving to be weaker than our forecast noted a
year ago. In particular, we saw export growth of
11.9%yoy ytd in Q311, vs. our earlier forecast of 6.3%
growth for the whole year, while private consumption
expanded 2.7% and investment contracted 1.7% in 2011,
vs. our forecasts of 3.4% and 4.3%, respectively, noted a
year ago. The contraction in overall investment was largely
due to construction investment.
GDP growth supported by domestic demand
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
2007 2008 2009 2010 2011F 2012F 2013F
Net exports Stocks
Investment Govt
PCE GDP
% contribution to growth
Sources: CEIC and Deutsche Bank
Slowing G2 demand points to weaker South Korea
growth in 2012… Looking forward, we see weaker G2
growth, at 1% in 2012 vs. 1.7% in 2011, guiding South
Korea’s export growth lower, to 5.5% in 2012 from 10.6%
in 2011, with the net trade contribution to growth falling
to 1.0% from 2.0% in the same period. In comparison, we
expect private consumption to remain relatively stable,
supported by lower inflation, contributing 1.2% to overall
growth in 2012, vs. 1.3% in 2011. Meanwhile, we expect
recovery in construction to guide overall investment
higher, expanding 2.8% in 2012, after contracting 1.3% in
2011. As a result, we see investment adding 0.7% to
overall growth in 2012, after subtracting 0.4% in 2011,
while private consumption contribution should fall slightly,
to 1.2% in 2012 from 1.3% in 2011.
Export growth to slow…
30
35
40
45
50
55
60
65
-40
-30
-20
-10
0
10
20
30
40
50
2004 2005 2006 2007 2008 2009 2010 2011
SK exports
US ISM (rhs)
%yoy Index
Sources: CEIC and Deutsche Bank
…guiding facility investment lower… Facility
investment growth continued to fall relatively sharply, to
1.4% in Q311, despite a relatively stable export growth of
9.5% in the quarter. In light of the slowdown in 2011, we
expected further weakness in facility investment growth
to be limited to 1.7% in 2012, down from 5.4% in 2011,
especially as the operation ratio remains high at 104.3 in
October. This would add 0.2% to overall growth in 2012,
vs. 0.5% in 2011. On the other hand, we do not expect a
notable pick up in facility investment in 2012 amid weak
export growth and poor business sentiment. The latter
continued to fall in December, to its lowest level since
early 2009, led by concerns about export weakness and
inventory accumulation.
…weighing on facility investment growth
-30
-20
-10
0
10
20
30
40
2002 2004 2006 2008 2010
Facility Investment
Exports
%yoy
Sources: CEIC and Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 173
...while private construction investment recovers… In
contrast, we expect construction investment to expand
2.3% in 2012, after contracting 6.3% in 2011, adding
0.3% to growth in 2012, vs. -1.0% in 2011, as the
government seeks to increase housing in response to
rising rental prices. Construction investment fell 7.6% in
the first three quarters of this year, after contracting 1.4%
in 2010, led by weakness in residential building.
…while housing construction to recover
-30
-20
-10
0
10
20
30
40
2002 2004 2006 2008 2010
Non-residential Building Construction
Residential Building Construction
%yoy
Sources: CEIC and Deutsche Bank
...in response to rising rental prices… While purchasing
prices have moved sideways in Seoul, rental prices
continued to move upward, as households hold off on
home purchases, expecting a notable fall in housing prices
ahead. As households opted for rent, the jeonse (rental)
prices continued to rise, constituting 50.5% of purchasing
prices in October 2011, after bottoming at 38.2% in
January 2009.
…in response to rising rental prices
50
55
60
65
70
75
2001 2003 2005 2007 2009 2011
Jeonse to Purchase Price
%
Sources: CEIC and Deutsche Bank
Housing prices (rental this time) remain a source of
concern for the authorities. They continue to face a
difficult task of limiting rental price inflation by providing
more supply while preventing a sharp correction in the
housing market. We expect a more decisive policy
response on the issue in 2012. Furthermore, government
measures to alleviate households debt burden pose
upside risks to our private consumption growth outlook.
Private consumption growth to slow, modestly…
Payrolls continued to expand in October, by 1.7%yoy
3mma, supporting private consumption despite high
inflation. Private consumption rose 2.7% in the first three
quarters. Looking forward, we see private consumption
growth to weaken further, to 2.4% in 2012 from 2.6% in
2011, as a result of weaker payrolls gain. On the other
hand, we also see falling inflation to support real wage
income growth, which stood at -3.4%yoy in Q311, as
inflation averaged 4.3%. We note that consumer
sentiment improved in November, as a result of
anticipation of falling inflation and interest rates. In
particular, consumer inflation expectation fell to 4.1% in
November from 4.2% in October.
…amid persistent payrolls gain
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
-6
-4
-2
0
2
4
6
8
2005 2006 2007 2008 2009 2010 2011
PCE
Employment (rhs)
%yoy %yoy 3mma
Sources: CEIC and Deutsche Bank
…supported by falling inflation... The trend in CPI
inflation remains downward, at 4.0%yoy 3mma in
October, vs. 4.3% in September. This fall was led by food
price inflation, which fell to 6.4% from 9.1% in the same
period. We note that the Korean Statistical Information
Service (KOSTAT) rebased the consumer price index in
November to better reflect recent economic and social
changes and introduce established international standards
and advanced statistical techniques. The KOSTAT deleted
eight items from the basket, including Korean costume,
camcorder, electronic dictionary and gold ring. As a result,
the new series left headline CPI inflation 0.4ppts lower, at
4.0%yoy ytd in October.
Inflation to fall
0
1
2
3
4
5
2009 2010 2011 2012
CPI Forecast%yoy
Sources: CEIC and Deutsche Bank
6 December 2011 EM Monthly
Page 174 Deutsche Bank Securities Inc.
Looking ahead, we expect inflation to fall to 3.4% in 2012
from 4.0% in 2011, as a result of moderation in food price
inflation and below-trend growth. We note that the IMF
food price inflation has fallen 11.3%yoy 3mma in October,
after reaching its recent peak of 34.3% in April,
suggesting that imported food inflation will be limited.
Meanwhile, our commodity analysts expect little change
in oil prices in 2012 – only 3.5% increase in Brent oil
prices from this year.
Taylor rule model in line with our rate call
1
2
3
4
5
6
00 01 02 03 04 05 06 07 08 09 10 11 12
Actual Forecast Taylor%
Sources: CEIC and Deutsche Bank
…points to no rate change by the Bank of Korea until
2H 2013... Weaker growth and falling inflation point to no
rate change by the Bank of Korea (BoK) in 2012. We do
not expect rate hikes by the BoK until mid-2013. Given our
growth and inflation projection, our Taylor rule model
suggests that the BoK rate is where it should be.
Moreover, risks to rates remain to the downside, as
conditions in the G2 economies – Euroland in particular –
remain precarious, at best. Moreover, given Korean
households’ high gearing ratio (worse than their
counterparts in the US), lower rates would reduce the
household debt servicing burden. The fifth percentile
(lowest) income group’s debt servicing ratio stood at
20.4%, vs. the nation’s average of 11.5% in 2010.
Debt servicing ratio by income group
11.5
20.4
14.7
12
9.4 9.1
0
5
10
15
20
25
Total 1st quintile 2nd 3rd 4th 5th
%
Sources: OECD, Bank of Korea
…while the sovereign debt crisis in Europe check the
won’s gain. Despite large current account surpluses, the
won remained vulnerable to the sovereign debt crisis in
Europe. In response to the sharp increase in risk aversion,
capital outflows rose sharply in September, rendering the
won 10.4% weaker against the US dollar. In particular,
while South Korea’s current account surplus widened to
USD3.1bn in September, up from USD0.3bn in August, its
capital account deficit rose to USD4.7bn in September
from USD1.7bn in August, due to deterioration in ‚other
investments‛. The latter reported a net outflow of
USD17.1bn in September vs. a net inflow of USD4.6bn in
August, as a result of outflows of trade credit, FX loans
and deposits. In contrast, portfolio investment rebounded
in September, registering a net inflow of USD1.8bn vs. a
USD2.9bn outflow in August. FX reserves fell to
USD303.4bn in September, from USD312.2bn in August,
as a result. On a positive note, the Korean authorities
expanded FX swap lines with their Chinese and Japanese
counterparts, resulting in their increase to about
USD125bn combined.
Capital flow weighs on the won…
-20
-15
-10
-5
0
5
10
15
20
2008 2009 2010 2011
Fgn net purchase of debt securities
Fgn net purchase of equity securities
Fgn other investment
USDbn
Sources: CEIC and Deutsche Bank
We note that South Korea’s current account surplus
widened further in October, to USD4.2bn from USD2.8bn,
driven by the goods account. Meanwhile, the financial
account, excluding reserve assets, reported a surplus of
USD4.3bn in October vs. the USD17.2bn deficit reported
in September, as other investments stood at a surplus of
USD2.96bn in October vs. a deficit of 16.8bn in
September. Looking forward, we see the sovereign debt
crisis in Euroland and deleveraging by its banks to
continue to weigh on the won for the early part of 2012,
especially as South Korea’s current account reports a
deficit, temporarily in Q1, due to seasonal effects.
However, as mentioned earlier, with a much larger FX
reserve of USD311bn in October (225% and 79% of
short-term and total FX debt outstanding in Q311), and
USD125bn of FX swaps, we see limited volatility in the
won in 2012.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 175
…despite the positive fundamental
-5
-3
-1
1
3
5
7
-50
-30
-10
10
30
50
70
2007 2008 2009 2010 2011
Trade Balance (rhs)ImportsExports
USD bn%yoy 3mma
Sources: CEIC and Deutsche Bank
Juliana Lee, Hong Kong, (852) 2203 8305
Investment strategy
Local rates: Given the strong technicals, we maintain our
moderate bullish steepening view with a target on 10Y
KTB yields of 3.75% by year end. Concerns over lack of
reinvestment demand from offshore investors have
reduced, which is supportive of 2Y-3Y segments. We also
see December KTB issuance plan of KRW6.5tn as an
indicator of the likely KTB issuance pattern in 2012, with
increased allocations towards the 10Y and 20Y KTBs,
given large maturities in 2014 (KRW56.6tn). Asian central
banks remain key on the demand side, having bought
USD9.9bn (net) till September this year. It is less than
certain if they would buy an equivalent amount in 2012. To
that extent, we think swaps would outperform bonds,
especially in the long-end. The risk on BOK is skewed
towards the possibility of a rate cut if global conditions
worsen. With milder RRR regulation, the spread between
the 91D CD rates and the policy rate could also gradually
tighten towards the year's low of 23bp. This will likely
cause swaps to outperform bond equivalents, which
would be more pronounced in the long end as rolldown
and carry for the front-end swap receivers is expensive.
The risk to this view could be radical household measures
aimed at shifting more household debt into fixed rate
loans. Such measures would reduce the interest from
banks to receive long end swaps.
FX: The won’s high beta to global risk sentiment appears
to be the only reason to be underweight this currency at
this juncture. Even so, we note that the won is now less
sensitive to global USD funding conditions, not least
because Korean FIs have reduced their dependence on s/t
external funding in recent years. A strong current account,
cheap currency valuations, a positive carry and growing
foreign demand for Korean bonds are reasons to retain a
core medium-term bullish view on the currency.
Kiyong Seong, Hong Kong, (852) 2203 5932
South Korea: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National income
Nominal GDP (USDbn) 1015 1115 1165 1280
Population (m) 48.8 48.9 49.0 49.1
GDP per capita (USD) 20799 22797 23769 26060
Real GDP (YoY%) 6.2 3.7 3.4 4.0
Private consumption 4.1 2.6 2.3 3.0
Government consumption 3.0 2.7 3.3 0.8
Gross fixed investment 7.0 -1.3 2.8 3.5
Exports 14.5 10.6 5.5 9.8
Imports 16.9 7.6 4.4 8.7
Prices, money and banking
CPI (YoY%) eop 3.0 4.1 3.1 4.3
CPI (YoY%) ann avg 2.9 4.0 3.4 3.5
Broad money (M3) 9.5 8.0 8.5 9.0
Bank credit (YoY%) 3.4 6.8 7.0 7.0
Fiscal accounts (% of GDP)
Central government surplus 1.4 1.6 0.3 0.3
Government revenue 23.3 23.2 21.9 22.8
Government expenditure 21.9 21.5 21.7 22.5
Primary surplus 2.8 3.1 1.8 1.8
External accounts (USDbn)
Merchandise exports 464.3 554.5 600.6 684.7
Merchandise imports 422.4 522.4 585.8 664.5
Trade balance 41.9 32.1 14.9 20.1
% of GDP 4.1 2.9 1.3 1.6
Current account balance 28.2 25.7 8.3 15.3
% of GDP 2.8 2.3 0.7 1.2
FDI (net) -19.4 -11.0 -10.0 -13.0
FX reserves (USDbn) 297.1 317.6 320.7 344.7
FX rate (eop) KRW/USD 1135 1120 1080 1050
Debt indicators (% of GDP)
Government debt1 35.2 34.7 34.2 33.9
Domestic 34.3 33.9 33.4 33.1
External 0.9 0.8 0.8 0.8
Total external debt 35.8 34.8 23.4 22.5
in USD bn 359.4 395.0 288.0 286.0
Short-term (% of total) 37.6 35.4 45.1 42.0
General
Industrial production (YoY%) 17.3 8.5 6.8 8.8
Unemployment (%) 3.7 3.4 3.4 3.3
Financial markets Current 3M 6M 12M
BoK base rate 3.25 3.25 3.25 3.25
91-day CD 3.60 3.60 3.60 3.70
10-year yield (%) 3.80 4.00 4.10 4.20
KRW/USD 1143 1130 1100 1080 Source: CEIC, Deutsche Bank Global Markets Research, National Sources
Note: (1) FX swap funds unaccounted for. (2) Includes government guarantees..
6 December 2011 EM Monthly
Page 176 Deutsche Bank Securities Inc.
Sri Lanka B+(Pos)/BB- S&P/Fitch
Economic Outlook: Real GDP growth likely to
moderate to 7.5% in 2012 (from 8% in 2011), led by
a negative base and weak external demand.
Main Risks: There is a non-trivial risk that the
ongoing fiscal consolidation process suffers a
setback, in the event of any external shock, that
threatens to lower growth below 7% in 2012.
Growth to moderate to 7.5% in 2012
Through 2011, the Sri Lankan economy has shown
exceptional resilience, despite a highly unsupportive
global environment and severe flooding in early part of the
year, which affected domestic agricultural production
substantially. Notwithstanding these adversities, the
economy will likely record 8% real GDP growth in 2011
(same as in 2010), aided by an acceleration in non-farm
sector growth to 9.0%, up from 8.2% in 2010. But will Sri
Lanka manage to record 8% growth for the third year in a
row in 2012? We think it is unlikely. Our estimates show
that non-farm growth momentum in Sri Lanka is likely
to moderate in 2012 (to about 7.8%), led by a negative
base and weak external demand, which should drag
overall growth to around 7.5% (the government expects
growth to be around 8.5-9.0% in 2012). In contrast,
agricultural sector growth is likely to be supportive,
bouncing back from a low base of this year. Note that our
base case growth forecast of 7.5% assumes an orderly
resolution to the present debt crisis in EU. However, if the
EU crisis were to unfold in a disorderly fashion, downside
risk to growth could rise appreciably, through the trade
and confidence channel. In such a scenario, the central
bank would cut rates aggressively and the government
would likely compromise on its fiscal consolidation goal to
ramp up public spending, in an effort to prevent growth
from heading below the 7% mark.
Resilient growth despite various adversities
0
2
4
6
8
10
12
2007 2009 2010 2011
Real GDP Non-farm GDP% yoy
Source: CEIC, CBSL, Deutsche Bank
Inflation to stay in mid single digits
CPI inflation moderated to 4.7% in November, after
peaking at 8.8% in April of this year. We forecast CPI
inflation to moderate further, led by lower food inflation
and stable fuel prices, to end the year around 4.0%, which
should lead to an annual average inflation rate of 6.7% for
2011 (up slightly from 6.2% in 2010). Core inflation should
also moderate to around 4.5% by year-end. The inflation
trajectory should remain favorable through the first half of
2012 as well, after which CPI inflation should rise to touch
7.5% by end-2012. Overall, we expect inflation to
average 5.5% in 2012, barring any supply shocks.
This benign inflation trajectory should have allowed the
Central Bank of Sri Lanka (CBSL) to cut interest rates to
support growth, especially in an environment, where the
government is expected to continue with its fiscal
consolidation process and given potential growth risks
due to heightened global uncertainty. But broad money
supply (20.7%yoy) and bank credit growth (34.4%yoy)
remains exceptionally high, indicating strong demand side
pressures. Perhaps owing to this, the CBSL Governor
Ajith Cabrral recently described the current monetary
policy stance as ‚appropriate‛, thereby signaling that
the central bank is not yet ready to cut the policy rate or
the reserve ratio immediately.
But we think that there is a possibility for this stance
to change in the first quarter of 2012, as i) inflation
moderates further in the coming months; ii) credit growth
eases; iii) 4Q 2011 GDP growth falls below 8%; and iv)
global conditions worsen. Consequently, we factor in two
25bps rate cuts, each in the first and (early) second
quarter, which should take the reverse-repo rate to 8% by
mid-2012, from the current 8.50% levels.
Colombo CPI and core CPI inflation forecast
0
2
4
6
8
10
12
2009 2010 2011 2012
CPI CPI proj.
Core CPI Core CPI proj.
% yoy
Source: CEIC, CBSL, Deutsche Bank
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 177
Fiscal consolidation will be challenging
We think the 2012 budget deficit target of the Sri Lankan
government (6.2% of GDP) is slightly on the optimistic
side. While the expenditure target seems broadly
reasonable, we think the government is overestimating
likely revenue outturn, based on its expectation of 8.5-
9.0% real GDP growth for 2012, which is unlikely in our
view. Further, while the various expenditure targets look
realistic in line with the past trend, there is a non-trivial risk
that those targets could be breached, in the event growth
starts slowing sharply. In such a scenario, the Sri Lankan
authorities could decide to sacrifice the fiscal targets by
boosting expenditure, to give impetus to growth. Given
these various risks, our base case scenario therefore
builds in a budget deficit forecast of 7.0% of GDP
(unchanged from 2011 levels), with further upside risks
likely, if global conditions worsen. Consistent with our
budget deficit forecast, we expect the debt-GDP ratio to
edge lower to 75.1% in 2012, from a likely 78.5% in 2011.
Deutsche Bank vs. Government forecast for 2012
% of GDP 2010 2011 2012 DB
forecast
2012 budget
forecast
Total revenue and grants 14.9 14.3 14.3 15.0
Total expenditure 22.9 21.4 21.3 21.2
Recurrent 16.7 15.6 14.8 14.7
Capital and net lending 6.1 5.8 6.5 6.5
Budget deficit -8.0 -7.0 -7.0 -6.2
Source: Department of Fiscal Policy, Deutsche Bank
Rupee likely to appreciate in 2H 2012
Post the devaluation of the rupee by 3% on 21 November,
the LKR is currently trading at 113.9 levels versus the
dollar, as against 110.4 previously. The central bank
governor has assured market participants that there
will be no further sharp depreciation of the rupee in
the immediate future, although risks remain, in our
view. We expect the rupee to depreciate further to 114.5
levels by mid-2012 as dollar strength intensifies in the
coming months. However, there could be a bigger
depreciation risk to the rupee if the BOP position worsens
significantly from our baseline forecast (we forecast
current account deficit to be 4.9% of GDP in 2012, and
overall BOP surplus to be 0.8% of GDP ), led by a severe
external shock. Without an external shock, we expect the
rupee to reverse course in the second half of 2012, and
appreciate to 112.5 levels by end-Dec 2012.
Kaushik Das, Mumbai, (91) 226658-4909
Sri Lanka: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 49.6 58.2 64.5 75.4
Population (mn) 20.7 20.9 21.1 21.3
GDP per capita (USD) 2401 2789 3062 3541
Real GDP (YoY %) 8.0 8.0 7.5 8.0
Total consumption 8.6 8.6 8.2 8.3
Total investment 8.0 9.2 8.7 10.0
Private 7.0 9.0 8.0 10.0
Government 12.0 10.0 11.0 10.0
Exports 9.0 12.0 10.0 11.0
Imports 10.0 13.0 11.5 12.0
Prices, Money and Banking
CPI (YoY%) eop 6.8 4.1 7.6 6.3
CPI (YoY%) avg 6.2 6.7 5.6 6.7
Broad money (M2b) eop 15.8 19.0 15.6 15.5
Bank credit (YoY%) eop 24.9 28.2 15.4 13.4
Fiscal Accounts (% of GDP)
Central government balance -8.0 -7.0 -7.0 -6.5
Government revenue 14.9 14.3 14.3 14.5
Government expenditure 22.9 21.4 21.3 21.0
Primary balance -1.7 -1.6 -1.6 -1.3
External Accounts (USD bn)
Merchandise exports 8.3 10.8 11.9 14.3
Merchandise imports 13.5 18.2 19.9 23.9
Trade balance -5.2 -7.4 -8.0 -9.6
% of GDP -10.5 -12.8 -12.4 -12.7
Current account balance -1.4 -3.3 -3.1 -3.9
% of GDP -2.9 -5.6 -4.9 -5.2
FDI (net) 0.4 0.8 0.8 1.0
FX reserves (USD bn) 6.0 6.8 7.3 8.2
FX rate (eop) LKR/USD 111.0 113.9 112.5 111.0
Debt Indicators (% of GDP)
Government debt 81.9 78.5 75.1 71.5
Domestic 45.8 44.3 42.4 40.3
External 36.1 34.2 32.7 31.2
Total external debt 43.3 41.3 40.3 37.2
in USD bn 21.4 24.0 26.0 28.0
Short-term (% of total) 13.5 12.9 12.9 12.9
General
Industrial production (YoY %) 10.4 3.8 7.6 7.4
Unemployment (%) 4.9 4.8 4.7 4.5
Financial Markets Current 3M 6M 12M
Reverse Repo rate 8.50 8.25 8.00 8.00
LKR/USD 113.9 114.2 114.5 112.5 Source: CEIC, DB Global Markets Research, National Sources
6 December 2011 EM Monthly
Page 178 Deutsche Bank Securities Inc.
Taiwan Aa3/AA-/A+ Moody’s/S&P/Fitch
Economic Outlook: With exports at 74% of GDP,
we see weak G2 growth of 1% in 2012, vs. 1.7% in
2011, guiding Taiwan’s growth lower to 3.0% from
4.4% in the same period.
Main Risks: Risks to our rates outlook remain to the
downside amid the sovereign debt crisis in Euroland.
Strategy Recommendations: We believe TWD
interest rate swap curve is unlikely to break its recent
range in the next three months unless CBC surprises
the market with cuts in the policy rates. We
recommend to hold paying the belly in TWD 2x5x10
notional neutral butterfly position.
Macro View
Weak exports to depress growth in 2012… We see
Taiwan’s GDP growth slowing to 3.0% in 2012 from 4.4%
in 2011, as export growth remains weak. After soaring to
25.7% in 2010, we see export growth slowing to 5.0%
this year and 4.2% next year. In 2012, we see Taiwan’s
growth coming under further pressure, as G2 (US/EU)
growth should slow sharply, to 1.0% from 1.7% this year.
As for the growth dynamics, we see Taiwan’s growth
bottoming at 1.7% in Q1 2012, as export growth troughs.
The latter will also push private consumption growth
lower, to 2.6% in 2012 from 3.1% in 2011, further
depressed by negative wealth effects of lower stock
prices. Note that the securities share of households’ total
assets (including fixed assets) stood at 18.6% (in 2009).
We note that consumer sentiment continued to decline in
November 2011 to 80, below the 12mma of 84.9, after
peaking in August at 87.
GDP growth to bottom in Q1
-30
-20
-10
0
10
20
30
40
50
-10
-5
0
5
10
15
2007 2008 2009 2010 2011 2012 2013
GDP (lhs) GDP Forecast
Exports Exports forecast
%yoy%yoy
Source: CEIC and Deutsche Bank
On average, we see private consumption contribution to
growth falling to 1.4% in 2012 from 1.7% in 2011, while
the net trade contribution also declines to 2.6% from
3.6% in the same period. The latter in turn points to
sustained weakness in investments in 2012, providing no
support to growth in 2012, albeit better than the -0.6% in
2011. Meanwhile, we believe inventory destocking will
likely continue to weigh on growth, by 1.1% in 2012 vs.
0.3% in 2011.
Net export contribution to growth to fall
-10
0
10
20
2007 2008 2009 2010 2011F 2012F 2013F
PCE Govt Investment
Stocks Net exports GDP
% contribution to growth
Source: CEIC and Deutsche Bank
The Central Bank of China to stay on the sidelines
until 2H 2013, with risks to the downside. We expect
CPI inflation to ease modestly in 2012 to 0.9% from 1.3%
in 2011, as food price inflation eases and oil price increase
remains limited. We note that the IMF food price inflation
has fallen 11.3%yoy 3mma in October, after reaching its
recent peak of 34.3% in April, suggesting that imported
food inflation will be limited. Meanwhile, our commodity
analysts expect little change in oil prices in 2012 – only
3.5% increase in Brent oil prices from this year. Moreover,
housing price inflation continued to fall in 2011, as has
credit growth, after peaking in April 2011 at 8.7%yoy
3mma. While we expect no rate change by the CBC until
2H 2013, we see risks to our rates outlook to the
downside amid falling inflation and weak growth.
Inflation to fall modestly
-3
-2
-1
0
1
2
3
4
2009 2010 2011 2012
CPI Forecast%yoy
Source: CEIC and Deutsche Bank
Meanwhile, low rates and weak exports point to only a
limited appreciation of the TWD in 2012. Weak exports
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 179
suggest a narrower current account surplus of 7.6% of
GDP, although still high compared to its peers. Moreover,
although risks to growth, rates and the TWD remain to the
downside due to the sovereign debt crisis in Euroland, we
see a relatively stable TWD – compared to the KRW, for
example – as Taiwan remains a net investor to the world.
We also note that its FX reserve of USD393.3bn in
October stood more than three times its total external
debt of USD124.6bn (in Q211).
Juliana Lee, Hong Kong, (852) 2203 8312
Investment strategy
Rates. We believe TWD interest rate swap curve is
unlikely to break its recent range in the next three months.
A potential near-term catalyst is any surprise cuts in the
policy rates, which could be justified if domestic growth
slowdown is a more material threat than the upside risk
on inflation.
Currently the market is pricing in the scenario that CBC
will remain on hold for the next 12 months, which is in line
with our expectation. We are less convinced on the
directional risk on the IRS curve in the near-term and we
prefer to maintain our TWD 2Y/5Y/10Y butterfly spread.
FX. We think gains in TWD will lag regional currencies in
2012 and thus prefer to use it as a funder for intra-region
trades. The main argument is that Taiwan’s exports
growth has slowed considerably, and that central bank’s
FX policy has tended to be motivated by cyclical factors.
The Taiwanese government is the first in the region to
have announced an economic stimulus package, including
measures to help the exports sector. With headwinds to
exports still growing and layoffs (unpaid leave for workers)
on the rise, we think CBC is likely to intervene more
actively to slow gains in the currency to provide support
for the exports sector. One key risk for the TWD in 2012
is the presidential elections. A change in political
leadership could potentially slow economic integration
with the mainland, a key economic development that has
provided significant support to Taiwan’s economic activity
and BoP (exports, tourism inflows, freight and passenger
transportations services, etc.) in recent years.
Linan Liu, Hong Kong, (852) 2203 8709
DennisTan, Singapore, (65) 6423 5347
Taiwan: Deutsche Bank’s forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USDbn) 433.2 475.0 472.5 505.5
Population (m) 23.2 23.2 23.3 23.4
GDP per capita (USD) 18706 20456 20297 21639
Real GDP (YoY%) 10.9 4.4 3.0 4.4
Private consumption 3.7 3.1 2.6 2.9
Government consumption 1.8 -0.4 1.0 1.4
Gross fixed investment 23.4 -3.1 -0.3 3.7
Exports 25.7 5.0 3.9 9.1
Imports 28.2 0.2 0.6 9.6
Prices, money and banking
CPI (YoY%) eop 1.2 1.0 0.6 1.9
CPI (YoY%) annual average 1.0 1.3 0.9 1.1
Broad money (M2) 4.5 6.0 6.0 7.0
Bank credit1 (YoY%) 5.3 5.8 4.0 6.0
Fiscal accounts (% of GDP)
Budget surplus -2.4 -3.2 -3.4 -2.3
Government revenue 16.5 16.6 17.0 17.4
Government expenditure 18.9 19.8 20.4 19.7
Primary surplus -0.6 -1.0 -1.2 -0.1
External accounts (USDbn)
Merchandise exports 273.8 310.6 336.2 394.1
Merchandise imports 247.3 285.2 313.6 373.8
Trade balance 26.5 25.4 22.5 20.3
% of GDP 6.1 5.3 4.8 4.0
Current account balance 39.9 40.7 35.8 34.1
% of GDP 9.2 8.6 7.6 6.7
FDI (net) -9.1 -15.0 -13.0 -13.0
FX reserves (USD bn) 382.0 395.5 412.9 428.6
FX rate (eop) TWD/USD 30.3 30.0 29.0 27.5
Debt indicators (% of GDP)
Government debt2 40.5 43.3 46.2 47.5
Domestic 38.7 41.4 44.3 45.6
External 1.9 1.8 1.9 1.8
Total external debt 23.4 28.5 30.7 30.7
in USDbn 101.6 130.0 145.0 155.0
Short-term (% of total) 82.4 80.8 82.8 83.9
General
Industrial production (YoY%) 29.1 6.0 4.5 7.0
Unemployment (%) 5.0 4.4 4.4 4.4
Financial markets Current 3M 6M 12M
Discount rate 1.88 1.88 1.88 1.88
90-day CP 0.80 0.80 0.80 0.80
10-year yield (%) 1.32 1.25 1.30 1.30
TWD/USD 30.1 30.0 29.7 29.0
Source: CEIC, Deutsche Bank Global Markets Research, National Sources
Note: (1) Credit to private sector. (2) Including guarantees on SOE debt
6 December 2011 EM Monthly
Page 180 Deutsche Bank Securities Inc.
Thailand Baa1/BBB+/BBB Moody’s/S&P/Fitch
Economic Outlook: We see GDP growth rebounding
to 3.9% in 2012 from 1.8% in 2011, supported by
reconstruction activities. The latter and weak exports,
however, point to a current account deficit of 1.9% of
GDP in 2012.
Main Risks: Risks to growth remain to the downside
due to fragile external conditions and implementation
risks to reconstruction plans.
Strategy Recommendations: Bond and swap curves
to steepen driven by valuations, supply concerns and
a more dovish outlook on monetary policy.
Macro View
Growth to rebound sharply ahead, as the country
rebuilds… Natural disasters continued to pressure
Thailand’s production this year. Although far from home,
Japan’s earthquake earlier this year rendered Thailand’s
manufacturing production weaker than it otherwise would
have been in 1H, due to supply chain disruptions. This
quarter the manufacturing sector saw its worst downturn
on record, due to the floods. According to the latest data,
manufacturing production fell 35.4%mom (35.8%yoy) in
October, after contracting 4.1% in September. For the
quarter, we see the economy contracting 4.5%qoq (down
2.2%yoy) in Q4. In contrast, we see a strong start to
2012, with the qoq growth rebounding to +3.6% in Q1, as
reconstruction efforts gain their full momentum. As the
economy moves further into the year, however, we see
growth momentum slowing to around 1% in Q4. As a
result, we see qoq growth of 2.4% in 2012, vs. the 0.5%
contraction we forecast for 2011, while the yoy growth
surging to 9.9% in Q412, supported by favourable base
effects.
Domestic demand drives growth in 2012
-10
-5
0
5
10
2007 2008 2009 2010 2011F 2012F 2013F
PCE Govt
Investment Stocks
Net exports GDP
% contribution to growth
Sources: CEIC and Deutsche Bank
…but limited by weak exports… As Thailand rebuilds
itself, also supported by credit support, wage hikes and
rice price guarantees, we see domestic demand
expanding at a faster pace, with its contribution to growth
increasing to 3.8% in 2012, from 2.2% in 2011. In
contrast, we see a relatively weak export growth of 5.4%
in 2012 vs. 8.3% in 2011, as G2 growth falls to 1.0% in
2012 from 1.7% in 2011. With import growth relatively
stable, supported by stronger domestic demand for
capital goods, we see net trade becoming a drag on
growth, by 0.2% in 2012, after contributing 1.2% in 2011.
Meanwhile, we expect a modest positive contribution to
growth from inventory restocking.
…while the Bank of Thailand stays on the sidelines
until Q3, as inflation eases. The Bank of Thailand (BoT)
delivered a 25bps rate cut as the flood’s effect was
deemed ‚more widespread and severe.‛ The BoT
expects the economy to expand 1.8% in 2011, vs. its
earlier forecast of 2.6%. While the extent of the rate cut
was less than our forecast of 50bps, the BoT’s tone was
dovish, noting that ‚the MPC would remain vigilant in
monitoring developments in the global economy, as well
as progress on domestic restoration efforts and stand
ready to take appropriate actions.’ The BoT sees GDP
growth of 4.8% in 2012, sharply higher than our forecast
of 3.8%. We see weaker G2 growth; 1.0% in 2012 vs.
1.7% in 2011, to weigh on Thailand’s export growth.
Hence, with growth disappointing, we see the BoT
delivering another 25bp rate cut in Q112, as inflation
continues to ease.
Inflation moderates and stay within the target range
-6
-4
-2
0
2
4
6
2009 2010 2011 2012
CPI forecast%yoy
Sources: CEIC and Deutsche Bank
We see inflation continuing to trend downward in 1H
2012, bottoming in June at 3.5%yoy 3mma, then move
more or less sideways, ending the year at 3.6%. On
average, we see headline inflation falling to 3.7% in 2012
from 4.1% in 2011. We see food price inflation easing
further in 2012, as the flood effect drops out of the data
and as the Brent price increase is limited to 3.5% in 2012
(the latter calculation derived from our commodity
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 181
research forecast). Given the inflation dynamics and weak
growth, we see the BoT remaining on the sidelines until
2013, after one more rate cut in Q112. We note that the
BoT will be targeting headline inflation of 1.5-4.5% in
2012, vs. core inflation of 0.5-3.0% in 2011. With the BoT
on hold, we see no notable support for the baht until 2H
2012, as stronger domestic demand vs. exports result in a
current account deficit of 1.9% of GDP in 2012.
Juliana Lee, Hong Kong, (852) 2203 8305
Investment Strategy
Rates: For FY12 (Oct-2011 to Sep 2012), the MoF plans to
issue THB540bn of bonds(including T-bills and linkers)
which is close to 20% higher than the issuance last year.
On a net basis, the issuance will be up nearly 40% YoY.
On a slightly positive note, the entire increase in gross
issuance comes from the introduction of the new 3Y
benchmark and T-bills. Therefore we note duration of
supply is not as concerning as the headline numbers
suggests.
However, there are still a few reasons why bond investors
should be cautious going into 2012: 1) The above
issuance plan was announced before the budget deficit
got revised upwards from THB350bn THB400bn due to
floods. In fact the deficit number could still be revised
higher as the damage due to floods has been much more
severe than initially anticipated. 2) Roughly 50% of the net
issuance in FY11 was bought by foreigners. Given the
possible impact on currency due to sharply slowing
exports and systemic risks emanating from Europe,
inflows into EM debt funds could be more muted next
year compared to FY2011.
We would like to point out that onshore liquidity remains
abundant and AUM of insurers and pension funds
continues to grow at double digit rates. In fact, Thailand is
one of the few countries in Asia, where domestics have
continued to buy aggressively despite rich levels of the
curve. The question then becomes, how much could be
the increase in supply. This would depend on how
aggressively the administration plans to implement the
reconstruction projects and how it plans to finance it.
FX: Thailand is likely to see temporary weakness in the
BoP due to recent nation-wide floods which have severely
disrupted exports and tourism activities. Imports are likely
to rise in the near-term to meet shortages in domestic
supplies, while FDI plans are likely to be put on hold. As
such, the buffer from current account flows against capital
outflows has weakened. However, we expect BoT to
maintain stability or limit gains in the THB to provide some
support to the exports sector during the recovery phase. Arjun Shetty, Singapore, (65) 6423 5925
Dennis Tan, Singapore, (65) 6423 5347
Thailand: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USDbn) 318.8 350.4 378.7 626.2
Population (m) 63.9 64.2 64.5 64.8
GDP per capita (USD) 4989 5458 5871 9664
Real GDP (YoY%) 7.8 1.8 3.9 4.8
Private consumption 4.8 2.3 2.6 3.0
Government consumption 6.4 1.8 7.3 5.3
Gross fixed investment 9.4 4.0 8.5 5.7
Exports 14.7 8.3 5.5 11.0
Imports 21.5 8.6 7.5 11.8
Prices, Money and Banking
CPI (YoY%) eop 3.0 4.1 3.3 4.1
CPI (YoY%) ann avg 3.3 3.9 3.7 3.7
Core CPI (YoY%) 0.9 2.4 2.7 2.7
Broad money 8.0 8.0 8.0 9.0
Bank credit1 (YoY%) 8.4 8.0 8.5 9.0
Fiscal Accounts2 (% of GDP)
Central government surplus -1.1 -3.7 -4.9 -3.2
Government revenue 16.8 16.3 15.6 16.5
Government expenditure 17.9 19.9 20.5 19.7
Primary surplus -0.8 -2.6 -3.9 -2.2
External Accounts (USDbn)
Merchandise exports 193.7 220.0 247.6 289.7
Merchandise imports 161.4 204.2 238.9 268.6
Trade balance 32.2 15.7 8.7 21.1
% of GDP 10.1 4.5 2.3 3.4
Current account balance 14.8 0.1 -7.3 5.5
% of GDP 4.6 0.0 -1.9 0.9
FDI (net) 1.0 -4.5 3.1 2.2
FX reserves (USDbn) 172.1 173.0 174.7 188.9
FX rate (eop) THB/USD 30.6 31.0 30.5 29.5
Debt Indicators (% of GDP)
Government debt2,3 35.2 35.9 39.5 38.8
Domestic 33.0 34.9 38.2 37.7
External 2.2 1.1 1.3 1.1
Total external debt 31.5 32.5 33.1 32.4
in USDbn 100.6 115.0 125.0 135.0
Short-term (% of total) 50.4 53.0 55.2 56.3
General
Industrial production (YoY%) 15.4 -7.0 10.0 7.0
Unemployment (%) 1.1 1.1 1.0 1.0
Financial Markets Current 3M 6M 12M
BoT o/n repo rate 3.25 3.00 3.00 3.00
3-month Bibor 3.30 3.05 3.10 3.10
10-year yield (%) 3.40 3.50 3.80 3.80
THB/USD (onshore) 31.0 31.0 30.9 30.5 Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Depository institutions credit to the
6 December 2011 EM Monthly
Page 182 Deutsche Bank Securities Inc.
Vietnam B1(Neg)/BB-(Neg)/B+ Moody’s/S&P/Fitch
Economic outlook: We expect a modest slowdown
in GDP growth, to 5.6% in 2012 from 5.9% in 2011,
as lower inflation and rates counter the negative
impact of weaker external demand.
Main risks: The banking system remains under
pressure, posing downside risks to growth and the
dong.
Macro View
Weaker exports to leave overall growth weaker, at
5.6% in 2012 from 5.9% in 2011… Year-to-date, the
economy expanded 5.8%yoy in Q3 2011, down from
6.5% in the same period last year. We expect growth to
remain under pressure in Q4, compared to 2010, leaving
the growth at 5.9% in 2011 compared to 6.8% in 2010.
This weaker growth is the consequence of
macroeconomic imbalances which resulted in high
inflation and weakness in the dong. To address these
issues, the authorities have adopted various tightening
measures, including raising rates and credit tightening.
We discussed their efforts in detail in our report ‚Vietnam:
Seeking sustainable growth‛ published on 4 November.
Weaker growth…
0
1
2
3
4
5
6
7
8
9
-15
-10
-5
0
5
10
15
20
2007 2008 2009 2010 2011F 2012F 2013F
Net trade Changes in Stock
Investment Private Cons
Govt Cons GDP (rhs)
%% contribution to growth
Sources: CEIC and Deutsche Bank
As for 2012, we expect weak external demand – we see
G2 growth falling to 1.0% in 2012 from 1.7% in 2011 -- to
guide Vietnam’s growth lower, to 5.6% from 5.9% this
year. That is, we expect net trade to become a heavier
drag on growth, at 2.1% in 2012 vs. 1.7% in 2011. In
contrast, we see domestic demand growth remaining
relatively stable, with its contribution to growth
moderating slightly, to 6.8% in 2012 from 7.1% in 2011.
…while inflation falls… We expect headline inflation to
fall to 12.7% in 2012 from 18.7% in 2011, led by food.
The latter rose 23.3%yoy ytd in November 2011, leading
the headline inflation to 18.7% this year, from 9.2% in
2010. Note that food constitutes 32.5% of the CPI basket
in Vietnam. In 2012, we expect a reversal of this trend,
with lower food price inflation guiding overall inflation
lower, further pressed by below-trend growth.
Note that the IMF world food price index rose at a sharply
lower pace of 11.3%yoy 3mma in October compared to
its recent peak of 34.3% in April. Meanwhile, our
commodity analysts expect little change in oil prices in
2012 – only 3.5% increase in Brent oil prices from 2011.
We expect inflation to continue to trend downward,
bottoming below 11% in Q4 2012, providing the SBV
sufficient room to maneuver.
…and lower inflation to prompt rate cuts
0
5
10
15
20
25
30
2006 2007 2008 2009 2010 2011 2012
Refinancing rate
Headline inflation
%
Forecast
Sources: CEIC and Deutsche Bank
…prompting the State Bank of Vietnam (SBV) to
deliver rate cuts in 2012… In response to lower inflation
and weak growth, we expect the SBV to deliver 300bps
rate cuts in 2012, leaving the refinancing rate at 12% by
end-2012. We expect the SBV to stop short of guiding the
policy rate below inflation, to keep the economy on the
path of sustainability and balanced growth. Note that the
National Assembly passed a resolution on socioeconomic
plans which target GDP growth of 6.5–7.0% in 2011–
2015, compared to its earlier target of 7.5–8.0%, while
targeting a headline inflation of 5.0–7.0% in the same
period.
Meanwhile, we reiterate the importance of reforming the
banking sector, as it would play a key role in stabilizing the
economy and its currency. Although those efforts may
bring on bouts of volatility and thereby pose downside
risks to growth, we believe that the negative impact is
likely to be short term in nature. We again highlight the
importance of preparing for a more dramatic consolidation
of the banking sector, thereby reducing systemic risks and
pursuing restructuring of the state-owned enterprises.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 183
Needless to say, the stability of the banking system is
critical in the dong’s stability.
External imbalances to continue
-3
-2
-1
0
1
2
3
4
-60
-40
-20
0
20
40
60
80
2004 2005 2006 2007 2008 2009 2010 2011
Trade Balance (rhs)
Exports
Imports
%yoy 3mma USD bn
Sources: CEIC and Deutsche Bank
…while the dong continues to weaken, albeit
relatively modestly… We expect a relatively weaker
external demand to result in a larger current account
deficit in 2012, albeit at a below five-year average of
6.57%, at 5.0% of GDP. However, we expect falling
inflation to ease the pressure on the dong, limiting its
depreciation against the US dollar to about 5.0% in 2012.
As noted earlier, the dong’s fragile stability rests much on
the Vietnamese public, not foreigners, as Vietnam remains
a highly dollarized economy. We also expect the
Vietnamese authorities to continue to monitor FX market
activities closely to curb grey market activities. Risks to
our FX outlook remain to the downside, due to the
sovereign debt crisis in Euroland and sustained pressure
on the domestic banking system.
Dong remains under pressure, but limited
15,000
16,000
17,000
18,000
19,000
20,000
21,000
22,000
2008 2009 2010 2011
Reference rate
Spot rate
VND/ USD
Sources: CEIC and Deutsche Bank
Juliana Lee, Hong Kong, (852) 2203 8305
Vietnam: Deutsche Bank Forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 103.4 117.2 132.4 150.1
Population (m) 86.9 87.9 88.8 89.8
GDP per capita (USD) 1190 1334 1491 1672
Real GDP (YoY%) 6.8 5.9 5.6 6.5
Private consumption 10.0 5.5 4.8 6.0
Government consumption 12.3 5.5 7.0 6.0
Gross fixed investment 10.9 6.0 6.8 7.5
Exports 16.0 10.0 5.5 9.0
Imports 15.4 9.4 6.2 8.5
Prices, Money and Banking
CPI (YoY%) eop 11.7 18.6 10.8 13.5
CPI (YoY%) ann avg 9.2 18.7 12.7 13.0
Broad money (M3) 25.0 19.0 22.0 25.0
Bank credit (YoY%) 27.0 15.0 17.0 18.0
Fiscal Accounts1 (% of GDP)
Federal government surplus -6.5 -5.3 -6.0 -5.0
Government revenue 28.1 28.0 27.5 28.0
Government expenditure 34.6 33.3 33.5 33.0
Primary fed. govt surplus -5.2 -3.8 -4.5 -2.5
External Accounts (USD bn)
Merchandise exports 72.2 90.0 106.0 132.0
Merchandise imports 77.4 95.5 114.0 139.0
Trade balance -5.2 -5.5 -8.0 -7.0
% of GDP -5.0 -4.7 -6.0 -4.7
Current account balance -4.3 -4.5 -6.8 -6.0
% of GDP -4.2 -3.8 -5.1 -4.0
FDI (net) 7.0 7.0 6.0 7.0
FX reserves (USD bn) 12.5 14.5 14.5 15.5
FX rate (eop) VND/USD 19500 21100 22200 23000
Debt Indicators (% of GDP)
Government debt 52.1 53.0 54.0 54.5
Domestic 21.0 21.0 22.0 22.5
External 31.1 32.0 32.0 32.0
Total external debt 42.2 42.7 41.5 40.7
in USD bn 43.6 50.0 55.0 61.0
Short-term (% of total) 2.1 11.6 12.7 14.8
General
Industrial production (YoY%) 10.9 6.8 6.0 7.5
Unemployment (%) 4.3 4.5 4.5 4.5
Financial Markets Current 3M 6M 12M
Refinancing rate 15.00 14.00 13.00 12.00
VND/USD 21011 21100 21500 22200
Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Fiscal balance includes off budget expenditure, while revenue and expenditure include only on
budget items.
6 December 2011 EM Monthly
Page 184 Deutsche Bank Securities Inc.
6 D
ece
mb
er 2
01
1
E
M M
onth
ly
Theme Pieces
November 2011
Foreign Reserve Adwquacy in EMEA
Africa’s Frontier Markets: Growing Up
Clustering Patterns in EMFX
Argentina – FX&Rates Outlook Amid Tighter Capital
Controls
Venezuela – Analyzing Negative Basis Trades
October 2011
Inflation Pass-through, Monetary & FX Policies in EM
Trading Tails in EM: Leaders & Laggards
Asian Growth is Slowing, That’s All
Em Corporates: Preserving Value
Equities—Latam factors: What’s Working, What’s Next
September 2011
EM and the Global Slowdown
EMEA: Still Vulnerable to an External Financing Squeeze
Introducing the EM Rates Volatility Report
A Primer on Asia Interest Rate Options
GCC Macro Updates: Still Resilient
Financial Condition Indicators in Latin America
Argentina: The Limits of Policy Continuity
Latam Equities: Stress Testing
July 2011
EM Trend Decoupling but Cyclical Coupling
CEE: Examining Contagion from Peripheral Europe
EMFX: Revisiting the Vol Dispersion Trade
EM Exchange Rate Fundamentals
Venezuela: Sailing on Uncharted Waters
June 2011
Sovereign Credit- Trading the Soft Patch
EMFX: Favoring EUR Funding
Dislocations in EM Swaption Vols
Revisiting the Credit Impulse in EMEA
EMEA: Updating Our Breakeven Oil Price Estimates
Is Indonesia the Next Brazil?
Brazil Equities – Navigating Through Choppy Waters
May 2011
Perceived Inflation Asymmetries and Rate Anomalies
Reacting to Core Vs Headline Inflation in EMEA
Assessing CDS Curve Dynamics in EM
EM Rates: How Much Carry is Left?
The Pressure Cooker in Asia – Bubbling Away
LatAm Factors – What’s Working, What’s Next?
April 2011
LatAm Rates: Is There Any Value Left?
Monetary Policy in EMEA: Who’s (Running) Hot and
Who’s Not
Peru: Countdown to Presidential Elections
In Vogue: Reserve Requirements in Turkey and Russia
In a Sideways Market: Buy LatAm Dividend Elite
March 2011
High Oil Prices: Winners and Losers Updated
Hedging the Non-Linear Effects of Oil Prices
Sovereign Credit: CDS as Substitute for Bonds
Macro Repercussions of MENA Crisis
Oil Spike: Ways to Play the Spike in LatAm Equities
February 2011
EM Rates: Repricing the Cycle and Commodities Risk
Is Inflation in EMEA Back?
Introducing Sovereign Credit Relative Value Monitor
A Closer Look at Ruble Fixed Income
Colombia: Introducing COP/IBR Interest Rate Swaps
Impact of Technical Rotation: Too Much Ado
Latam Equities: Tactics to Combat EM Outflows into
US
January 2011
EM Inflation Acceleration: The Commodity Fuel Once
Again
Argentina CER Bonds: Seitch from Duration to Carry
GCC 2011 Outlook
2011 Outlook: Key Themes for Latam Equities
The Year of the Rub
December 2010
Outlook for EM Rates
Outlook for EM FX
Outlook for EM Sovereign Credit
Perspectives on the Capital Flows to EM
EM Sovereign Risks in 2011 ( and Beyond)
EMEA Domestic debt – 2011 Supply and Demand
Global EM Equities – Evolving Structural Drivers
2011 Latin America Equity Market Target
November 2010
A Detailed Examination of Local Currency Debt
Returns
Surveying Onshore/Offshore Relative Pricing in EM
EM Sensitivity to Greater Renminbi Flexibility
Responding to Capital Flows in EMEA
Asia Rates: Supply to Force Greater Differentiation in
2011
October 2010
Ever Emerging Markets
Lessons From a decade of Outperformance
Revisiting EMEA External Positions
Argentina: Not Yet Time to Take Profit
Asian Equity Volatility – The World’s Cheapest Buy?
CEE: Food Inflation Ahead
Regulatory Dis
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 185
Contacts
Name Title Telephone Email Location
EMERGING MARKETS
Balston, Marc Head of EM Quantitative Research 44 20 754 71484 [email protected] London
Brown, Latashia EM Strategy 1 212 250 5774 [email protected] New York
Cañonero, Gustavo Head of Economic Research LA&EMEA 1 212 250 7530 [email protected] Buenos Aires
Cassard, Marcel Global Head - Macro & Fixed Income Research 44 20 754 55507 [email protected] London
Evans, Jed Head of EM Analytics 1 212 250 8605 [email protected] New York
FIlho, Jose LatAm Strategy 1 212 250 5932 [email protected] New York
Giacomelli, Drausio Head of EM Strategy 1 212 250 7355 [email protected] New York
Jiang, Hongtao EM Strategy 1 212 250 2524 [email protected] New York
Parisien, Denis Global Head of EM Corporates 1 212 250 7568 [email protected] New York
Zhang, Jack EM Strategy 1 212 250 0664 [email protected] New York
LATIN AMERICA
Faria, Jose Carlos Senior Economist, LA 5511 2113 5185 [email protected] Sao Paulo
Losada, Fernando Senior Economist, LA 1 212 250 3162 [email protected] New York
Marone, Guilherme EM Strategy 1 212 250 8640 [email protected] New York
Roca, Mauro EM Strategy & Senior Economist 1 212 250 8609 [email protected] New York
Menusso, Marcelo Head of LatAm Corporates 1 212 250 6135 [email protected] New York
EMERGING EUROPE, MIDDLE EAST, AFRICA
Akyurek, Cem Senior Economist, EMEA 90 212 317 0138 [email protected] Istanbul
Bougueroua, Lamine EM Strategy, EMEA 44 20 7545 2402 [email protected] London
Boulos, Tala EMEA Corporates 44 20 754 53664 [email protected] London
Burgess, Robert Chief Economist, EMEA 44 20 754 71930 [email protected] London
Grady, Caroline Economist, EMEA 44 20 754 59913 [email protected] London
Gulberg, Henrik Economist,EMEA 44 20 754 59847 [email protected] London
Lissovolik, Yaroslav Senior Economist, EMEA 7 495 967 1319 [email protected] Moscow
Kapoor, Siddharth EMEA Strategy 44 20 754 74241 [email protected] London
Masia, Danelee Senior Econom st, EMEA 27 11 775 7267 [email protected] Johannesburg
Ozturk, Kubilay Economist, EMEA 44 20 7547 8806 [email protected] London
Shilin, Viacheslav Head of EMEA Corporates 44 20754 79035 [email protected] London
ASIA
Baig, Mirza FX Strategy 65 6423 5930 [email protected] Singapore
Baig, Taimur Chief Economist, India 65 642 38681 [email protected] Singapore
Goel, Sameer Head of Asia Rates & FX Research 65 6423 6973 [email protected] Singapore
Das, Kaushik Economist 91 22 6658 4909 [email protected] Mumbai
Lee, Juliana Senior Economist 852 2203 8312 [email protected] Hong Kong
Leung, Mickey EM Economics 852 2203 8307 [email protected] Hong Kong
Liu, Linan Rates Strategy 852 2203 8709 [email protected] Hong Kong
Ma, Jun Chief Economist, China 852 2203 8308 [email protected] Hong Kong
Seong, Ki Young Rates Strategy 852 2203 5932 [email protected] Hong Kong
Shetty, Arjun Rates Strategy 65 6423 5925 [email protected] Singapore
Spencer, Michael Chief Economist, Asia Pacific 852 2203 8305 [email protected] Hong Kong
Tan, Dennis FX Strategy 65 643 5347 [email protected] Singapore
6 December 2011 EM Monthly
Page 186 Deutsche Bank Securities Inc.
Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see
the most recently published company report or visit our global disclosure look-up page on our website at
http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the
undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in
this report. Drausio Giacomelli
Deutsche Bank debt rating key
CreditBuy (‚C-B‛): The total return of the Reference
Credit Instrument (bond or CDS) is expected to
outperform the credit spread of bonds / CDS of other
issuers operating in similar sectors or rating categories
over the next six months.
CreditHold (‚C-H‛): The credit spread of the
Reference Credit Instrument (bond or CDS) is expected
to perform in line with the credit spread of bonds / CDS
of other issuers operating in similar sectors or rating
categories over the next six months.
CreditSell (‚C-S‛): The credit spread of the Reference
Credit Instrument (bond or CDS) is expected to
underperform the credit spread of bonds / CDS of other
issuers operating in similar sectors or rating categories
over the next six months.
CreditNoRec (‚C-NR‛): We have not assigned a
recommendation to this issuer. Any references to
valuation are based on an issuer’s credit rating.
Reference Credit Instrument (‚RCI‛): The Reference
Credit Instrument for each issuer is selected by the
analyst as the most appropriate valuation benchmark
(whether bonds or Credit Default Swaps) and is detailed
in this report. Recommendations on other credit
instruments of an issuer may differ from the
recommendation on the Reference Credit Instrument
based on an assessment of value relative to the
Reference Credit Instrument which might take into
account other factors such as differing covenant
language, coupon steps, liquidity and maturity. The
Reference Credit Instrument is subject to change, at the
discretion of the analyst.
6 December 2011 EM Monthly
Deutsche Bank Securities Inc. Page 187
Regulatory Disclosures
1. Important Additional Conflict Disclosures
Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the
"Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.
2. Short-Term Trade Ideas
Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent
or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at
http://gm.db.com.
3. Country-Specific Disclosures
Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of
the Australian Corporations Act and New Zealand Financial Advisors Act respectively.
Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and
its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly
affected by revenues deriving from the business and financial transactions of Deutsche Bank.
EU countries: Disclosures relating to our obligations under MiFiD can be found at
http://www.globalmarkets.db.com/riskdisclosures.
Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration
number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117.
Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan,
Japan Securities Investment Advisers Association. This report is not meant to solicit the purchase of specific financial
instruments or related services. We may charge commissions and fees for certain categories of investment advice, products
and services. Recommended investment strategies, products and services carry the risk of losses to principal and other
losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the
purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and
other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating
agencies in Japan unless ‚Japan‛ is specifically designated in the name of the entity.
Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from
time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may
engage in transactions in a manner inconsistent with the views discussed herein.
Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any
appraisal or evaluation activity requiring a license in the Russian Federation.
Risks to Fixed Income Positions
Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay
fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in
interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the
maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in
inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to
receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets
holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency
conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are
also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be
mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are
common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the
actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly
important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate
reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs
6 December 2011 EM Monthly
Page 188 Deutsche Bank Securities Inc.
from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps
(swaptions) also bear the risks typical to options in addition to the risks related to rates movements.
Hypothetical Disclaimer
Backtested, hypothetical or simulated performance results have inherent limitations. Unlike an actual performance record
based on trading actual client portfolios, simulated results are achieved by means of the retroactive application of a backtested
model itself designed with the benefit of hindsight. Taking into account historical events the backtesting of performance also
differs from actual account performance because an actual investment strategy may be adjusted any time, for any reason,
including a response to material, economic or market factors. The backtested performance includes hypothetical results that
do not reflect the reinvestment of dividends and other earnings or the deduction of advisory fees, brokerage or other
commissions, and any other expenses that a client would have paid or actually paid. No representation is made that any
trading strategy or account will or is likely to achieve profits or losses similar to those shown. Alternative modeling techniques
or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest
results are neither an indicator nor guarantee of future returns. Actual results will vary, perhaps materially, from the analysis.
David Folkerts-Landau Managing Director
Global Head of Research
Guy Ashton
Head
Global Research Product
Marcel Cassard
Global Head
Fixed Income Research
Stuart Parkinson
Associate Director
Company Research
Asia-Pacific Germany Americas Europe
Fergus Lynch
Regional Head
Andreas Neubauer
Regional Head
Steve Pollard
Regional Head
Richard Smith
Regional Head
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Global Disclaimer
Emerging markets investments (or shorter-term transactions) involve significant risk and volatility and may not be suitable for everyone. Readers must
make their own investing and trading decisions using their own independent advisors as they believe necessary and based upon their specific
objectives and financial situation. When doing so, readers should be sure to make their own assessment of risks inherent to emerging markets
investments, including possible political and economic instability; other political risks including changes to laws and tariffs, and nationalization of assets;
and currency exchange risk. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with
the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent
with that taken in this research report.
Foreign exchange transactions carry risk and may not be appropriate for all clients. Participants in foreign exchange transactions may incur risks arising
from several factors, including the following: 1) foreign exchange rates can be volatile and are subject to large fluctuations, 2) the value of currencies
may be affected by numerous market factors, including world and national economic, political and regulatory events, events in equity and bond markets
and changes in interest rates and 3) currencies may be subject to devaluation or government imposed exchange controls which could negatively affect
the value of the currency. Clients are encouraged to make their own informed investment and/or trading decisions. Past performance is not necessarily
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