WHAT’S REALLY HAPPENING IN EMERGING MARKETS?

For Professional Investors I April 2015 I

THE EMERGING MARKETS CREDIBILITY FACTOR • The Federal Reserve (FED) is not in a rush to raise benchmark interest

rates, but will ultimately take the plunge.

• We ask which emerging markets are the least vulnerable to tighten US monetary conditions and why.

• Low debt levels small fiscal deficits, little borrowing in US dollars and ample international currency reserves cushion countries from external funding shocks.

• We also found that countries that have embarked on a clear reform process benefit from a “premium” that often overlay some of their current weaknesses.

• We will focus on Brazil, Turkey and India to illustrate this: India clearly leads, Turkey lags while Brazil slowly awakens

Patrick MangeHead of Strategy Emerging Markets BNP Paribas Investment Partners

(Chief Editor)

Welcome to our first quarterly edition of What's Really Happening in Emerging Markets? Using our unrivalled local network of teams across the globe, we aim to provide you with insights on important themes and debates in the emerging world.

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 2

As was broadly expected, on 18 March 2015 the US Federal Reserve removed the word “patient” from its monetary policy statement, opening the door for the start of a rate hike cycle. But by lowering its estimate for the non-accelerating inflation rate of unemployment (NAIRU) and growth expectations, the Fed also signalled that it is in no hurry to tighten the monetary reins; and when it does, it will most likely do so very cautiously, i.e. in incremental steps over time. This surprisingly “dovish” Fed posture capped strength of the US dollar and led to a retreat in US Treasury yields, both of which lent support to emerging markets equities, bonds and currencies.

However, the Fed also made clear that it will eventually raise benchmark rates. While we do not expect mid to long dated US bond yields to increase meaningfully, nor the dollar to strengthen much further, markets in general and emerging markets in particular (chiefly the most vulnerable), are expected to come under pressure.

Not all emerging markets are equalThe real question is: which emerging equity markets are the most vulnerable to external shocks in the form of stronger US dollar and US rate hikes, and could thus present good buying opportunities once they correct on the back of the Fed’s actions? We expect, it would be those countries that:

• Have high debt levels • Run significant fiscal deficits limiting their ability to raise

additional taxes.• Are net borrowers with much of their debt funded in US dollars• Have not accumulated large enough international currency

reserves to cover their external liabilities.

Among these, net commodities exporters are particularly ‘fragile’. After benefiting strongly in recent years from rising commodity prices, they are now suffering the consequences of sharply falling prices which have decreased their national revenues due to lower growth and thus lower tax revenues.

With some exceptions, Asia appears generally to be the region most immune to worsening external funding conditions.

Fragile – but not all to the same extentEvidently, some emerging countries are less ‘fragile’ than others, and better able to resist a strong US dollar, changing their “business model” by improving the efficiency of their economies and public institutions.

Structural reforms and better economic policy governance boost long term confidence in institutions and markets, since it results in more predictable, more sustainable and higher quality growth. This strongly “time-relativises” some reforming countries’ “weaknesses”. We talk of this as the “credibility factor”, which in our view has been steadily growing in importance in recent months in light of continuing macroeconomic uncertainty at a time when global growth – in the past a key driver for emerging equities as an asset class – remains tepid.

Credibility mattersHere we look at three examples – Brazil, India and Turkey – all of which belong to the so-called ‘five fragiles’ (Indonesia and South Africa are the other two).

Brazil: Reform initiationChart 1: External debt vulnerability (Z-scores)

-3.00 -2.00 -1.00 0,00 1.00 2.00

GreecePhilippines

PeruArgentinaIndonesia

ChileVenezuela

HungaryMalaysiaColombia

RussiaTurkeyBrazil

PolandMexico

EgyptThailand

Czech Rep.South-Africa

IndiaChina

South-KoreaTaiwan

Source: Thomson Reuters Datastream, BNPP IP, as of 03/31/2015Equal weighted score of Public external debt to GDP, Public external debt to general government debt, interest payments on external debt and international reserve coverage of external debt

Chart 2: Brazil External Public Debt and Currency Reserves

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Ratio of international FX reserves to external debt

Source: BNPP IP, as of 03/31/2015

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 3

Brazil is relatively solidly positioned according to our external sovereign debt risk indicator (chart 1), especially as it has built substantial international reserves equivalent to almost three times its external sovereign debt (chart 2). Brazil is a net borrower (i.e. it runs high external deficits), a net commodity exporter and has little room to manoeuvre in both fiscal and monetary terms: it still has a substantial fiscal deficit and inflation is increasing. Brazil is also mired in a recession that started even before commodity prices began to slide. Yet under pressure from the sovereign debt rating agencies – the country has started to put its finances in order. There remains far more to be done, but after many years of political inaction during the commodity boom, it represents an important step in the right direction. If sustained, it should help improve its credibility in terms of the ability to deliver reforms. The current context is more favourable to Brazilian fixed income than equities, as Eduardo Yuki from our team in Brazil shows in the next section, but once the worst has past in economic terms and equity valuations regain their appeal, investor interest is likely to refocus on this asset class, provided the government keeps pushing its reforms through.

Turkey: Waiting for the reform process to resumeChart 3: Five Fragile's Equity Indices – Local Currencies

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7019 26 2 9 16 23 2 9 16 23 30 6 13

Jan 2015 Feb 2015 Mar 2015

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BIST NATIONAL 100 - Turkey IDX COMPOSITE - Indonesia BRAZIL BOVESPA - BrazilFTSE/JSE ALL SHARE - South-Africa CNX NIFTY (50) - India

Source: Thomson Reuters Datastream, BNPP IP, as of 06/04/2015

Turkey, in contrast, as a major net commodities importer, benefits markedly from very low crude oil prices. That said, Turkey is a net borrower, and while it has increased its foreign exchange reserves in recent years, these still fall short of its outstanding external liabilities. However, Turkey’s borrowing needs are declining as lower crude oil prices narrow its current account deficit and boost its revenues. More importantly, Turkish banks’ balance sheets are solid, which strongly limits the contagion risk from the private to the public sector. Moreover, the well-diversified Turkish economy is highly geared towards the Eurozone and will thus benefit from European Central Bank’s quantitative easing (QE) programme and the region’s economic recovery. Notwithstanding these constructive positives, Turkish equities have performed almost as poorly as Brazilian equities since the “taper tantrum” arising from the US Fed’s May 2013 announcement about reducing QE, and they remain below the levels nearly two years ago (chart 3).

Whether justified or not, Turkey still seems to lack the “strategic” trust of foreign investors and – like Brazil – so far it remains a volatile and rather cyclical market. But we believe that “credibility” and “reliability” can be restored after the general election to be held in June this year once the new government resumes its structural reform process. In fact, Turkey’s aspiration to accelerate its reforms has become more of a “must have” rather than “good to have” if it is to claw itself back to pre-Lehman growth rates. As our Turkish colleague Pinar Uguroglu explains later on in this publication, any such hint of a reformist government would convince us – and in all likelihood the global investor community – of Turkey’s eventual elevation from its current “Buy because it’s really cheap” market status to one that says “Buy and hold because it’s really delivering”.

India: Reforms in full swingIndia ranks well in our vulnerability score as the central bank has over the last two years accumulated foreign exchange reserves sufficient to cover over double its external sovereign liabilities. India also greatly benefits from lower commodity prices. Yet the fiscal deficit is one of the biggest among its emerging economy peers. This is not expected to narrow by much this year according to the budget plans for fiscal year 2015/16 as the government focuses on infrastructure spending to kick-start the investment cycle. Inflation has fallen, but remains at high levels compared to other emerging economies. However, India’s interest rate is relatively leaving room for further monetary easing beyond the 50bp of cuts the central bank has implemented so far in 2015. Finally, India remains a net borrower, even though like Turkey, its borrowing needs are declining. Most importantly since Narendra Modi’s election last May, India benefits from justified credibility boost, as Karthikraj Lakshmanan from BNP Paribas India shows in the last section. The credibility factor has here played a major role in supporting the market and will likely continue to do so, with the Indian government more than ever committed to reform – as demonstrated by the latest budget plans.

Asset allocation processes should consider the “credibility factor”To sum up, diversification within emerging equity markets is more crucial than ever when seeking better and more stable investment performances. We believe the “credibility factor” should play an important role in any emerging markets strategic asset allocation process.

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 4

BrazilTARGETING GREATER MACRO EFFICIENCY

After (too) many years of inaction, the newly elected government, backed by the central bank, has announced several budgetary and fiscal measures to structurally improve macroeconomic conditions. The ongoing implementation of tighter monetary and fiscal policies aims to boost national savings, improve external accounts and reduce inflation expectations.

This “rebalancing” should lead to a decline in real interest rates and, looking ahead, will very likely lend support to a new round of infrastructure concessions to the private sector. But in the short to medium term, these painful economic adjustments are likely to mean a big fall in domestic demand. We forecast the real GDP growth rate to drop by 1.7% this year and expand by only 0.5% in 2016. This below-consensus activity forecast is based on three drivers: labour cost adjustment, fiscal consolidation and tight monetary policy.

Labour cost adjustment In the last seven years, unit labour costs have increased substantially and markedly reduced corporate profitability. The aggregate return on equity of listed companies on average has been below the local base interest rate since 2013, which has strongly hit investment and motivated companies to look for bottom-line savings and greater productivity. This has led to a rise in unemployment and negative real wage increases, which are both weighing strongly on household purchasing power. But these “forced” adjustments at company level should ultimately improve local competitiveness, lead to more employment and encourage more investment once idle production capacities are taken up.

Fiscal consolidation and tight monetary policyThe new finance minister, Mr. Joaquim Levy, announced a severe fiscal consolidation programme for 2015 and 2016. These structural measures are likely to reduce real domestic demand by at least 2% in the coming quarters. We believe the primary fiscal surplus will rise from -0.6% of GDP to close to 1.8% of GDP in 2016. Better fiscal accounts should improve solvency indicators and increase national savings.

The Brazilian central bank (BCB) has been increasing interest rates since the beginning of 2013. At this moment, monetary conditions are very tight and credit concessions have slowed markedly. Monetary aggregates indicate that credit conditions will continue deteriorating in the coming quarters. This too will contribute to higher national savings and lower external funding requirements over the same period.

Higher national savings will reduce the need for external savings

Chart 4: Brazil: Current Account vs Real Effective Exchange Rate

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Real Effective Exchange Rate

Source: Brazilian Central Bank, Bank of International Settlement, BNPP IP, as of 02/2015

Decrease in domestic demand and real effective exchange rate depreciation in the last four years should benefit the trade balance and improve the current account from -4.2% of GDP in 2014 to -3.0% in 2016. The balance of payment surplus should increase from +0.5% of GDP in 2014 to +2.0% of GDP next year. A positive balance of payments means that the BCB will continue to accumulate foreign exchange reserves. International reserves, which stand at USD 369 billion, are already equivalent to 17% of GDP, which strongly minimises external solvency risk.

Spare output capacity may soon create a disinflationary environment. The pass-through from currency depreciation to inflation will likely be lower than historical levels due to low pricing power, underused production capacities and weaker commodity prices. Inflation should drop from around 8.0% this year to 5.0% in 2016.The consequences of this rebalancing process have created good opportunities in local financial markets:

Fixed income: fiscal consolidation reduces equilibrium real interest rateCurrently constrained by high nominal and real credit rates, the private sector should soon benefit from a softer monetary policy, i.e. lower rates, but this time, thanks to fiscal reforms, on a more sustainable basis. We believe that the BCB will start to cut interest rates between September and October of this year and pave the way for a gradual economic recovery in 2016 and 2017. This represents an interesting opportunity in the Brazilian fixed-income market, especially if one takes into account that the currency may now be priced lower than is justified by fundamentals. We are overweight on rates in Brazil.

Eduardo YukiHead of Economic and Market AnalysisBNP Paribas Asset Management Brazil

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 5

Equities: Still too early to buyChart 5: Brazil: Manufacturing Confidence Index

1996 97 98 99 2000 01 02 03 04 05 06 07 08 09 10 11 12 13 14 1560

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Source: FGV, BNPP IP, as of 03/2015

There are positive and negative tactical drivers for the local stock market. On one hand, valuations, which are close to their historical average, are not yet cheap, meanwhile the recessionary environment is a major source of uncertainty for earnings estimates. On the other hand, improving economic fundamentals and the expected easing monetary cycle will help restore confidence in the market. In our view, it’s too early to increase portfolio exposure to equities. Equities may attract investors again towards the year end, if, as we believe, the first signs of an economic turning point may emerge by then, and the government does not depart from its reform route.

In conclusion: Brazilian economic policy seems finally to be in a “reform mood”. This implies there will first be a painful ‘rebalancing’ process to put the public house in order and get rid of blatant budgetary inefficiency. The costs are, as elsewhere, weaker activity in the short term. The gains are improved local fundamentals and higher potential real GDP growth in the medium to long term. The government’s new macro policy will also further strengthen already solid solvency indicators and thus improve the credibility of both the country and its institutions, i.e. lead to a decrease of the risk premium on Brazilian assets.

TurkeyIN NEED OF CREDIBILITY ENHANCEMENT

Turkish equities look quite reasonable in terms of valuation. Our proprietary consensus estimate, gathered from more than fifteen Turkish brokers, shows the market currently trades at 10.4x 2015 expected price-earnings (P/E) compared to the MSCI EM (ex-China) average of 13.7x. Turkish equities’ discount to EM (ex-China) has widened to 27% versus its historical average of 20% (source

Bloomberg). Financial stocks, which constitute the bulk of the Turkish index, are now trading at a 38% 2015e P/E discount to their MSCI EM peer banks. In fact, Turkish financials have grown more strongly since the Lehman crisis, on average tripling their equity capital since then. Turkish banks’ capital adequacy is the highest in Europe, at almost 13%.

Chart 6: Turkey: Current Account Deficit

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Source: BNPP IP, as of 01/2015

Chart 7: Turkey: CPI (%)

Jan-14 Mar-14 May-14 jul-14 Sep-14 Nov-14 jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-153.50%

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Actual CPI ( % ) Expected CPI ( % )

Source: BNPP IP, as of 03/2015

Indeed, for the first month of this year, Turkish equities were some of the best performers among emerging markets, mainly because as a major oil importer, it gained the most from the sharp drop in oil prices. But the party did not last long in the face of: i) oil

Pinar UgurogluDeputy CIO and Head of Research

Turkey TEB Asset Management

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 6

prices recovering slightly from their December 2014 lows; ii) strong US employment data sparking a heightened debate on the Fed’s potential “hawkishness” and lift-off; iii) the Turkish Central Bank (CBRT) getting too excited about the disinflationary impact of oil prices and its benefits to Turkey’s long-debated current account deficit and perhaps cutting rates before actually seeing the inflationary benefits; iv) while the CBRT was perceived as dovish by market players, politicians argued otherwise and started a “lose-lose” debate on the central bank’s policies. As a result, the Turkish lira came under attack and year-to-date it is the second worst-performing emerging market currency, ahead only of Brazilian real. At current levels, it is rather safe to say that the lira is undervalued in terms of the real effective exchange rate.

Turkish equities’ fragility not justified by facts Our view is that the actual fragility of the market is not based on facts, but driven by sentiment. Headline inflation should have peaked in February. As oil prices are remaining lower for longer than the consensus predicted and also due to lower food prices, inflation will very likely gradually trend down. Secondly, the current account deficit had already started to normalise in 2014. Oil is a bonus for 2015 that will bring the C/A deficit down from 5.7% of GDP to about 4%. This substantial improvement could help Turkey move out of the “fragile five” category. Thirdly, Turkish external borrowing (essentially private sector debt) is almost entirely owed to European institutions, so roll-over should not be an issue thanks to the abundance of liquidity. Additionally, unlike Russia or Brazil, Turkey could independently achieve real GDP growth of some 2% to 3% through infrastructure investment and population growth. A likely export recovery (and EU recovery is key here since Germany is still one of Turkey’s largest trading partners) would bring added growth. Finally, Turkish governments have proven election after election that fiscal discipline can be maintained as the underlying budget balance has never been sacrificed, paving the way to a desirable 1.3% budget deficit of GDP in Turkey.

We would also argue that the debate about the CBRT’s independence/credibility is much ado about nothing. First of all, unlike many other large emerging markets, Turkey is an open economy in both market

and currency terms. Politicians and bureaucrats understand that Turkey does not have a fall-back plan and/or generous natural resources if/when the country’s attractiveness for foreign capital sours significantly. Hence, debates that put pressure on.

As to the CBRT’s perceived “dovishness”, it is true that the central bank has a dovish bias, which can play into the hands of the politicians. But does this necessarily mean that the bank is doing the wrong thing? In a global deflationary environment coupled with timid local business activity, the “normal” course of action would be to ease when possible, i.e. when justified from a macroeconomic and financial standpoint. The timing or pace can of course be subject to debate, but it should not cast a sustained doubt over the credibility or independence of the monetary institution.

Hopes of change in political course after June general electionsObviously, some headwinds remain in place. We do for example share the view that, as is the case for most emerging markets, the US Fed risk will continue to be an “Achilles’ Heel” for the Turkish market.

Essentially, we argue that the “fragility” of Turkey does not stem from its macro performance or the underlying dynamics of the economy, but rather from the perceived “credibility” of its institutions and “business-friendliness” or “reform-appetite” of its politicians. Realistically, we do not expect much to come from the political side (or from the equity market in that respect) before the general election in June this year. But, for a sustained recovery of the economy and the markets, it is a “must” that the new government post-June prioritises structural reforms and does not waste valuable time and energy on internal debates. There is a well-documented structural reform agenda in place, but unlike in the case of India, investors are not apparently ready to give Turkey the benefit of the doubt to actually deliver these reforms. Hence, we will need to see actual evidence that a market-friendly government is in place and functioning in order to unleash Turkey’s great potential. Such a fundamental shift in the mind-set would duly reward global investors, we believe.

India

MODI GOVERNMENT: HOPE, REFORMS AND DELIVERYIn May 2014, the Narendra Modi-led government was given the strongest mandate in 30 years on its promise of growth and development. This clear majority gives the government the room to focus on economic efficiency rather than politically-motivated decisions. From the outset, the government has been vocal about the reform measures it plans to implement during its term. While its

list of reforms seems ambitious, it has also followed an incremental approach, continuing with some of the measures that the previous government had started: Fuel price deregulation, direct benefit transfers and fiscal consolidation, to name a few.

India’s new government has made a fairly good start to a five-year economic agenda. This was important, because the market had been building high expectations, given the election campaign’s focus on the economy and the PM’s track record as a Chief Minister. It’s a good start because the government has ticked most reform and execution boxes, although the pace is gradual.

Karthikraj LakshmananPortfolio Manager

BNP Paribas Asset Management India

THE GROWING IMPORTANCE OF THE “CREDIBILITY” FACTOR FOR EMERGING MARKETS I APRIL 2015 I 7

Some of the reform measures worth mentioning are:

• Inflation control by reducing minimum support price hikes to as low a level as possible;

• Focus on fiscal consolidation• Tax reforms by way of pushing to implement the Goods & Services

tax by FY17• Direct benefit transfer to reduce leakages and thus government

social costs,• ‘Jan Dhan Yojana’, a bill that aims to give every household a bank

account as a first step towards financial inclusion besides helping in direct benefit transfers,

• ‘Swach Bharat Abhiyan’ – an effort to clean up India with a long-term view of improving health, hygiene and productivity

• ‘Made in India’ – A thrust to vitalise and move more manufacturing to India: for jobs, raising exports, reducing imports and building skills,

• ‘Digital India’ – an aggressive effort to wire-up India through broadband access across rural areas

There are also other planned measures such as ‘Skill India’, ‘Smart Cities’, ‘Housing for all by 2022’, and on improving the ease of doing business, transparency in allocation of natural resources, and banking reforms.

These initiatives not only imply government spending; they are also participative and inclusive, and will entail investment by the banks and private sector as well as by the government. We believe these various measures when implemented over the next few years will provide significant gains in terms of higher and more balanced and sustainable economic growth. However, some of the measures will be time-consuming and their benefits will become clear gradually. The challenges the government faces are the ability to pass some bills in the upper house of the parliament where it doesn’t have a clear majority, the risks related to timely execution of initiatives and any headwinds arising from global market conditions.

FY16 Union Budget: Stimulative & credibleThe Union Budget for the fiscal year to March 2016 (FY16) has successfully managed to balance maintaining fiscal discipline and promoting growth by focusing on infrastructure investment and improving the ease of doing business. The budget appears both stimulative and credible in terms of revenue and deficit estimates. It confirms our view that policy actions will be incremental and tactical rather than tectonic, aiming to gradually put India’s economy back on track towards a sustainably higher growth rate. Achieving a higher growth rate is critical for India to ensure its ‘demographic dividend’ – a young population and a low and falling dependency ratio – does not become a burden because of insufficient job creation.

To promote growth, the government is focusing on infrastructure investment, financed by the less stringent fiscal deficit target as well as the fall in crude oil prices, which should help trim the subsidy burden by 50% to INR 300 billion (USD 4.9 billion). In total, the government aims to allocate an additional INR 700 billion (USD 11.3 billion) to infrastructure investment in FY16 compared to FY15. It plans to set up a National Investment and Infrastructure Fund (NIIF) with an annual investment of INR 200 billion (USD 3.2 billion). Allocation to roads and railways (budgetary support plus internal resources) has expanded by some 175% and 52% respectively compared to FY15, amounting to about INR 1 800 billion, or 1.3% of

GDP. Lastly, it wants to create tax-free infrastructure bonds to fund road, railways and irrigation projects.

Cooperative federalismThe states have been responsible spenders, with their fiscal and revenue deficits declining by 60bp and 90bp respectively between FY10 to FY15. So the higher allocation by the centre to the states in its FY16 budget – routed directly through state government treasuries rather than routing them through lower level implementation bodies – gives higher expenditure flexibility and control to the states. If a significant portion of the excess funds inflow from the centre is used by the states for capex growth, it would give the much required push to revive the investment cycle.

Chart 8: India: Inflation Rate (%)

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INFLATION RATE : India

Source: Thomson Reuters Datastream, BNPP IP, as of 06/04/2015

The Reserve Bank of India (RBI) and the government recently finalised the monetary policy framework introducing inflation targeting to rein in a long history of volatile price rises. The CPI inflation target has been set at 4% (+/-) 2% for FY2017 and beyond aiming to keep inflation below 6% by January 2016. Already below 6% inflation targeting, more commonly seen in developed economies, will try to deliver a stable inflation rate while optimising the trajectory of long-term GDP growth. India’s decelerating inflation in recent quarters can be seen as a positive as a disinflationary environment can help the country start to pursue inflation-targeting. For inflation targeting to succeed, the government and RBI need to co-ordinate their efforts; the RBI has to deliver on its broad target of 4% (+/- 2%) and be consistent and transparent in its communication with the market about the method being pursued, while the government has to deliver on fiscal consolidation.

Equity outlookAfter the strong market recovery in 2014, the Indian equity market should remain on an uptrend but with some potential short-term corrections along the way as investors may expect ‘too much too soon’ from the government. We believe that, as long as the fundamentals are improving, such corrections may provide investors with an opportunity to enter the market or reinforce their exposure. In our view the outlook for Indian equities appears very positive for the next two to three years, due to lower commodity prices, progress in reforms, a loosening of monetary policy, all of which should help to accelerate growth.

www.bnpparibas-ip.com

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