directional economics emea 270318 - research.ing.com€¦ · [email protected] egor fedorov...

SEE THE DISCLOSURES APPENDIX FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION

Global Markets Research

Directional Economics EMEAReady, aim, invest

27 March 2018

EM Economics & Strategy

• Azerbaijan

• Bulgaria

• Croatia

EMEA Economics and Strategy TeamSee details at end of report

research.ing.com

• Poland

• Romania

• Russia

• Czech Republic

• Hungary

• Kazakhstan

• Serbia

• Turkey

• Ukraine

Directional Economics EMEA March 2018

Contents

Summary 1 Ready, aim, invest ................................................................................................................................ 1

ING main trade recommendations 6

Ready, aim, invest 8

The FDI proposition 9 CEE: The investment destination of choice .................................................................................. 10 Why companies choose to invest in CEE ..................................................................................... 11 Making the decision .......................................................................................................................... 13 Focus: FDI prospects in Russia and Turkey ................................................................................... 21

Looking for value in EMEA FX 22 Lowering EUR/CZK fair value; PLN the cheapest CE3 FX ........................................................... 22 TRY the most undervalued high yielders, vs rich ZAR ............................................................... 25

Cross market performance, flows and relative value 27 Performance and what will drive it ................................................................................................ 27 Emerging markets space still in favour ........................................................................................ 28 EMEA Relative Value .......................................................................................................................... 30

EM Credit: Technicals on top 32 Corporate fundamentals continue to improve ........................................................................... 32 Technicals remain supportive ......................................................................................................... 33 Core rates seem unlikely to destabilise credit ............................................................................ 33 So how should we position in EMEA? ............................................................................................ 34

Countries 37 Azerbaijan ............................................................................................................................................ 38 Bulgaria ................................................................................................................................................ 40 Croatia .................................................................................................................................................. 42 Czech Republic .................................................................................................................................... 44 Hungary ............................................................................................................................................... 48 Kazakhstan .......................................................................................................................................... 52 Poland................................................................................................................................................... 54 Romania ............................................................................................................................................... 58 Russia ................................................................................................................................................... 62 Serbia .................................................................................................................................................... 66 Turkey ................................................................................................................................................... 68 Ukraine ................................................................................................................................................. 72

Disclosures Appendix 77

Chris Turner Global Head of Strategy and Head of EMEA and LATAM Research London +44 20 7767 1610 [email protected]

Rafal Benecki Chief Economist, Poland Warsaw +48 22 820 4696 [email protected]

Ciprian Dascalu Chief Economist, Romania Bucharest +40 31 406 8990 [email protected]

Egor Fedorov Senior Credit Analyst, Russia & CIS Moscow +7 495 755 5480 [email protected]

Padhraic Garvey Global Head of Debt and Rates Strategy London +44 20 7767 8057 [email protected]

Petr Krpata, CFA Chief EMEA FX and IR Strategist London +44 20 7767 6561 [email protected]

Muhammet Mercan Chief Economist, Turkey Istanbul +90 212 329 0751 [email protected]

Dmitry Polevoy Chief Economist, Russia and CIS Moscow +7 495 771 7994 [email protected]

Jakub Seidler Chief Economist, Czech Republic Prague +420 2 5747 4432 [email protected]

Nick Smallwood Senior Emerging Markets Credit Analyst London +44 20 7767 1045 [email protected]

Péter Virovácz Senior Economist, Hungary Budapest +36 1 235 8757 péter.virová[email protected] Cover photograph courtesy of shutterstock Publication date 27 March 2018


1

Summary Ready, aim, invest Notwithstanding the recent rise in protectionist sentiment, Eurozone growth is showing some real momentum. Capacity constraints are close to being reached, meaning that investment will be a necessity if the strong demand for new orders is to be filled. We expect Eurozone investment to pick-up both at home and into the CEE.

Typically the Central and Eastern Europe (CEE) region has been a major beneficiary of Foreign Direct Investment (FDI) from the Eurozone. And if protectionism is on the rise, the prospect of ‘near-shoring’ – or the outsourcing of services to companies in a nearby country - becomes especially relevant in 2018.

Our feature article in this edition of Directional Economics looks at the FDI proposition offered by the CEE. Its strengths are its geographical links, the quality of its human capital and its productivity. These are also supported by the provision of EU funds.

The main challenge to FDI into the CEE is the increasing scarcity of labour. If reforms are not enacted to encourage a higher and broader labour participation rate across the CEE then the flow of FDI may increasingly be directed to the next wave of EU entrants in the western Balkans. Our team also highlight particular priority sectors in each country.

We also offer three further thematic articles. The first provides an update on our medium-term fair value levels for EMEA FX. We find the PLN most undervalued of the CE3 currencies, while we also find that higher productivity levels are justifying higher levels of CZK fair value as well. The TRY is the most undervalued within EMEA, though the TRY recovery in real terms will largely be driven by inflation – not nominal TRY gains.

Our debt and credit team also provide updates on EM fund flows and EM credit trends. On the former, we prefer local over hard currency positions – and at shorter duration – in EM sovereign debt. Our credit team also feel that strong technicals, including better net issuance trends, can keep EM credit spreads relatively tight.

In terms of strategy ideas, our conviction call of a weaker USD/Europe (we continue to see EUR/USD rising to 1.35 in 2019) sees us re-iterating our view of a much lower USD/CZK. We also like to express a bearish EUR/PLN view through options. Receiving positions at the short end of HUF swap curve should also do well. And in the domestic bond market, we expect further narrowing in Polish sovereign spreads to Germany.

As always our Directional Economics report showcases the unique footprint of ING’s macro-economic research team across the EMEA region. Growth trends in the CEE should remain strong. The provision of EU funds should continue to help Poland, Hungary and the Czech Republic. However, inflationary trends are only registering with the Czech National Bank and should elicit two hikes and further CZK strength this year.

Strong growth rates of 2017 look unlikely to be repeated in the likes of Romania and Turkey this year. Last year’s near 7% growth rates in both countries were driven by consumption and government-sponsored investment, respectively. Fiscal and current account imbalances leave Romania and Turkey vulnerable to the external environment. Russia should continue its modest recovery, with financial assets less volatile.

We hope you enjoy the publication and encourage you, our customers, to continue engaging with our research team who are always on hand to help.

Chris Turner, Global Head of Strategy and Head of EMEA and LATAM Research London +44 207 767 1610


2

Country summaries: CE4

Czech Republic Hungary The Czech economy grew by 4.5% last year, at the second fastest pace of the last ten years. The strong economic activity was broad-based, driven by renewed investment, solid household consumption and foreign demand. Domestic demand should be the main growth-factor this year, with the tight labour market pushing wages up. Though the GDP print is expected to be slightly lower this year, domestic consumption will remain strong, with some demand-driven inflationary pressures building. As such, CPI will gradually return above the target, after declining below in Feb-18 due to lower food prices, a stronger CZK and a higher base from the previous year. As CZK might not bring enough tightening – in contrast to the current more dovish CNB rate forecast – we still expect room for two hikes in 2H18.

GDP growth accelerated to 4.0% YoY in 2017, its second highest rate of the past 11 years. However, Hungary is slightly lagging regional peers. Net exports were a drag on growth, due to the pick-up in imports on strong domestic demand and one-off limitations in export activity. Investments posted their highest growth rate since 1995. We see 3.9% YoY GDP growth for 2018 with strengthening net exports and weakening domestic use. The fiscal stance will remain accommodative in 2018-19 mainly due to tax cuts, but deficit targets look safe. The NBH is keen to keep the monetary stance loose, preserving relative stability in EUR/HUF and HGB/IRS spreads vs core markets. The NBH doesn’t need to worry on inflation as it will remain within its tolerance band, but above 3%, in 2019.

Poland Romania The expected sound GDP dynamics, solid fiscal stance (with 2018 general government deficit at 1.5% of GDP), high coverage of 2018 borrowing needs (50% after 1Q18) and elevated MinFin cash buffer offer solid backing for POLGBs, especially the long end. We see Bund spreads tightening across the curve. The dovish MPC limits appreciation potential for PLN, which has usually served as an “activity currency”. But we see major gains in PLN vs US$. We see limited and late NBP hikes in 4Q19 only. Politics should play a lesser role in 1H18 due to the low risk of introduction of meaningful sanctions against Poland. 2H18 should bring discussion about the 2019 election budget. Market rate hike expectations should hover below 50bp for 2019 over coming months.

In 2017, Romania grew out of fiscal troubles by posting a 7.0% GDP advance driven mostly by private demand which led to a build-up in inflationary pressures triggering NBR tightening way ahead of peers. 2018 is likely to bring a moderation due to scarce labour resources, higher interest rates and slower advances in real incomes. It was mainly fiscal and wage policies which led to this unsustainable backdrop and fiscal consolidation is rather unlikely as 2019 and 2020 are electoral years. Hence, the correction would come via a suboptimal mix of higher interest rates (negative in real terms) and some nominal currency weakness. We see little chance that the government will restart structural reforms. On the contrary, risks of roll-back of some reforms are on the rise.

Country summaries: Other Central & Eastern Europe

Bulgaria Croatia Bulgaria meets the nominal Maastricht criteria and aims to enter the ERM-II mechanism by July. While PM Borissov found support for its ERM-II bid, it could prove more difficult to get the guarantees for EUR adoption. With low real convergence (the lowest GDP per capita in the EU), low institutional integration (still under EC supervision on justice and outside the Schengen space), such guarantees are hard to get, in our view. Adopting the euro without achieving higher total factor productivity growth (via structural reforms) might limit the convergence process and leave the country vulnerable to shocks in the future, similar to countries exposed by the European debt crisis which triggered internal devaluation. Nevertheless, ERM-II represents another anchor for prudent public policies.

The Croatian economy has been growing over the past three years and we see no major reasons to doubt that this trend will continue. Nevertheless, there is an opportunity to step up reforms in key areas such as the labour market and in public administration, and also to consolidate recent fiscal discipline which in turn will help to further bring down high public debt ratios. Uncertainties related to Agrokor’s restructuring might still pose some risks but, looking at the bigger picture, the favourable external conditions, increased absorption of the EU funds and investments should be supportive for growth in the near future. Benefiting from its “safe destination” status and a structural upgrade, tourism is likely to reach new highs.

Serbia Turkey Serbia is benefiting from the robust European growth backdrop, although GDP disappointed slightly last year. The country appears to be committed to using the cyclical recovery to reduce the debt overhang and increase the buffers for hard times. IMF assistance helped Serbia’s fiscal consolidation and a new precautionary deal is likely. Part of the decline in Serbia’s debt-to GDP ratio is also attributable to RSD appreciation vs the EUR and to USD weakness. The government is aiming to address the sensitivity of government debt to FX rates going forward, after the NBS managed to boost its inflation-targeting credentials which allowed it to bring local currency interest rates sharply down in recent years.

Moody’s has cut Turkey’s credit rating a second time since the failed coup attempt in mid-2016, citing continuing deterioration in institutional strength and rising external vulnerabilities. Despite some efforts recently – with automatic enrolment to private pension schemes, legislation to reduce FX risk of corporates and initial steps to restructure VAT – Turkey needs a more concrete structural reform initiative in the face of downgrade pressures from rating agencies. Regarding key macro indicators, growth remains strong thanks to credit and fiscal impulses while CPI has remained at double digits, albeit less in recent months, with core close to the peak in the current series. The CBT uses a combination of new and old unorthodox policy tools, keeping the effective cost of funding elevated.


3

Country summaries: CIS

Russia Kazakhstan Despite weaker GDP growth in 2017, we stick to our 2% call for 2018. We got the expected real wages surge, so consumption is to follow. Investments ended 2017 on a strong footing too, and positive momentum may re-emerge following the elections, as anecdotal surveys show. We now have a higher oil price assumption vs 2017. We also upgrade our 2019 call from 1.5% to 1.8% envisaging some positives from growth-stimulating initiatives of the President/MinEco. Key uncertainty/risks are about their funding sources, including the need to adjust/hike taxes. We believe the tax burden will be untouched as it has long been one of the major growth hurdles for business. No unity among officials is good. Low CPI/stable RUB will see the key rate lower, supporting OFZs. US$ bonds look mostly okay.

The 2017 growth story was even better than our long-standing +ve view and this, together with higher oil price, keeps us constructive on the 2018 outlook. We upgrade our GDP call from 2.9% to 3.4%. Lower CPI inflation, expanding lending, prudent monetary policy and properly-tuned fiscal stance (with lower planned deficit, but a focus on state-driven spending on infrastructure and development projects) will keep domestic demand growing. Exports should also keep expanding, but stronger growth in imports is likely to dampen the overall net export contribution. With a promising KZT outlook and the 2017 measures to tackle banking sector fragility, overall risks look manageable. The sovereign creditworthiness will stay strong, supporting sovereign/quasi-sovereign debt attractiveness.

Ukraine Azerbaijan After the nearly 16% drop over 2014-15, the resumption of 2.1-2.3% GDP growth in 2016-17 was clearly a positive, but the economy stands 12% below the pre-crisis level. Hence, officials shouldn’t be complacent about the expected 3-3.5% GDP growth in 2018-19. Hikes in min. wages and other social spending helped consumption, and will likely continue to do so. Investment is set to ease after a strong recovery, while still growing. Major direct and indirect risks come from the uncertain outlook for the country’s cooperation with the IMF. While this doesn’t look to be overriding at this stage, it is still crucial for setting investor perception for sovereign risk, especially given where US$ papers trade now. The solid anti-inflationary NBU stance keeps local bonds a “BUY”, conditional on UAH stability.

The economy has turned the corner and should post growth in 2018. This likely won’t be high and we stick to our 1.8% call. Major global institutions see it between 0.9% (World Bank) and 3.5-4% (EBRD) compared to the official 1.5% call under US$45/bbl. Domestic demand should recover, helped by higher oil prices and post-recession momentum, but a still fragile banking sector and not fully liberal FX and monetary policies will likely cap GDP upside. External and fiscal balances look healed by high crude prices, and low inflation is key to move closer to inflation targeting. This may raise the mid-term GDP outlook and drive sovereign rating upgrades, but this will take time. The Apr-18 presidential elections will prolong Mr Aliyev’s rule, but key is whether structural issues will be addressed.


4

ING main macroeconomic and financial forecasts Real GDP (% YoY) Exchange rate (quarterly is eop, annual is avg)

1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Azerbaijan 1.5 2.4 1.4 1.7 1.8 2.0 USD/AZN 1.70 1.65 1.60 1.55 1.64 1.54 Bulgaria 3.7 3.2 3.5 4.3 3.7 3.5 EUR/BGN 1.96 1.96 1.96 1.96 1.96 1.96 Croatia 2.6 2.5 2.4 1.8 2.3 2.5 EUR/HRK 7.43 7.40 7.35 7.36 7.36 7.26 Czech Rep 4.5 2.8 3.2 3.8 3.5 3.4 EUR/CZK 25.40 25.20 25.00 24.80 25.15 24.69 Hungary 3.8 3.5 4.1 4.2 3.9 3.1 EUR/HUF 312.0 310.0 306.0 303.0 308.2 298.4 Kazakhstan 4.5 3.4 3.1 2.6 3.4 2.7 USD/KZT 320.0 310.0 315.0 315.0 318.5 305.0 Poland 4.8 4.3 3.5 3.6 4.5 3.6 EUR/PLN 4.16 4.14 4.12 4.13 4.12 4.14 Romania 6.0 4.8 3.9 4.4 4.7 4.0 EUR/RON 4.66 4.70 4.70 4.67 4.68 4.64 Russia 2.3 1.5 1.8 2.1 2.0 1.8 USD/RUB 56.90 57.50 58.20 58.00 57.80 58.60 Serbia 3.4 3.1 2.7 2.5 2.9 3.7 EUR/RSD 118.0 118.0 117.0 117.0 118.1 115.5 Turkey 4.0 5.1 3.9 4.3 4.3 4.5 USD/TRY 3.90 3.91 4.01 4.10 3.94 4.27 Ukraine 3.0 2.8 2.7 2.6 2.8 2.9 USD/UAH 27.00 28.00 28.50 30.00 28.31 29.90 Eurozone* 2.7 2.5 2.2 2.1 2.4 1.8 US* 2.9 3.0 3.1 3.1 3.0 2.6 EUR/USD 1.25 1.28 1.28 1.30 1.30 1.35

*% QoQ ann. Source: National sources, Bloomberg, ING estimates

Source: National sources, Bloomberg, ING estimates

CPI (%YoY, quarterly is eop except for US/EZ avg, annual is avg) Central Bank rate (%, eop)


Azerbaijan 3.0 3.5 3.7 3.5 4.0 4.8 Azerbaijan 13.00 11.00 10.00 9.00 9.00 8.00 Bulgaria 2.7 2.9 2.3 2.6 2.4 2.9 Bulgaria 0.00 0.00 0.00 0.00 0.00 0.25 Croatia 1.7 2.3 2.1 1.8 1.7 1.8 Croatia 0.30 0.30 0.30 0.30 0.30 0.70 Czech Rep 1.9 2.0 2.0 1.9 1.9 2.2 Czech Rep 0.75 1.00 1.00 1.25 1.25 1.75 Hungary 2.4 2.6 2.7 2.8 2.6 3.1 Hungary 0.90 0.90 0.90 0.90 0.90 0.90 Kazakhstan 6.5 6.0 5.8 5.2 6.1 5.1 Kazakhstan 9.50 9.25 8.75 8.50 8.50 8.00 Poland 2.2 1.8 1.6 2.2 1.8 2.8 Poland 1.50 1.50 1.50 1.50 1.50 1.75 Romania 4.7 4.6 4.5 3.4 4.4 3.4 Romania 2.25 2.75 2.75 2.75 2.75 3.50 Russia 2.3 2.0 2.5 3.0 2.4 3.4 Russia 7.25 6.75 6.50 6.25 6.25 5.75 Serbia 1.7 2.0 2.8 2.9 2.4 3.1 Serbia 3.25 3.00 3.00 3.00 3.00 3.50 Turkey 10.1 10.3 10.2 9.2 10.0 8.6 Turkey 8.00 8.00 8.00 8.00 8.00 8.00 Ukraine 12.6 11.5 9.7 8.5 11.2 8.2 Ukraine 17.00 17.00 17.00 16.00 16.00 12.00 Eurozone* 1.4 1.5 1.6 1.5 1.5 1.7 Eurozone 0.00 0.00 0.00 0.00 0.00 0.25 US* 2.4 2.8 2.7 2.4 2.6 2.2 US 1.50 1.75 2.00 2.25 2.25 2.75

Source: National sources, Bloomberg, ING estimates *Lower level of 25bp range. Source: Bloomberg, ING estimates

10yr local yield (%, quarterly is eop, annual is avg) 3m local rate (%, quarterly is eop, annual is avg)


Azerbaijan n/a n/a n/a n/a n/a n/a Azerbaijan n/a n/a n/a n/a n/a n/a Bulgaria 1.20 1.20 1.25 1.30 1.30 1.50 Bulgaria 0.02 0.02 0.02 0.02 0.04 0.25 Croatia 2.25 2.35 2.40 2.40 2.36 2.68 Croatia 0.55 0.50 0.50 0.50 0.45 0.60 Czech Rep 2.00 2.10 2.20 2.30 2.10 2.50 Czech Rep 0.90 1.18 1.20 1.48 1.10 1.67 Hungary 2.60 2.65 2.70 2.75 2.54 2.90 Hungary 0.02 0.02 0.02 0.02 0.02 0.02 Kazakhstan n/a n/a n/a n/a n/a n/a Kazakhstan 10.50 10.25 9.75 9.50 10.25 9.15 Poland 3.41 3.48 3.51 3.67 3.42 3.83 Poland 1.73 1.73 1.73 1.73 1.73 1.79 Romania 4.55 4.40 4.30 4.45 4.43 4.63 Romania 2.15 2.40 2.60 2.85 2.50 3.56 Russia 7.10 6.80 6.60 6.50 6.93 6.30 Russia 7.34 6.80 6.60 6.30 6.98 6.05 Serbia 5.00 4.80 4.70 4.70 4.80 4.40 Serbia 3.00 2.70 2.70 2.80 2.80 3.10 Turkey 12.60 12.14 12.09 11.43 11.96 11.17 Turkey 13.64 13.65 13.53 13.15 13.54 12.54 Ukraine n/a n/a n/a n/a n/a n/a Ukraine n/a n/a n/a n/a n/a n/a Eurozone 0.65 0.75 0.80 0.85 0.85 1.20 Eurozone -0.33 -0.33 -0.33 -0.33 -0.33 0.10 US 3.00 3.20 3.40 3.30 3.30 3.20 US 2.05 2.15 2.45 2.60 2.60 3.20

Source: National sources, Bloomberg, ING estimates Source: National sources, Bloomberg, ING estimates


5

ING EM FX and local rates views summary

Country Foreign exchange Local debt and rates

Poland We expect moderate PLN appreciation over 2018, with EUR/PLN at 4.10-12 by the year-end. The zloty is backed by strong domestic fundamentals and a sound budget position helping POLGBs inflows. Local political risks should play a minor role, reflecting the low risk of meaningful sanctions as well as the Polish government attempts to de-escalate the standoff with the EC.

With our non-consensus call of at most one rate hike by 2019 (pencilled in for 4Q19), we receive 1y2y PLN within our 1y2y PLN-CZK spread narrowing recommendation. We look for POLGB-Bund spreads to further tighten in 2Q18. The total debt supply for 2018 is expected to be again below plan due to lower deficit but also MinFin’s excessive cash buffer.

Hungary We expect EUR/HUF to continue hovering around its gravity line of 310 for now, with the accommodative NBH policy offsetting the positive impact from the current account surplus. Once the general elections are behind us, we look for a back-loaded HUF strength in 2H18 (towards EUR/HUF 303) as the current flattening programmes are likely to be nearing the end.

1y1y HUF receiver is one of our highest conviction trades. The NBH remains inherently dovish: inflation is below the target while any pre-mature sharp rise in Bubor would lead to material and unwarranted HUF strength. Bubor to remain flat this year and next. The ongoing MIRS tenders provides a back-stop to material idiosyncratic (and non-core driven) curve steeping.

Czech Republic

We are short EUR/CZK as well as short USD/CZK, with the latter being our top trade for 2018 . CZK remains undervalued vs EUR and the hike-prone CNB should push EUR/CZK lower via further interest rate increases (as CZK is unlikely to appreciate in the absence of hikes). We look for EUR/CZK to reach 24.80 by end-18 (which is less bullish than the 24.60 CNB forecast).

We have re-engaged into CZK payers (via 1y2y CZK) as we believe the market is currently under-pricing the pace of CNB tightening cycle. We look for some modest flattening of the 2s10s IRS curve, as upward pressure on the back-end rates from rising core yields should be more than offset by the increasing front-end IRS rates due to CNB tightening (as a response to the stable CZK).

Romania While on the surface the NBR tries to talk down RON, we believe that this is because it wants to discourage RON strength resulting from higher carry. But due to the higher FX pass-through into inflation, we don’t believe the NBR can “afford” material RON weakness from here. We look for a broad EUR/RON stability this year, not materially breaching above the 4.70 level

We can’t rule out a repetition of a scenario similar to the one from late last year, with short-term interest rates moving sharply higher from the deposit facility to above key rate level. Given the expectations for NBR outlook and spread versus peers, back-end ROMGB yields seem to price in most of the risks, except new political tensions related to judiciary system

Russia We expect capital flows to be a “marginal” driver for the RUB given the adjusted fiscal rule, effectively neutralising the current account balance (along with capital outflows). We still see RUB levels slightly weaker over 2018 at 57.50-58.50/USD as C/A seasonality still plays its role. At the current levels, we see RUB as modestly overvalued against USD.

Although we still see value in long OFZ positions (mainly the 10y segment) on the CBR rate outlook/liquidity surplus, its risk/return profile is less appealing than before due to external markets risks. On the rates side, 1y1y/2y1y XCCY of 5.60/5.90% looks fair vs our CBR rate view. We would receive 1Y/2Y IRS at 6.96%/6.78%.

Ukraine The real effective exchange rate of hryvnia has approached its strongest levels since early-2014, and with the expected positive inflation differential the external competitiveness will be eroding. Our estimates suggest that to have the REER stable at current levels, the nominal UAH rate should slowly weaken to 28.5-29/USD in 2018-19.

With inflation set to slow to single-digits and the NBU likely resuming rate cuts in late 2018, we see local UKRGB bonds as attractive, despite the remaining risks to UAH stability. Although the local authorities are delaying crucial IMF reforms, the NBU has still been committed to prudent monetary policy via raising the policy rate from 12.50% to 17%.

Kazakhstan We retain our positive KZT outlook due to the expected BoP stability, decent GDP growth and prudent fiscal and monetary policies keeping the carry in check. We target USD/KZT 310 by the year end.

Local bond yields do not look that enticing with Euroclear/Clearstream story developing slowly

Turkey Geopolitical risks, large external imbalances, persistently high inflation in comparison to CBT rates and residents’ inclination to hold FX deposits have all been factors weighing on TRY performance. Despite the lira cheap valuation, we look for a gradual USD/TRY uptrend as excessively high inflation puts some appreciation pressure on the real TRY exchange rate partly offsetting the decline in the nominal lira rate. USD/TRY to reach 4.10 by the year-end.

The recent TRY decline put a halt to the USD-TRY xccy and TURGB curves re-steepening. We see a limited scope for material steepening as TRY softness limits the potential for policy normalization (ie, rate cuts). An improvement in US-Turkey relations (potential agreement on North Syria issue) may lead to an one-off curve steepening. Limited TURGB supply pressure in coming 3 months after the heavy borrowing in February should provide some relief.

Source: ING


6

ING main trade recommendations

FX and rates trade recommendations Entry

date Entry level

Exit level S/L Rationale

FX and rates

Receive 1y1y HUF forward swap 16 Feb 2018

0.49% 0.24% 0.61% We see the outlook for the NBH as the most mispriced by the market among other CE3 countries. The market is currently pencilling in close to 60bp worth of rise in 3-month Bubor by end-2019 vs our call for no change in the interbank rate this year and next. The NBH remains inherently dovish. The subdued inflation further strengthens its case while any pre-mature sharp rise in Bubor would lead to material currency strengthening and also negatively affect floating rate mortgage paying households. Front end HUF rates should decline. See EM FX & Rates Trader for details.

Narrowing 1y2y PLN-CZK forward swap spread

13 March 2018

0.69% 0.39% 0.82% The approach to rate hikes from NBP (hike-averse) and CNB (hike-prone conditional on CZK) do not justify current market pricing by each central bank by 2020. We only look for one hike by the NBP vs five hikes by the CNB. With EUR/CZK not moving much, the CNB will eventually have to hike to tighten monetary conditions. In Poland, the CPI shouldn’t breach the upper tolerance band of 3.5%, allowing the NBP to remain hike averse. Hence, 1y2y PLN-CZK spread should narrow. See EM FX & Rates Trader for details.

Short EUR/PLN via 6-month EUR/PLN leveraged put spread Buy 6m put with a strike at 4.2000, sell double the notional of 6m put with a strike at 4.1000. The cost is 0.25% of notional (spot ref. 4.2270).

22 March 2018

4.2270 4.1000 We fade the recent move in EUR/PLN higher as the dovish MPC re-pricing channel seems exhausted. Solid Polish activity data should drive the undervalued PLN higher (PLN is cheapest CE3 currency). We also expect the MPC to prefer a stronger PLN to increasing interest rates as a means to tighten monetary conditions should it be necessary. We target EUR/PLN 4.10. The structure offers an attractive cost return ratio of 1:10. The position starts losing money if EUR/PLN is below 4.00 (which we see as unlikely). See EM FX & Rates Trader for details.

Sell USD/CZK via 1-year downside seagull We provide a fresh updated pricing for a 6m alternative: Buy 6m put with strike USD/CZK 19.90, sell 6m put with strike USD/CZK 19.00, sell 6m call with strike USD/CZK 20.90); Zero-cost (spot ref. 20.51); Max potential return 4.5%

5 Dec 2017

21.61 19.50 Short USD/CZK has been our top FX trade for 2018. The position reflects our two high conviction views: (a) bullish EUR/USD outlook, targeting 1.30; and (b) the CNB generated CZK strength (EUR/CZK to move below 25.00 by the year end). The CNB is an outlier in the global central banking space, being an institution which desires some FX strength. With EUR/USD structural bull trend under way and the ECB policy normalization to push EUR/USD further up, USD/CZK should fall by around 7% this year. See 2018 FX Outlook (page 2) for details.

Source: ING

Prepared jointly with ING FX Strategy team Chris Turner, London +44 20 7767 1610

Petr Krpata, CFA, London +44 20 7767 6561


7

ING main trade recommendations

FI trade recommendations Entry date Current level Exit level S/L Rationale

Domestic curves

Sell DBR0.5 28 and Buy POLGB2.75 28

23 Mar 2018

275bp 250bp 285bp POLGB’s 10y spreads vs the German curve tightened in early 2018. Scope for Bund spreads tightening in 2Q18 is still present. Markets should price less than 40bp of hikes for 2019 given the dovish MPC stance. Most important arguments are lower net borrowing needs due to better budget and high MinFin’s cash buffer.

Buy TURKGB10.6 26 and Sell RFLB7.75 26

23 Mar 2018

550bp 450bp 575bp Trending in recent months has been the rate cut led rally out of Russia, versus the ongoing Turkish rate elevation story. And Russia has been an outperformer, at -0.8% over the same period, in contrast to Turkey at -2.0%. We think the time has come to begin to fade this trade back in the other direction, with the bulk of the performance coming from the Turkish leg. At the worst, the trade offers good running carry.

Buy ROMGB5.8 7/27 and Sell HGB3 10/27

23 Mar 2018

185bp 150bp 200bp Up until the turn of the year dominant themes centred on concession building in ROMGBs versus a persistent richness build in HGBs. The performance of ROMGBs since has been helped by a more benign rate hike discount. This has helped to engineer a 60bp outperformance vs HGBs in the 10yr. We’d stick with the recent trend. ROMGBs remain vulnerable, but HGBs don’t have a concession protection built.

Buy HGB2 10/27 and Pay 10yr IRS (long ASW)

23 Mar 2018

48bp 35bp 60bp More material increases or decreases in back-end HUF rates and yields should be largely a function of core yields as the NBH now targets a stable spread between 10yr HGB and bund. Asset swaps at the long end are wide though, and we position for some tightening. HGB 27A vs 10yr IRS to decline towards the 40bp level.

Hard currency

Buy ISCTR 6.125% 2024 vs AKBNK 5.125% 2025

23 Mar 2018

350bp 300bp 380bp ISCTR is our pick of the Turkish banks on fundamentals With an NPL ratio of 2.1%, a CT1 ratio of 12.2% and its status as the largest private bank in Turkey, we do not feel that a pick-up of 60bp vs AKBNK is justified. This bond is highly liquid ($1.25bn issue size) and provides good carry.

Buy QNBFB 4.875% 2022 vs TCZIRA 5.125% 2022

23 Mar 2018

300bp 250bp 350bp QNBFB, despite its status as a second-tier bank, benefits from its ownership by QNB (largest Qatari bank, rated A+), which regards it as a strategic investment. For those who worry about the political trends in Turkey, this represents a good way of gaining Turkish spreads while substantially reducing Turkey-driven event risk.

Buy KZOKZ 5.75% 2047 vs KAZAKS 6.5% 2045

23 Mar 2018

300bp 250bp 330bp KMG remains a solid company, despite a modest increase in leverage top a manageable 2.2x. It also performs a vital state function as the main integrated gas company in Kazakhstan, backstopped by its sovereign owner. For those looking for duration, this bond is close to one-year wides against the sovereign of 85bp, which represents an attractive entry point.

Buy ROMANI 2.375 27 and Sell BGARIA2.625 27

23 Mar 2018

75bp 45bp 90bp The good Bulgarian fiscal story led to a series of rating agency upgrades. ERM-II should be another mechanism in securing prudent policies. So, while contemporaneous fundamentals support BGARIA trading through ROMANI, we would now be buying into the very wide spread offered in the 27’s and 28’s. Bottom line, the current spread has overshot BGARIA positives. It trades as a 3-notch differential when in fact it’s a 1-notch spread.

Sell RUSSIA4.75 5/26 and Buy AZERBJ4.75 3/24

23 Mar 2018

65bp 40bp 75bp A “Stable” outlook from all rating agencies means no external drivers for AZ sovereign bonds apart from the high oil price. Only stronger growth and healthy banks will help to lift ratings. We see opportunity in tactical/opportunistic “longs”, especially if spreads widen further.

Source: ING

Prepared jointly with ING EMEA Debt Strategy team Padhraic Garvey, London +44 207 767 8057


8

Ready, aim, invest Eurozone investment demand has risen to the highest levels since the financial

crisis and is likely to lead to increasing FDI inflows into the CEE region.

The CEE region is well positioned for ‘near-shoring’ FDI inflows, especially as the proposition shifts to business process outsourcing (BPO) from manufacturing.

Geographical links, high quality human capital and productivity are the main advantages over the likes of China and India. The provision of EU funds also helps.

Eurozone outward FDI prospects much improved… After years of poor economic performance, the Eurozone economy has started to grow at a surprisingly strong pace. GDP growth accelerated to 2.3% in 2017 with domestic demand improving significantly. We expect GDP growth to come in even stronger this year at 2.4%. And even though investment started its recovery last year, there is still plenty of room before it reaches pre-crisis levels. Capacity constraints are currently being reached, meaning that investment will be a necessity to keep up with strong new orders for European businesses.

Financial conditions remain very accommodative and the strengthening of the European banking sector makes for easier borrowing conditions. This has caused the investment outlook to improve significantly, with businesses indicating that demand for investment is at the highest level since the crisis. Growth in investment is not limited to domestic economies though, investment at home and abroad is very correlated. This means that Eurozone outward FDI will likely benefit from the positive investment environment.

Real estate continues to be the dominant sector for outward FDI into the region and saw a jump in FDI in 2017. Investment in automotive and transport services has recently been adding to the pickup. Energy investments, both renewable and fossil, have not yet seen levels of FDI pick up to previously seen numbers.

With Eurozone investment demand rising, we expect FDI to CEEs to improve further. With about 18% of total value added in CEE countries for Eurozone final demand, improving Eurozone GDP will surely help CEE investment trends. This should be helped by near-shoring gaining attractiveness, perhaps helped by global trade uncertainties emerging recently. Secondly, growth in the CEE economies is set to continue to outperform that in western Europe in the longer run adding to attractiveness for investment. But a decade after the last FDI boom, where should companies invest?

Fig 1 Western Europe FDI to CEE (US$m)

Source: FDI Intelligence

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Eurozone businesses are indicating that demand for investment is at the highest level since the crisis

But a decade after the last FDI boom, where should companies invest?


9

The FDI proposition Fig 2 Go East!

Source: ING

Fig 3 What the EMEA region offers to potential FDI investors Local strengths Sector expertise/positioning Local challenges

CE4

Czech Republic Favourable economic outlook Automotive, machinery, electrical equip. Labour scarcity, wage growth Limited restrictions for dividends outflow Increasing productivity Limitations for importing foreign workers

Hungary Largest FDI stock in CEE Automotive, Electronics, SSC Labour shortage, strongly rising wages Lowest corporate income tax in EU One of the most integrated in the GVC Slightly eroding competitiveness

Poland Nearly 50% of CE4 domestic demand Shared services/IT Uncertain legal environment Vast workforce (16m + 1m migrants) Manufacturing (diversified) Labour shortage, but limited wage growth

Romania High GDP growth ratios Autos, BPO, IT&C, Agricultural potential Volatile fiscal legislation Second lowest labour cost in the EU High domestic value added for exports Poor infrastructure, regional disparities

Other Central & Eastern Europe

Bulgaria 10% corporate income tax BPO and IT, automotive, chemical Rule of law and corruption issues Lowest labour costs in the EU Fast competitiveness gains Tricky geopolitical balancing act

Croatia High quality infrastructure Tourism, shipyards, electronics Low labour participation and high wages Unique geostrategic position Relatively high productivity level Fluid politics, fragmented parliament

Serbia Untapped, educated labour supply Automotive, electronics, food Kosovo issue still unsolved Committed to join the EU Pre-accession funds, privatisations Slower than expected reform agenda

Turkey Market size & growth potential Logistics, transport due to geography Political and policy uncertainty Relatively low-cost labour Government support for infrastructure Volatility in neighbouring countries

CIS

Russia Priority market given size, growth prospect Consumer, machinery, materials Demographic challenges, low productivity Relatively stable FX rate under fiscal rule Construction with gov’t infrastructure plan Geopolitical risks, sanctions, corruption

Kazakhstan State focus on economic diversification Consumer, machinery, construction Institutional weakness, corruption Prudent monetary/fiscal policy mix Energy/commodity processing, higher VA The “succession story”, local politics

Ukraine Still promising market by size Agriculture, consumer goods Local politics, corruption/vested interests Focus on EU integration, logistical links Energy efficiency, natgas technologies Weakening reforms momentum

Azerbaijan A need to diversify from oil & gas Oil & gas and pipelines, refinery Unorthodox monetary policy, oil depend. Strategic energy exporter position Agriculture, textile, consumer goods Institutional weakness, corruption

Source: ING

PolandCzech

Republic Ukraine

RomaniaHungary

BulgariaSerbia

Croatia

TurkeyAzerbaijan

Kazakhstan

Russia


10

CEE: The investment destination of choice Since the fall of Communism, the CEE region has been an important recipient of investment inflows given the proximity to Western Europe and relatively cheap labour costs. Since then the development gap between East and West has been partially closed and the initial manufacturing-driven outsourcing inflows have been recently replaced by services. Faster growth rates relative to developed markets in Europe were both the catalyst and the result of investments.

The size of the target market is considered as one of the main drivers for foreign direct investments (FDIs), while the cost of labour is viewed as the main advantage of doing business in the CEE. Labour skills are not far from those in Western Europe and represent an important advantage versus other cheap labour destinations. Recent years have also seen important progress in productivity and competitiveness across CEE - but some issues relating to institutional reforms persist.

CEE countries show strong export competitiveness for the medium tech and intermediary goods segments and are less competitive in high tech and sophisticated goods. Most CEE exports have an important foreign value added component, with CEE countries well integrated into global value chains. On services, the region is very competitive in the sophisticated segment.

Tight labour markets represent an issue that has to be addressed by authorities through structural reforms to make the recent growth sustainable. However, the outlook for investments is robust as companies in the CEE region look to extend capacities.

Fig 4 Industrial production is moving East (%-share in EU's industry gross value added (excluding construction))

Source: Thomson Reuters, Deutsche Bank

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11

Why companies choose to invest in CEE According to an Ernst & Young’s (EY) 2015 Global Investment Monitor, the largest driver for companies when considering FDI, apart from general political and legal stability, is the size of the target market, followed by infrastructure connections and then the possibility to enhance the company’s productivity.

The main advantage for the CEE is the cost of labour according to a Deloitte survey from its study on the automotive industry in CEE, while the main disadvantage is the unreliability of the legal system.

Fig 5 FDI drivers (% of responses)

Fig 6 CEE: Competitive advantages/disadvantages (% of responses)

Source: E&Y 2015 Global Investment Monitor Source: Deloitte Study, 2016 We’ll use the key findings of these surveys as a lens through which to evaluate the investment proposition in CEE a little later in this report. But first we’ll take the temperature of local businesses in the CEE region.

What do local managers feel about investment trends in their own countries and how is that split between manufacturing and services?

Investment outlook remains supportive According to the EIB Investment Survey 2017, over 40% of companies in the manufacturing sector in CEE locations are planning to increase investment in the current financial year with Hungary topping the rankings. Nearly 40% of services companies are planning to boost investment this year, with Croatia leading the pack.

Fig 7 Investment plans for this year in manufacturing? Fig 8 Investment plans for this year in services?

Source: EIB Investment Survey 2017 Source: EIB Investment Survey 2017

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On a three-year horizon, the main focus for investments seems to be the need to expand capacity for existing products followed by developing new products and replacing the existing capacities in the manufacturing sector. For the services sector, the priorities in investment for the three years ahead are mainly on expanding capacity followed by the intention to broaden the range of services offered.

Fig 9 3-year investment plans in manufacturing Fig 10 3-year investment plans in services

Source: EIB Investment Survey 2017 Source: EIB Investment Survey 2017

The EIB survey finds that the investment outlook has improved and a larger number of firms plan to invest into expanding capacities.

This is the most important driver of investments as firms in the CEE tend to invest less in intangible assess versus the EU average. The lack of labour and skills and the uncertain outlook are mentioned as the main barriers for business by the EIB study.

Which sectors are hot? According to the 2017 EY European Investment Monitor1, the manufacturing FDI pipeline in Europe expanded by 6% in 2016 versus the previous year, with CEE having a 49% share of total FDI in Europe manufacturing from 45% in 2015 and up by 15% YoY.

Fig 11 Most projects concentrated in software and business services…

Fig 12 …but automotive creates most of the jobs

Source: EY European Investment Monitor (EIM), 2017 Source: EY European Investment Monitor (EIM), 2017

In Europe, high-end services are the hottest sector, but manufacturing is creating most of the jobs. Hence it tends to get more of the attention and more government incentives – an important consideration when deciding in which location to invest.

1 Full report from E&Y here: http://www.ey.com/Publication/vwLUAssets/ey-attractiveness-europe-2017/$FILE/ey-attractiveness-europe-2017.pdf

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13

Making the decision Domestic markets: fast growing and converging Countries in Eastern Europe have posted much faster GDP growth rates versus the Eurozone over the past twelve years. This has helped narrow the standard of living gap and led to an acceleration of the real convergence process. With the convergence process set to continue, CEE markets will become ever more appealing for companies offering top-end products and services, such as private healthcare and financial services.

Fig 13 Population vs GDP growth (%) Fig 14 GDP per capita converging (ppt, EU27=100)

Source: Eurostat, ING Source: Eurostat

Growth rates in CEE countries are also beneficiaries of relatively large sums of EU funds aimed at helping recipients close the development gap more quickly. EU funds are helpful in several areas: from upgrading infrastructure to retraining labour resources, from research and development to agriculture and rural development.

Fig 15 FDI slowdown replaced by inflows of EU funds Fig 16 FDI Regulatory Restrictiveness Index

Source: WB Source: OECD And OECD data suggests that regulatory constraints for FDI are below the OECD average for most of the CEE countries (with the exception of Poland), supporting significant inflows since the fall of the Iron Curtain.

Logistics and infrastructure: the proximity advantage Recently the region has also benefited from its status as a top destination for outsourcing services as companies are looking east for cost optimisation and labour resources.

The main advantage of the CEE versus other servicing outsourcing destinations is the business environment. And it is in close competition with Asia for financial attractiveness. Labour availability and skills are the main disadvantage of the CEE, likely due to tight labour market and unsupportive demographic trends.

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14

Fig 17 2017 Global Services Location Index Fig 18 Index of human capital (based on schooling years)

Source: A.T. Kearney Source: Penn World Table Good transport connections to Western Europe are also key for CEE exports. Consequently, the time to export is relatively good, although some countries lag, likely due to bureaucratic procedures. This issue is usually crucial in global value chains.

Fig 19 Rail lines (km/square km of land area) Fig 20 Time to export (no of days)

Source: ComNet Source: CompNet Productivity in CEE: Looking for a boost Most countries in Eastern Europe have made significant progress in improving competitiveness over the past ten years, according to the World Economic Forum (WEF), leading to a surge in labour productivity.

Fig 21 WEF global competitiveness index (7 is the best) Fig 22 Leading to a surge in productivity

Source: WEF Source: Eurostat

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15

There is more room to invest in order to enhance the productivity as the CEE has mainly been a destination for investments seeking a cheap labour force. Nevertheless, productivity remains significantly above competing FDI destinations.

Fig 23 Productivity below EU average across the sectors… Fig 24 …but TFP* still strong versus competition

Source: Eurostat, ING *Total Factor Productivity at current purchasing power parity Source: Eurostat

Integration: CEE’s position in the global value chain Participation in the global value chain (GVC) index summarises the importance of the global supply chain for the country. In other words, it shows the integration level into GVCs and is somewhat similar to a trade openness indicator. The participation index has to be read in conjunction with the position index, as two countries can have identical values in the GVC position index while having very different degrees of participation in GVCs.

The position in the global value chain is defined as the log ratio of a country’s supply of intermediates used in other countries’ exports to the use of imported intermediates in its own production. This index captures a country’s position (i.e., upstream or downstream) in the production chain and allows cross country comparisons to be made. If the country tends to specialise in upstream segments of a production chain (e.g., typical for countries with important natural resources), the numerator tends to be large. On the other hand, if it lies downstream, then the denominator is large.

Fig 25 GVC participation: CEE well integrated Fig 26 GVC position: downstream on value chain

Source: CompNet Source: CompNet CEE countries are well integrated within the single market and the share of imported raw materials in their production is relatively high - which puts them on the downstream side of the global value chain.

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Key challenge: Labour market constraints ING clients tell us that one of the key challenges to the CEE investment proposition is the availability of labour. Finding employees has become a bottleneck, generating knock-on effects such as high turnover and increasing labour costs.

These concerns are echoed in surveys, where labour is increasingly cited as a factor limiting growth in the manufacturing sector. Most countries in the region are near full employment, hence structural reforms are needed to increase labour force participation - which hovers below the EU average for most of the region.

At the same time, many governments have imposed higher minimum wages to share with voters the benefits of foreign investment. In some cases, this threatens the competitiveness of labour intensive investments. Nevertheless, labour costs are still very low compared to the EU average.

Fig 27 Labour force becomes scarce Fig 28 Wages – a fraction of EU average (% of EU avg)

Source: Eurostat Source: Eurostat, ING

Except for the Czech Republic, labour force participation is below the EU average – albeit on an improving trend. Thus not only higher wages are needed, but also labour market reforms. Or maybe a complete re-think of labour market policy is needed to boost potential growth.

Indeed, the labour market situation in some cases resembles that of Germany in the early 2000s, when it was called ‘the sick man of Europe’. Root and branch reforms, known as Hartz reforms, were needed to break the deadlock. If little progress is made here, investors will look at the next wave of EU enlargement targeted for 2025 – with non-EU countries in the Balkans enjoying the most significant labour market slack.

Fig 29 Higher minimum wages not enough… Fig 30 …to boost participation; structural reforms needed

Source: Eurostat Source: Eurostat, ING

Providing the right skills in a changing economic environment is the key challenge looking forward for the CEE countries. The growth model based on cheap labour is not bullet proof as rising labour costs (due to tight labour market and government policies to hike minimum wages) are exposing the low skilled labour force either to automation or to business relocation to cheaper destinations.

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17

Corporate tax levels: very attractive The CEE region also benefits from a friendly corporate tax environment. Hungary stands out with the lowest level in Europe, followed by Bulgaria. All CEE countries have corporate tax levels below the EU average and significantly below the averages for other regions of the world.

Fig 31 Corporate tax rates in Europe vs other regions of the globe (%) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Bulgaria 23.50 19.50 15.00 15.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 Croatia 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 18.00 Czech Republic 31.00 28.00 26.00 24.00 24.00 21.00 20.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 France 34.33 34.33 33.83 33.33 33.33 33.33 33.33 33.33 33.33 33.33 33.33 33.33 33.33 33.30 33.33 33.00 Germany 39.58 38.29 38.31 38.34 38.36 29.51 29.44 29.41 29.37 29.48 29.55 29.58 29.72 29.72 29.79 30.00 Hungary 18.00 16.00 16.00 16.00 16.00 16.00 16.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 9.00 9.00 Italy 38.25 37.25 37.25 37.25 37.25 31.40 31.40 31.40 31.40 31.40 31.40 31.40 31.40 31.40 24.00 24.00 Netherlands 33.00 34.50 31.50 29.60 25.50 25.50 25.50 25.50 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 Poland 27.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 Romania 25.00 25.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 Russia 24.00 24.00 24.00 24.00 24.00 24.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 Serbia 14.00 12.33 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 15.00 15.00 15.00 15.00 15.00 15.00 Turkey 30.00 33.00 30.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 22.00 Ukraine 30.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 21.00 19.00 18.00 18.00 18.00 18.00 18.00

Africa average 32.36 32.36 30.79 30.73 30.52 28.75 28.83 28.49 28.64 29.07 28.37 27.85 28.17 28.06 28.21 28.26 Americas average 31.29 30.55 30.52 29.97 29.27 28.84 28.82 28.28 29.31 28.67 28.35 27.77 27.61 27.81 28.29 27.89 Asia average 30.19 30.35 29.79 28.99 28.34 26.24 25.37 23.72 22.91 22.72 22.13 22.00 21.98 21.41 21.04 21.21 EU average 27.95 26.69 25.15 24.83 23.97 23.17 23.11 22.93 22.70 22.51 22.75 22.39 22.15 22.09 21.33 21.29 Europe average 26.72 25.60 24.03 23.70 22.99 21.95 21.64 21.46 20.83 20.44 20.60 20.42 20.05 19.97 19.53 19.48 Global average 29.42 28.95 28.00 27.55 26.96 25.66 25.32 24.65 24.52 24.38 24.15 23.85 23.74 23.58 24.04 24.00 OECD average 30.08 29.28 28.37 27.67 27.00 25.99 25.64 25.70 25.42 25.18 25.32 24.98 24.77 24.69 23.95 23.50

Source: KPMG

Nevertheless, stability and transparency of the political, legal and regulatory environments is deemed much more important than the relative tax advantage by companies that invest abroad.

Regulation and sensitive micro level issues Corruption has frequently been a problem affecting investments and has been more pronounced in countries that joined the EU in the later stages. In most cases, this is combined with a weak judiciary system.

When adding to the above concerns that in some countries the progress achieved since joining the EU might be partially rolled-back, then the investment outlook may not prove so bright. In terms of regulatory quality and government effectiveness, there is a sizeable gap between those CEE countries that joined the EU in the first enlargement phase and those at later stages. As Serbia is still in a negotiation phase to join the single market, we might witness visible progress in the near future.


18

Fig 32 CEE countries still need to improve their institutions, but are scoring better than Germany on freedom of trade*

*An index comprising: (i) Credit market regulations; (ii) Labour market regulations; and (iii) Business market regulations Source: CompNet

In terms of the legal system, property rights and freedom of trade, the gap to developed markets in Europe is relatively small. Typically this is because these reforms were made as a pre-condition to joining the EU.

In order to secure a high rating on freedom of trade, a country must have low tariffs, easy clearance and efficient administration of customs, a freely convertible currency, and few controls on the movement of physical and human capital.

Fig 33 Market determined prices* Fig 34 Start-up cost as a percentage of gross national income (GNI) per capita (%)

*Index assessing market prices Source: CompNet

Source: CompNet

In terms of government intervention in price setting, most CEE countries are more liberal relative to Germany for example. In order to score highly in this portion of the index, countries must allow markets to determine prices and refrain from regulatory activities that retard entry into business and increase the cost of producing products.

Governments must also refrain from “playing favourites”, that is, from using their power to extract financial payments and reward some businesses at the expense of others. The cost of starting up a new business is relatively heterogeneous.

It takes more time on average in the CEE to enforce a contract measured by the number of days from filing of the lawsuit in court until the final determination and, in appropriate cases, payment.

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Nevertheless, in most cases, registering a property is easier relative to Germany. The time required to start a business is relatively business friendly in most of CEE economies. Yet, likely due to legislative caveats, it takes considerably more time from the filing for insolvency in court until the resolution of distressed assets.

Fig 35 As young democracies, CEE countries need to improve legislation to become more business friendly

Source: CompNet

The comparative advantage: Add value or lose out? To asses export competitiveness, we use the Revealed Comparative Advantage (RCA) index which measures the importance of a sector in the export bundle of a country with respect to the importance of that sector in worldwide export flows. The benchmark threshold for this indicator is 1. If the RCA is higher than unity, the country is said to have a comparative advantage in the trade in the sector for which it was computed.

Fig 36 Revealed Comparative Advantage for different products and services

Source: Compnet

Based on the CompNet database, the region’s exports are competitive in the medium high tech and intermediary goods segments and on sophisticated services and less competitive on high tech and sophisticated products. This is also supported by anecdotal evidence with car components being widely produced across the CEE and exported to Western Europe for assembly. The relative competitiveness has recently attracted large business process outsourcing projects (BPO) with market reports suggesting that there is much more upside potential.

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3.0

3.5

4.0

4.5


Time Required to Enforce A Contract (years, lhs) Time to Resolve Insolvency (years, lhs)

Time Required to Register Property (days, rhs) Time Required to Start A Business (days, rhs)

0.0

0.5

1.0

1.5

2.0


RCA in high-tech industries exports 2014 RCA in Medium High Tech Exports 2014 RCA Exports, Intermediates 2014

Goods Export sophistication Index 2014 Services Export sophistication Index 2011


20

Fig 37 Price and non-price competitiveness* Fig 38 Risk of being crowded out by China (%)

Source: CompNet. *Euros per unit of utility Source: CompNet Non-price competitiveness in the CEE is very strong as the geographic position likely weighs in, but also it scores far better on human capital, regulatory and productivity metrics. Nevertheless, exports from the CEE face significant overlap with China and risk being crowded out in some of the export markets, particularly where countries are less integrated into GVCs and export goods are lower value added.

Summing up The CEE region should continue to attract significant investment and is becoming the workshop of Europe. Competitiveness driven by low wages and EU membership providing a strong institutional anchor for safeguarding foreign investments make a compelling offering.

The geographical proximity to the Eurozone is also a clear advantage, but the CEE region stands out versus other developing markets for human talent and high productivity. To keep the current growth rate sustainable, these countries will have to accelerate reforms, especially those related to the labour market.

In particular, efforts to improve labour force participation and raise educational standards will be required to fend-off automation risks as labour costs converge towards EU averages. If not, companies will increasingly turn to the next wave of EU membership - with the Balkans targeting single market membership by 2025 and offering significantly more labour market slack.

Ciprian Dascalu, Bucharest +40 31 406 8990 Bert Colijn, Amsterdam +31 20 563 4926

EMEA Economics Team

-40-20

020406080

100120140

Non-price competitiveness Price competitiveness

0

2

4

6

8

10

12

14


21

Focus: FDI prospects in Russia and Turkey Russia Dmitry Polevoy, Chief Economist, Russia & CIS

Inward FDI flows in Russia (US$bn) Recovering after the 2014-15 shock, but upside remains FDI has recovered after the 2014-15 shock, but not fully

Soft GDP outlook, sanctions and geopolitics have shifted the regional structure from West to East, and are likely to weigh on FDI further…

…but Russia remains top-2 CEEMEA market for many multinationals due to market size, prudent economic policies, stable RUB

The FDI topic has always been in the spotlight for Russia, deemed as suffering a lack of investments to diversify the economy. Yet, distinguishing ‘real’ FDI from money coming back from offshore zones, where it was parked before, is an issue. If still looking at inward FDI, after a solid recovery in 2010-13 following the GFC-driven drop in 2009, FDI fell sharply in 2014-15 due to a deterioration in the external backdrop. Plunging oil prices and sanctions eroded the GDP outlook and fuelled fears of capital controls, all driving the FDI drop in 2015. A prudent policy response and flexible RUB helped to restore some confidence, but not to the full extent and with an eye-catching shift in regional distribution from West to East. Yet, Rosneft privatization affected the 2016 print. The low growth outlook and geopolitical risks/sanctions weigh on FDI, yet many foreign companies still see Russia as a priority market in CEEMEA (after Poland) for the next three years (DT Global Business Consulting survey in Dec-17). Over 2016-17, 25-30% of corporations have reported capex plans to localise production/import-substitute and gain market share, and they plan to proceed in 2018. In 2014-17, mining (53%), manufacturing (19%), finance/insurance (16%) and trade (12%) took most of the FDI. There is likely to be a promising market in agriculture, consumer, pharma, construction materials and transport/machinery.

Source: CBR

Inward FDI by regional distribution (% share over period)

Source: CBR

Turkey Muhammet Mercan, Chief Economist, Turkey

FDI outlook since 2003 (12M rolling) FDI not in good shape currently Turkey’s FDI stock is well below that of other CEE countries

Logistics, transport energy, telecom and government support for infrastructure provides investment opportunities

Long-term stability and reforms required to accelerate flows

The successful implementation of first generation reforms following the 2001 financial crisis supported an acceleration in FDI inflows in the early 2000s. Investment opportunities with a large market size and growth expectations based on population and income growth prospects as well as the potential to reduce production costs by competitively priced inputs and labour also contributed to the FDI outlook. But, the momentum has lost pace in recent years. In addition to usual factors (complex bureaucratic procedures, dependence on energy imports, geopolitical uncertainties), the most important factor that has weighed on FDI appetite towards Turkey is a shift in the investment climate. In other words, reasons adversely affecting the FDI outlook range from the lack of a level playing field between foreign investors and locals, tax policy, rigidities in the labour market and the domestic political developments as well rising geopolitical sensitivities. The weak currency and rising/elevated inflation do not help either. But Turkey maintains efforts to make its investment environment more attractive and move up the ranks on the World Bank's Ease of Doing Business index. Improvement in the long-term investment climate and a strong structural reform programme is likely to increase FDI inflows sustainably. Logistics and transport due to geographic position, energy, telecom as well as government support for infrastructure offer opportunities.

Source: CBT, ING Bank

FDI by sectors (btw 2002-17, % share)


0

10

20

30

40

50

60

70

2010 2011 2012 2013 2014 2015 2016 2017f

-10%-5%0%5%

10%15%20%25% 2009-13 2014-17

0

12

24

36

48

60

72

84

0

4

8

12

16

20

24

28

12-0

308

-04

04-0

512

-05

08-0

604

-07

12-0

708

-08

04-0

912

-09

08-1

004

-11

12-1

108

-12

04-1

312

-13

08-1

404

-15

12-1

508

-16

04-1

712

-17

Net FDI (USD bn) Net FDI (as % of c/a deficit, rhs)

Finance and insurance

37%

Manufacturing23.8

Utilities13%

Communication9%

Wholesale and retail trade

6%

Construction & Real Estate

5%

Transport and storage5%


22

Looking for value in EMEA FX We increase our koruna fair value estimate to EUR/CZK 25.20. Within CE3, PLN is

the cheapest even adjusting for the unaccounted migration effect on productivity.

We are long both CZK and PLN in our strategy section. Among the high yielders, TRY is the cheapest while ZAR is the most overvalued against USD.

Yet, the lira’s apparent 15% undervaluation is no reason to go long as the persistently high inflation corrects the misvaluation over time.

We employ our Behavioural equilibrium exchange rate (BEER) model framework and provide the latest update on the medium-term fair values of EMEA currencies. We look at CE3 FX (we exclude RON as the managed nature of the currency does not allow us to the use the model effectively) and three EMEA high yielders (TRY, ZAR and RUB). The valuation summary is provided in Figure 39.

Fig 39 PLN is the cheapest CE3 currency while ZAR is the most expensive high yielder

Source: ING

Lowering EUR/CZK fair value; PLN the cheapest CE3 FX CZK: We increase our estimate of koruna fair value to EUR/CZK 25.20 We revise our estimate of the medium-term EUR/CZK fair value level lower by c.1%, from 25.50 to 25.20. The revision is due to: (1) improved Czech labour productivity relative to the EZ; and (2) a change to the way fair value is derived, following the CNB’s exit from the FX floor regime in April last year.

On the former, the EUR/CZK fair value has declined by close to 1% since the CNB exit from the FX floor, with the key downward driver (stronger CZK fair value) being the relative growth in labour productivity (Figure 40). We also note that there has been some upward revision to Czech labour productivity data, with 2016 and 1H17 numbers being stronger than initial estimates. This has also led to an increased ex-post CZK fair value.

On the latter, we previously derived EUR/CZK fair value (and the cross’ sensitivity to its drivers) over a sample period ending at 3Q13. This is because the FX floor was introduced in 4Q13, with FX interventions in following years distorting the natural EUR/CZK reaction function. However, with EUR/CZK being free floating yet again (for around a year), we again explore estimations of EUR/CZK fair value over the full sample period. As Figure 41 shows, there is a degree of difference between the two estimates (the full sample period

-25%-20%-15%-10%

-5%0%5%

10%15%20%25%

EUR/PLN EUR/HUF EUR/CZK USD/TRY USD/RUB USD/ZAR

+/- 1.5 standard deviation band Misalignment

%, CEEMEA real exchange rates misalignments vs their medium-term BEER fair values

CEEMEA currency undervalued / EUR or USD overvalued

CEEMEA currency overvalued / EUR or USD undervalued


23

and the restricted sample period), with the difference in fair value increasing from c.3% in the years prior to the FX floor to 4.5% on average since the FX floor was introduced.

Given that it is still too early to switch to the full sample period estimate as it contains: (1) a 14-quarter period of distorted EUR/CZK reaction function from the FX floor; and (2) the natural post FX floor correction in EUR/CZK and the existing positioning-related distortion adjustments from 2Q17 onwards, we switch to an average of the two fair values to gauge the equilibrium EUR/CZK level, which is currently at 25.20 (suggesting that EUR/CZK is still c.1% above its medium term fair value – Figure 42). In this way, we react to the change in CZK regime yet still account for distortions related to the FX floor.

Fig 40 Relative productivity driving EUR/CZK fair value lower

Fig 41 A degree of difference in estimates of fair values

Source: ING Source: ING

Looking ahead, we expect EUR/CZK fair value to continue modestly declining, largely due to the upward pressure on Czech labour productivity. With the Czech labour market very tight (the Czech Republic currently enjoys the lowest unemployment rate in the EU), the next step for local companies to increase or retain profit margins (the latter is more probable given rising wage pressures) is to improve productivity.

We expect the downward pressure on the still overvalued EUR/CZK to continue (due in large part to upcoming CNB interest rate increases) and reiterate our short EUR/CZK recommendation (FX Trader) and our trade of 2018 in short USD/CZK (see 2018 FX Outlook).

PLN: Still the cheapest CE3 currency even if we adjust for migration PLN remains the most undervalued CE3 currency, being cheap by c.4% vs EUR. As Figure 43 shows, persistent PLN cheapness has been in place since late 2015, when the current ruling party (PiS) won parliamentary elections, eventually followed by the credit rating downgrade in early 2016 (negative for both POLGBs and PLN). Since then, EUR/PLN fair value has remained stagnant, but still low enough for EUR/PLN spot not to catch up with it (following the 4Q15/1Q16 sell off). The adjustment in real EUR/PLN exchange rate has largely been through nominal PLN levels as the inflation differential has remained largely unchanged over recent years, thus not exerting material upward or downward pressure on the real exchange rate (unlike EMEA high yielders – see below).

We also note potential distortions to the measures of Polish labour productivity following the influx of workers from Ukraine over the past years. As these workers are not accounted within official measures. Our economists provide an alternative migration adjusted measure of Polish labour productivity. As Figure 44 shows, the migration adjustment lowers labour productivity. Translating this into our BEER model fair value estimate, the migration adjustment lowers PLN fair value by 1% vs EUR, in turn making EUR/PLN 3% overvalued vs the 4% overvaluation if we don’t adjust for the migration

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

Productivity Terms of Trade Govconsumption

Total BEER fairvalue

Contribution of various factors towards EUR/CZK BEER value value from Q2 2017 (when the CNB FX floor ended)

-4%

-2%

0%

2%

4%

6%

55

65

75

85

95

1999 2002 2005 2008 2011 2014 2017

Full sample EUR/CZK fair value Pre FX floor sample fair value

% difference, rhs Fixed period averages, rhs

Index, EUR/CZK fair value % difference bettween two fair value measures and fixed period averages


24

factor. Still, and even after the adjustment (which would raise EUR/PLN fair value from c.4.05 to 4.10), PLN remains the cheapest CE3 currency, as per Figure 39.

Fig 42 EUR/CZK is still 1% above its fair value Fig 43 Persistent PLN cheapness in place since late 2015


We also note that if any currency pair is close its fair value this does not mean it cannot under- or overshoot the equilibrium level. It can and EUR/PLN past price action is an example of this. We retain our positive outlook on PLN and expect EUR/PLN to converge towards 4.10 by year end. As per our EM FX & Rates Trader, we are short EUR/PLN via a 6 month leveraged put spread.

HUF: NBH compressing EUR/HUF around its fair value The NBH has managed to compress HUF around its fair value (Figure 45), with EUR/HUF trading very close to the medium-term equilibrium level over recent quarters and consistently showing a minimum degree of mispricing (as opposed to its CE3 peers). Although we have seen some modest decline in EUR/HUF fair value since 2016 (by c.2%), this was largely matched by the appreciation of HUF vs EUR in real terms over the same period. The real exchange rate appreciation was predominantly delivered by higher Hungarian inflation vs the euro area, allowing the nominal EUR/HUF to remain unchanged – something the NBH fully welcomes.

Fig 44 Migration adjusted labour productivity Fig 45 NBH compressing EUR/HUF around its fair value

Source: ING, OECD Source: ING

The fact that the forint has not been materially misvalued (predominantly on the rich side) has also allowed the NBH to so far successfully lean against material and persistent EUR/HUF downside below the 300 level. This contrasts with CZK, where the CNB was fighting against a heavily undervalued currency during the FX intervention period. (The difference between the two is evident in Figures 42 and 45).

-15%

-10%

-5%

0%

5%

10%

15%

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Real EUR/CZK deviation away from the BEER fair value + / - 1.5 standard deviation

% deviation of real EUR/CZK away from the BEER fair value

EUR/CZK still modestlyabove its fair value

75

80

85

90

95

2010 2011 2012 2013 2014 2015 2016 2017

BEER EUR/PLN fair value Real EUR/PLN

PLN has been persistently cheap against EUR since late 2015

Index, Q2 1999 = 100

95

100

105

110

115

120

2011 2012 2013 2014 2015 2016 2017

OECD labour productivity indexMigration adjusted index, version 1Migration adjusted index, version 2 (conservative estimate)

Index, Q1 2011 = 100

-15%

-10%

-5%

0%

5%

10%

15%

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Real EUR/HUF deviation away from the BEER fair value + / - 1.5 standard deviation

Very expensive

Very cheapLimited experience of a

large HUF mispricing over the past quarters

% deviation of real EUR/HUF away from the BEER fair value


25

Yet, the NBH still has to do a fair deal of work (via various types of unconventional monetary policy measures) to fight both the solid Hungarian current account surplus as well as the general upward pressure on CEE FX from the rising EUR/USD. Precisely because of the ongoing NBH’s ultra-loose policy set up (which aims to affect both short- and long-end rates) we expect EUR/HUF to trade around its 310 gravity line in coming months, with a more pronounced move lower (close to 300) expected in the latter part of this year if the NBH does not prolong the mortgage bond QE and its MIRS programme.

TRY the most undervalued high yielders, vs rich ZAR TRY: High inflation providing room for persistent depreciation TRY remains the cheapest EMEA currency, being undervalued by 15% against USD (Figure 46). Interestingly, although we are around the spot level of the USD/TRY peak of early 2017, USD/TRY is now 7% less expensive than was the case back then (using 3.70 as an average spot in 1Q17, the cross was overvalued by 21% at the time). This is predominantly because: (a) spiking Turkish CPI has translated into lira appreciation in real terms, offsetting the lira’s nominal weakness against USD; and (b) rising USD/TRY BEER fair value due to deteriorating Turkish fundamentals.

Fig 46 Lira remains meaningfully undervalued against USD

Fig 47 Real USD/TRY didn’t raise as much as nominal rate

Source: ING Source: ING, Bloomberg

The former is best depicted in Figure 47 which shows that the rise in real USD/TRY (the nominal rate adjusted for inflation) has materially lagged the increase in USD/TRY nominal exchange rate, largely due to the spike in Turkish CPI inflation (which translated into a partial lira strengthening in real terms). Indeed, during 2017 the nominal USD/TRY exchange rate appreciated by 15%, but the pair only appreciated by 5% in real terms, reflecting the 10% inflation differential between Turkey and the US (Figure 48).

The key conclusion from the above is that the bar for the valuation to put some limit on nominal TRY depreciation is set very high as long as Turkey has double digit inflation. This partly offsets the non-negligible annual TRY fall vs USD in nominal terms and is therefore not pushing the lira too quickly into extremely stretched territory (beyond the 1.5 standard deviation band as depicted in Figure 46). In fact, based on our economists’ CPI forecasts for Turkey and US inflation for this year and next (Figure 49), the cumulative inflation differential of c.14% should by and large wipe out all of the current USD/TRY overvaluation by the end of 2019 (assuming no change in nominal USD/TRY spot).

Under current circumstances, we don’t expect USD/TRY to converge towards its medium-term BEER fair value, but rather look for the current overvaluation to persist (and be bound by the 1.5 standard deviation level). This is consistent with our end-2019 USD/TRY forecast of 4.40 which implies that the lira’s nominal deprecation should be largely offset by the high Turkey inflation, suggesting largely flat lira in real terms.

-30%

-20%

-10%

0%

10%

20%

30%

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Real USD/TRY deviation away from the BEER fair value

+ / - 1.5 standard deviation

Very expensive

Very cheap TRY is undervalued, but less than in Q1 2017

% deviation of real USD/TRY away from the BEER fair value

0%

5%

10%

15%

20%

70

120

170

220

270

2005 2007 2009 2011 2013 2015 2017

USD/TRY real exchange rate USD/TRY nom exchange rate

CPI Turkey, rhs

Index, Q1 2005 = 100 YoY%, CPI


26

Fig 48 Very high Turkey CPI partly offsetting the lira’s fall Fig 49 14% cumulative CPI differential expected over 2y

Source: ING, Bloomberg Source: ING

RUB: Modest overvaluation no reason to worry RUB has all but corrected its extreme undervaluation of 2015 and early 2016, with the currency now modestly rich against USD. As per Figure 50, USD/RUB turned from c.35% overvalued in early 1Q16 to 5% undervalued currently. With the cross’ BEER fair value largely stable since early 2017, the level and stability of the rouble exchange rate ensured the persistence of this undervaluation.

We don’t see this as worrying or a reason to go long USD/RUB as the cross’ cheapness remains relatively muted and is still far away from the 1.5 standard deviation band of 20% which would signal stretched valuation levels. With the MinFin fiscal rule structurally pushing RUB volatility lower (and modestly leaning against any overly aggressive RUB appreciation), we expect USD/RUB to stay around current levels in quarters to come.

Fig 50 USD/RUB is modestly undervalued Fig 51 ZAR is the most overvalued EMEA currency


ZAR: The most expensive EMEA currency Following its pronounced rally since November last year, ZAR is now the most overvalued EMEA currency (Figure 39), being 11% rich against USD (Figure 51). This is consistent with our view that the bulk of the rand appreciation is now behind us, and with plenty of good news already in the price (buoyed by optimism that new President Ramaphosa will enact much needed reforms to improve growth and the budget trajectory), we look for USD/ZAR moves below 12.00 to be limited and short-lived.

Petr Krpata, CFA, Chief EMEA FX and IR Strategist, London +44 20 7767 6561

-10%

-5%

0%

5%

10%

15%

20%

Nominal USD/TRY Real USD/TRY Inflation differential(US-Turkey)

% changes in various variables throughout 2017 (using quarterly data)

0

2

4

6

8

10

12

14

16

2018 2019 Cumulativedifferential over 2

yearsTurkey CPI US CPI

%YoY CPI (ING forecast) and the expected cumulative differential between Turkey and US

-30%

-20%

-10%

0%

10%

20%

30%

40%

2003 2005 2007 2009 2011 2013 2015 2017

Deviation from USD/RUB BEER fair value + / - 1.5 standard deviation

% deviation of real USD/RUB away from the BEER fair value

-30%-20%-10%

0%10%20%30%40%50%60%

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Deviation away from the USD/ZAR BEER fair value + / - 1.5 standard deviation

% deviation of real USD/ZAR away from the BEER fair value


27

Cross market performance, flows and relative value Performance and what will drive it Global emerging markets (GEMs) have managed the uptick in US Treasury yields relatively well. Improved fundamental underpinnings have helped, but a steady-eddy Fed and containment in the US dollar have been key calming factors. Total returns for USD-denominated emerging market (EM) bonds are running at -0.9% in the past quarter. But US Treasuries have returned -1.2%. It has paid to be in EM so far in 2018.

Local currency returns And it gets even better when we look at local currency performance, in particular when translated back into USD. Local currency GEMs have returned 2.6% in the past quarter when translated to USD, and within that EMEA has returned 4.4%. So it has also paid to have overweighted local currency product. We also find that total returns have been better in shorter durations, amplifying the success of FX exposures over duration ones.

Fig 52 Local currency emerging markets total returns in the past three months (%)

Source: Bloomberg, ING estimates

Fig 53 Hard currency emerging markets total returns in the past three months (%)


0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

EMEA

Americas EM

Global Intermediate EM

Global EM

Asia EM

Global Long Maturity EM

-2.5 -2.0 -1.5 -1.0 -0.5 0.0

Brazil

Russia

Global Hard Currency

EMEA

Asia EM

Latam

Turkey

Mexico


28

Hard currency returns Back in hard currency (HC) space, it has paid not to be too far out the credit spectrum in the past quarter in investment grade, as AA’s have returned -1.2% versus -1.9% for BBB. That said, EM high yield has been a decent space to be, especially in BB where returns run at -1.1% in the past quarter, albeit not a return that pays for the higher risk exposure in terms of ratio to returns.

EMEA has also outperformed in hard currency space, at -1.2% versus -1.9% for Latam in the past quarter. And Russia has been an outperformer, at -0.8% over the same period, in contrast to Turkey at -2.0%. In Latam, Mexico has dragged performance down while Brazil has outperformed. Asia has treaded a middle ground between outperforming EMEA and underperforming Latam.

Prognosis ahead We’d stick with many of these trends in the months ahead. We continue to expect the US dollar to trade relatively soft, which minimised pressure on EM generally. It also maintains favour for local currency over hard currency, where short duration works best to help maximise the FX impact. With the ECB holding pat in the coming months, most CEE central banks can also hold their nerve on rates, maintaining an EMEA preference.

Being long duration remains a pain trade generally, as we expect to see the 10yr US Treasury break into the 3% to 3.5%, and this is a factor to be taken into account for both hard currency and local currency product. Risks to this base view for EM come from a more sinister rise in market rates than we discount and/or a precipitous appreciation in the US dollar (if so, then we’d favour hard currency and shorter duration).

Emerging markets space still in favour Apart from global macro and idiosyncratic factors, flows into and out of EM funds are a key element of total performance. Last year was an exceptional one for EM inflows, as inflows continued broadly uninterrupted despite the Fed’s clear ambition to get the Funds rate significantly higher. It virtually tripled in 2017 to hit 1.5%, and will likely double again to target 3% within the next 18 months (ING view). While the impact effect of early hikes were not big for emerging markets, the odds are that the space will begin to creak as the funds rate gets ever higher.

Fig 54 Change in Assets under Management in the past quarter

Source: EPFR Global, ING estimates

Mild outflows in play EM funds have seen an inflow of 16% of assets under management in the past year (excluding the effects of total returns). The inflows process has continued in the past quarter, but it has slowed and retail has seen outflows (Figure 54).

-2.00-1.000.001.002.003.004.005.006.007.008.009.00

Total Professional Retail

EM Hard Currency Funds EM Local Currency Funds EM Blend Currency Funds Total EM

% AUM PAST QUARTER


29

In the past fortnight there was a moderate outflow from emerging markets. Mostly from retail accounts, but professional accounts have also joined in. The bulk of the outflows have been from hard currency funds. Retail has been pronounced sellers of local currency too, while the bulk of the recent inflows have been into blend and local currency funds on the part of professional investors. Notwithstanding that, an inflow theme has dominated in a quarter that has seen core rates on the rise (Figure x).

Fig 55 Change in assets under management (AUM) Fig 56 Change in assets under management (AUM)

Source: EPFR Global, ING estimates Source: EPFR Global, ING estimates

On a positive cross-asset-note, the inflows to emerging markets in the past year have been practically the polar opposite to the outflows seen from developed markets (DM) high yield (AUM -10% for 2017), a trend that has continued in the early part of 2018 right up till last week. That said, this contrast does not show up in any significant performance deficit in high yield. It has been more a case of net redemptions than outflows per se, which in fact acts to lubricate the new issuance market in DM high yield.

Allocations shift In terms of the geographic split, we note a downsizing in exposure to Russia over the period mid Q4 2017 to mid Q1 2018, although allocations have no doubt been since re-built somewhat in the wake of the new 29’s launch. Allocation to Turkey has held up quite well despite the relative underperformance seen, although the glaring local currency yield differential is maintaining a hold-on-in-there mentality.

Fig 57 Latest average investor allocations Fig 58 Average investor allocations 3 months before


A fall in allocation to Romania is also in evidence, reflecting a sell-off on the domestic market, and some residual concerns for more. In contrast, allocation to Poland has increased in the wake of a decent performance, helped by central bank policy that is intent on providing front end support. A similar story is in play for Hungary, but has been more fully valued for some time, helped by the authorities coaxing rates on both ends of the curve to the lower end of fair value tolerance.

Allocation to Hungary is down in the past quarter, but still up on the 7.8% allocation seen a year ago. New hard currency issuance has helped here, alongside domestic support for the local currency product. Allocation to Ukraine is also holding up quite well

0 1 2 3 4 5

Czech

Hungary

Kazakhstan

Poland

Romania

Russia

S Africa

Turkey

Ukraine

Total…

% AUM PAST QUARTER

0 5 10 15 20 25

Czech

Hungary

Kazakhstan

Poland

Romania

Russia

S Africa

Turkey

Ukraine

Total…

% AUM PAST YEAR

Turkey, 20.4

Russia, 18.9

South Africa, 16.9Poland, 10.9

Hungary, 8.4

Romania, 4.0

Kazakhstan, 4.7

Ukraine, 7.2

Croatia, 2.6 Serbia, 1.3Azerbaijan, 0.8 Czechrepublic, 1.6

Cash, 1.0

Turkey, 20.4

Russia, 22.2

South Africa, 14.1Poland, 10.2

Hungary, 8.7

Romania, 5.0

Kazakhstan, 4.5

Ukraine, 7.2

Croatia, 2.6 Serbia, 1.3Azerbaijan, 0.7 Czechrepublic, 1.2

Cash, 0.1


30

as has been steady in the 7% area in recent months, and well up on the 5% allocation registered a year ago. Slightly reduced allocation to Kazakhstan has been one counter in this space. Finally, below contextualizes the Emerging Europe aspect within the global allocation. Latam allocation is down (performance), Africa is up (frontier appetite) and Europe is steady while Asia and Middle East are mildly down (Figures 59 and 60).

Fig 59 Latest average investor allocations Fig 60 Average investor allocations 3 months before


EMEA Relative Value Local currency short in HGBs vs ROMGBs and long TURKGBs vs OFZs Up until the turn of the year dominant themes centred on concession building in ROMGBs versus a persistent richness build in HGBs. On the latter we remain of the view that HGBs are in bubble territory, and while the front end of the curve presents a viable FX exposure play, relative value out the curve is minimal relative to comparables; the medium-term inflation prognosis does not rationalize persistent HGB richness.

Indeed, HGB’s have drifted in the past couple of months, and we expect more of the same ahead. POLGB’s have been the value trade from a duration perspective, helped by (almost Hungarian-style) verbal support from the central bank. The pickup from ROMGBs into POLGBs in the 10yr is now out to 120bp (Figure 61), although the more dramatic move was against HGBs as they trades some 250bp through at the extreme (Figure 62).

Fig 61 Pickup from 10yr Poland into Romania (bp) Fig 62 Giveup from 10yr Romania into Hungary (bp)

Source: Bloomberg, ING estimates Source: Bloomberg, ING estimates

The performance of ROMGBs since has been helped by a more benign rate hike discount on the front end of the curve, and the 2yr has managed to peak out having briefly hit 3%, and now trades a mere 30bp above the policy rate. This has helped to engineer a 60bp outperformance vs HGBs in the 10yr and has also helped to take ROMGB spreads off their highs versus POLGBs.

The leg of this trade that we’d stay long of is against HGBs i.e. remain long ROMGBs versus HGBs. For players that wish to short ROMGBs on account of domestic pressures, we’d suggest that a short versus POLGBs is the way to go. As it is there is still in excess of a 50bp pickup from 10yr HGBs into POLGBs (Figure 63), which offers something a performance cushion.

Africa, 8.8Middle East, 6.8

Other, 0.8

Asia Ex-Japan, 20.5

Emerging Europe, 23.6

Latin America, 35.9

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In terms of the arbitrage between POLGBs and HGBs we prefer to be long former. HGBs are fully valued, and have had trouble keeping up with the latest CE rally in POLGBs (Figure 63). The other trending trade in recent months has been the rate cut led rally out of Russia, versus the ongoing Turkish rate elevation story (Figure 64). We think the time has come to begin to fade this trade back in the other direction; looking for some outperformance of Turkey versus Russia to be a good remainder-of-2018 trade.

Fig 63 Giveup from 10yr Poland into Hungary (bp) Fig 64 Giveup from 10yr Turkey into Russia (bp)

Source: Bloomberg, ING estimates Source: Bloomberg, ING estimates

Hard currency We expect upward pressure from core US Treasuries to remain a key underlying driver as we face into Q2, as we target the 10yr yield to settle in the 3% to 3.5% range, which implies another c.40bp uplift in belly rates. Underlying flattening pressure along the 2/10yr segment remains a persistent input too, as is flattening pressure on the 10/30yr segment. Underweighting the belly versus the wings remains the preferred route, on a duration short overlay.

We identify a growing concession being built in long dated TURKEY versus RUSSIA, with the 10yr spread for example back out to 150bp. We’d be fading longs in here and also in the ultra longs. In terms of Croatia and Serbia, we remain most comfortable of the two in Croatia, and we’d remain long the carry versus Russia, but would be fading these on the approach of parity. We also remain comfortable in KAZAKS vs RUSSIA on a moderate giveup and we see value in the AZERBJ 24’s (Figures 65 and 66).

Fig 65 TURKEY vs RUSSIA, CROATIA and SERBIA Fig 66 UKRAINE vs RUSSIA, KAZAKS and AZERBJ

Source: Source: Bloomberg, ING estimates Source: Source: Bloomberg, ING estimates

UKRAINE trades at a decent concession, but will likely remain at a significant spread with some residual widening potential as risks remain elevated, especially as the initial wave of re-entry investment is behind us. In terms of the lower beta product, we’d be fading longs in ROMANI out of BGARIA in e.g. the 27’s as the spread has overshot BGARIA positives. We also note that POLAND USD paper has richened versus EUR paper to USD, and we’d fade this move. The opposite is the case in REPHUN lines where we identify the EUR 27’s as rich (when swapped) versus cheap USD 23’s, 24’s and 41’s.

Padhraic Garvey, London +44 20 7767 8057

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EM Credit: Technicals on top Rarely have technicals exerted such an influence over the pricing of credit in our

region. Supply, flows, core rates and rating actions have still dominate.

The supply backdrop is still supportive: net supply is expected to be strongly negative across our region this year.

Strong fundamentals and overwhelming technicals to outweigh tight valuations and to drive spreads tighter, given attractive pricing compared to DM peers.

While earnings calls pass with barely a flicker of price action in response (largely because results have largely turned out as expected), supply, flows, core rates and rating actions have maintained their influence on markets. The supply backdrop is still supportive: net supply is expected to be strongly negative across our region this year, with $10bn of Russian corporate debt set to mature over the next four months alone and Turkish banks moving to flat net issuance from strongly positive in 2016.

Offsetting this is the Fed’s more hawkish stance; the response in core rates caused a relatively muted steepening in credit curves, especially in Turkey. Finally, the latest round of Moody’s downgrades saw a number of Turkish corporates stripped of their IG ratings, causing them to trade wide of the sovereign for the first time in a year.

We remain of the opinion that, once the rates trade settles down, strong fundamentals and overwhelming technicals will outweigh tight valuations to continue to drive spreads tighter, given attractive relative pricing compared to DM peers. Flows have remained supportive until now, and we see no catalyst to change investors’ attitudes over the next few quarters.

Corporate fundamentals continue to improve Our base case is that appetite for credit will remain firm in the absence of a material negative catalyst. Across the region, economic growth is strong or strengthening and corporate fundamentals are improving. The one exception is the second-tier Russian banks, which saw the nationalisation of Otkritie and B&N Bank in late 2017. Other than that, though, corporate leverage is well controlled and cashflows remain strong. On the banks side, asset quality is improving and capitalisation is being boosted by organic earnings and/or subordinated debt issuance. We expect fundamentals to remain strong for the balance of this year.

Fig 67 Leverage is falling in the Russian Oil & Gas…

Fig 68 …and Steel sectors

Source: Bloomberg, ING Source: Bloomberg, ING

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Technicals remain supportive The strong technical backdrop also remains firmly in place. Not only have we seen generally robust inflows into EM credit and, within that, into our region, but our markets are among the few across the globe where technicals are getting stronger. Amid increased issuance from the likes of China and the Middle East, much of the 15% of Russian corporate debt that is due to mature by end-2018 will not be refinanced in the bond market as sanctions have cut the flow of investment. Meanwhile, Turkish credit saw significant redemptions in 2H17 for the first time, greatly reducing net issuance (see chart). While geopolitical tensions have limited performance here, leading to a difficult start to the year, investors have the comfort of relatively high yields to compensate for the inevitable volatility.

Fig 69 Monthly Portfolio EM Debt Flows (US$bn) Fig 70 Turkish Banks' net senior issuance fell sharply

Source: National Sources, IIF, Bloomberg, ING Source: Bloomberg, ING

Core rates seem unlikely to destabilise credit A more substantial rates shock is the key risk to EMEA credit, as the region otherwise benefits from a positive growth outlook, strong technicals and robust fundamentals. While we are cognisant of this risk, we take comfort from the relatively small spread reaction to the violent UST moves of late January, which leads us to believe that investors are not yet ready to take money out of our asset class. The very modest outflows in February can be explained by net redemptions rather than any more serious selling. The market is now very well aware of the Fed’s policy path, so we do not expect much further price action on this account unless investor perception on the Fed turns significantly more hawkish. With investors generally awaiting a market correction to invest, the buyers waiting in the wings should keep a life on spreads and help catalyse stronger performance in 2Q.

Fig 71 Spread moves since Jan have been modest… Fig 72 ...and confined to the longer end


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So how should we position in EMEA? Turkey remains the sweet spot Looking across our region, Turkey remains our market of choice. It offers over 100bp discount to other BB markets, while the risk/reward proposition is very attractive as the fundamentals of its banks and corporates are generally firmly in investment-grade territory. We continue to advocate buying the banks over the corporates, as the spread-to-sovereign of the latter is not appealing, though some corporates have weakened since the latest downgrades (see below). The banks enjoyed a very strong year, thanks partly to the Credit Guarantee Fund, which allowed them to boost profitability via significant loan growth and strengthen their regulatory capital ratios (see chart). Credit quality has improved, with NPL ratios remaining solid despite gradually increasing NPL inflows (see chart) and SME loan quality strengthening as the economic recovery gains traction, despite ongoing inflationary pressure.

Fig 73 Turkish banking sector capital ratios Fig 74 AKBNK - New NPL formations

Source: BRSA, Bloomberg, ING Source: Company data, ING

Within the bank space, we favour senior over sub debt due to tight valuations: the current sub/senior yield ratio stands at just 1.2x, though we acknowledge that sub debt can be attractive in the primary market. Within senior, our favoured names are ISCTR and QNBFB. The former trades with a political discount compared to AKBNK and GARAN due to the 28% stake held by the CHP, despite its credit fundamentals being best-in-class.

We do not agree that the political risk poses a serious threat to the bank’s financial profile and therefore see value in the ISCTR 6.125% 2024 bond, which trades 60bp wide of AKBNK 5.125% 2025 despite the latter having broadly similar fundamentals. QNBFB, meanwhile, has underperformed over the past few months due entirely to the Qatar story (recall that QNBFB is owned by QNB). We believe that the situation in the Middle East will normalise over time, and therefore advocate buying QNBFB 4.875% 2022 vs TCZIRA 5.125% 2022, with the potential to realise 40-50bp of profit in the medium term. This also represents a nice hedge against politically-induced volatility, as QNBFB is foreign owned, in stark contrast to the entirely state-owned TCZIRA.

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Fig 75 ISCTR 6.125% 2024 vs AKBNK 5.125% 2025 Fig 76 QNBFB 4.875% 2022 vs TCZIRA 5.125% 2022


We cannot leave Turkey without discussing two further issues: the ongoing HALKBK saga and the effect of the recent downgrades by Moody’s.

HALKBK clearly trades well wide to the sector – and much wider than justified by its robust fundamentals – due to fears that it could receive a fine from the US authorities following the conviction in the US of its Deputy General Manager for helping Iran evade sanctions. Our base case is that the bank will end up with a significant but ultimately manageable fine, as we do not believe that either the US or Turkey has any interest in irretrievably breaking their relationship. In this scenario, we expect a relief rally in HALKBK paper. However, there is clearly the risk of a much greater fine, which could escalate into a serious dispute between Turkey and the United States, in which case HALKBK – and indeed all Turkish assets – would be likely to sell off dramatically. HALKBK remains an enticing opportunity for those able to stomach the geopolitical risk (see chart).

The Moody’s downgrade of the Turkish sovereign led to follow-up action against several corporates, causing KCHOL, AEFES, MERSIN and CCOLAT to lose their IG rating at index level. Consequently, these bonds now trade at levels not seen for a year. KCHOL 23s, in particular, are now wide of the sovereign again (see chart). While the spreads on offer can’t compete with the banks, we believe that there is an opportunity here that will fade once the technical selling ends at month-end – especially since KCHOL enjoys ample access to hard-currency revenues.

Fig 77 HALKBK 2.875% 2020s have underperformed Fig 78 KCHOL 23s now trade wide of the sovereign


Russia & CIS – Looking beyond Russia for value Russian/CIS corporates showed strong performance in 2017, especially the Metals & Mining sector. Results were more mixed in the Oil & Gas and Banking sectors, where large banks benefited from turmoil amongst smaller peers. We like the vertically integrated steel companies and iron ore producers from Russia and Ukraine, which

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continued deleveraging in 2017. The forthcoming import tariffs by the US will not seriously affect the sector’s credit profile. We also like Kazakh and Azeri state-related Oil & Gas companies, Ukrainian agro producers and Russian private banks sub debt.

In Russia, we like EVRAZ and Polyus bonds due to their excellent track record on deleveraging and transparency regarding shareholder distributions. Sistema bonds also deliver an attractive premium over MTS after the discharge of all of its obligations to Bashneft and Rosneft, helped by a loan from Sberbank. Russian private banks’ Perpetual and Tier 2 bonds (Alfa-Bank, TCS Bank and Credit Bank of Moscow) deliver attractive premium over senior bonds. We don’t expect any further noise to do with these names. Elsewhere, we note that the corporate dispute between shareholders of Norilsk Nickel might lead to negative consequences for Norilsk and RUSAL if the latter started a “shoot out” mechanism on the purchase of Mr. Potatin’s 30.74% stake. We also would not be surprised in negative rating actions on Norilsk Nickel and RUSAL followed such an event. Negative rating actions following the growth of Rosneft’s leverage in 2017 and very weak FY17 results of SovComFlot are also a risk. O1 Properties has already been placed on Watch Negative by the agencies due to the planned change of ownership.

In Kazakhstan we note the widening of KMG bonds following the buyback of KMG EP shares (which cost the company around $2bn but provided access to a free cash flow positive entity). We note that KMG’s stand-alone credit profile remains strong despite the rise in net leverage to 2.2x from 1.6x. The spread-to-sovereign of KZOKZ 4 ¾ 04/19/27 (z+190bp) grew from 50bp to 100bp over the last 3 months, while that of KZOKZ 5 ¾ 04/19/47 (z+301bp) rose from 55bp in February to 85bp. We believe that Kazakhstan’s government will maintain control over KMG, though Royal Dutch Shell may become a 20% shareholder of KMG NC in 2018. Finally, TENGIZ 4 08/15/26 spread to sovereign widened to 90bp from 50bp over the period, while we note that KZTGKZ 4 3/8 09/26/27 trades flat to KZOKZ 4 3/4 04/19/27, which we feel represents a mispricing.

In Azerbaijan, SGC and SOCAR will remain investors’ focus in 2018 following the commissioning of the Shakh-Deniz-2 gas project (with 16 bcm of annual capacity) and its linked TANAP project (Trans-Anatolian Natural Gas Pipeline). We like Azerbaijan- guaranteed bonds SGCAZE 6 ⅞ 03/24/26 (z+255bp), which delivers around 60bp premium over the sovereign. In the longer end, we prefer SOIAZ 6.95 03/18/30 (z+300bp, sov+75bp) to the SOIAZ 23s.

Fig 79 KZOKZ 5.75% 2047 vs KAZAKS 6.5% 2045 Fig 80 SGCAZE 6.875% 2026 vs AZERBJ 4.75% 2024


Nick Smallwood, London +44 20 7767 1045 Egor Fedorov, Moscow +7 495 755 5480

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Azerbaijan Dmitry Polevoy, Chief Economist, Russia & CIS

Forecast summary Country strategy 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Real GDP (%YoY) 2.0 1.5 2.4 1.4 1.7 1.8 2.0 CPI (%YoY)* 7.9 3.0 3.5 3.7 3.5 4.0 4.8 Policy interest rate (eop, %) 15.00 13.00 11.00 10.00 9.00 9.00 8.00 3m interest rate (%)* n/a n/a n/a n/a n/a n/a n/a 10yr yield (%)* n/a n/a n/a n/a n/a n/a n/a USD/AZN* 1.70 1.70 1.65 1.60 1.55 1.64 1.54 EUR/AZN* 2.04 2.13 2.11 2.05 2.02 2.10 2.04

Macro Trend Political Cycle Ratings FC LC

Activity Presidential: Apr-18 S&P BB+ BB+ Fiscal Tighter Parliamentary: 2020 Moody’s Ba2 - Monetary Looser Local: Fitch BB+ BB+

The economy has turned the corner and should post growth in 2018. This likely won’t be high and we stick to our 1.8% call. Major global institutions see it between 0.9% (World Bank) and 3.5-4% (EBRD) compared to the official 1.5% call under US$45/bbl. Domestic demand should recover, helped by higher oil prices and post-recession momentum, but a still fragile banking sector and not fully liberal FX and monetary policies will likely cap GDP upside. External and fiscal balances look healed by high crude prices, and low inflation is key to move closer to inflation targeting. This may raise the mid-term GDP outlook and drive sovereign rating upgrades, but this will take time. The Apr-18 presidential elections will prolong Mr Aliyev’s rule, but key is whether structural issues will be addressed.

*Quarterly data is eop, annual is avg Source: National sources, ING estimates

GDP growth (%YoY YTD) It’s recovery time! 0.1% GDP growth in 2017 was a mix of -3.8%/+2.7% in oil/non-oil

sectors due to 5.7%/2.6% declines in oil/natgas prices. The gov’t/EIA sees oil output flat and 2.5% lower in 2018-19 on the OPEC+ deal and natural deterioration of oil deposits. Natgas may partly offset the effect after the likely launch of the Shah-Deniz II (SDII) field in 2H18 with higher output and export. Non-oil economy should grow on domestic demand. Stable AZN, lower CPI (stronger real income/ wages) and higher social spending (a 5.7% rise in pensions, 12% in min. wage) will help consumption. The SDII and public capex will likely help investments to outperform. Agriculture will also benefit from higher state support. Depressed lending will remain a hurdle.

Source: CEIC

Current account and fiscal balance (12M-rolling, % of GDP) Further strength on external/fiscal sides

Higher oil prices saw the 4Q-rolling current account (C/A) at 2.1% of GDP in 3Q17 vs a gap in 4Q15-1Q17, with the financial account (F/A) at-1.1%. The C/A is likely to firm further in 2018 on current oil prices and relatively weak AZN. Yet, rising domestic demand may limit improvements via a deteriorating non-oil balance, already seen in 3Q17. The fiscal story looks reasonable with the planned gap of 1.3% of GDP in 2018 at US$45/bbl having upside potential at the ING Brent forecast of US$60/bbl. With a rising oil fund (SOFAZ), this flags no major fiscal risks. The snap presidential elections in April won’t likely erode the fiscal stance as spending revisions are already in the budget and there is no clear need for extra social “stimulus”.

Source: CEIC, ING

Sovereign Z-spreads (bp) Focus on CBA rates/banks; sovereign debt a tactical play The CBA rate cut from 15% to 13% in Feb-18 reflects lower CPI (5.5%

vs 10%+ in 2017) even below our forecasts. Stable AZN, positive real rates, further (but slow) deposit de-dollarization and lower inflation expectations may allow extra CBA easing to support lending. After the IBA case, banks report record-positive net FX asset positions, unlike the huge gaps before. While household FX deposits are falling, corporate deposits are rising. Bank trends remain in focus. A “Stable” outlook from all rating agencies means no external drivers for AZ sovereign bonds apart from the high oil price. Only stronger growth and healthy banks will help to lift ratings. We see opportunity in tactical/opportunistic “longs”, especially if spreads widen further.

Source: Bloomberg

Trade Recommendation Entry date Entry level Exit level S/L

Sell RUSSIA4.75 5/26 and Buy AZERBJ4.75 3/24 27 March 2018 57bp 40bp 70bp

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Azerbaijan 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 10.8 9.3 5.0 0.1 2.2 5.8 2.8 1.1 -3.1 0.1 1.8 2.0 2.2 Private consumption (%YoY) 17.3 11.8 3.9 7.9 10.2 9.5 9.3 9.6 1.5 2.5 2.0 2.1 2.2 Government consumption (%YoY) 5.0 4.7 3.4 2.5 n/a n/a n/a -1.0 -4.0 -5.0 5.0 4.0 3.0 Investment (%YoY) 20.7 9.5 2.0 1.0 18.3 15.1 -1.7 -11.1 -26.1 -2.6 2.2 3.5 3.0 Industrial production (%YoY) 6.0 8.6 2.5 -5.0 -2.3 1.8 -0.6 -0.7 -0.5 -3.4 2.6 2.0 2.3 Unemployment rate (year-end, %) 5.9 5.7 5.6 5.4 5.2 5.0 4.9 4.8 5.0 5.0 4.9 4.9 4.8 Nominal GDP (AZNbn) 40.1 34.6 41.6 50.1 54.7 58.2 59.0 54.4 60.4 70.1 74.3 79.4 85.7 Nominal GDP (€bn) 33.2 30.7 38.6 45.3 54.0 55.8 57.0 48.1 34.1 35.5 35.4 38.9 42.9 Nominal GDP (US$bn) 48.7 42.9 51.8 63.4 69.7 74.2 75.2 52.9 37.5 40.8 45.3 51.7 57.9 GDP per capita (US$) 5,624 4,892 5,818 7,045 7,652 8,035 8,042 5,583 3,911 4,201 4,621 5,221 5,789 Gross domestic saving (% of GDP) 58.1 46.1 49.8 52.6 50.0 47.8 43.7 30.9 28.5 28.7 28.6 28.5 28.5

Prices CPI (average, %YoY) 20.8 1.3 5.7 7.8 1.0 2.4 1.4 4.0 12.4 12.8 4.0 4.8 5.6 CPI (year-end, %YoY) 15.3 0.7 7.8 5.5 -0.3 3.6 -0.1 7.7 15.5 7.9 3.5 5.7 5.5 Wage rates (nominal, %YoY) 17.9 19.1 5.9 11.5 9.8 7.1 6.6 4.2 7.0 6.4 8.5 8.0 8.3

Fiscal balance (% of GDP) Consolidated government balance 0.2 -0.7 -0.9 0.6 -0.2 0.6 -0.5 -0.5 -0.4 -1.6 -0.5 -0.7 -0.3 Consolidated primary balance n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a Total public debt n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a

External balance Exports (US$bn) 30.2 20.7 25.7 34.5 32.6 31.7 28.3 17.3 13.2 16.5 18.9 17.6 19.0 Imports (US$bn) 7.6 6.5 6.7 10.2 10.4 10.3 9.3 9.8 9.0 6.4 7.7 9.0 10.2 Trade balance (US$bn) 22.6 14.2 19.0 24.3 22.2 21.4 19.0 7.5 4.2 10.1 11.2 8.6 8.8 Trade balance (% of GDP) 46.4 33.1 36.7 38.3 31.8 28.8 25.3 14.2 11.2 24.8 24.7 16.6 15.2 Current account balance (US$bn) 16.5 10.2 15.0 17.1 15.0 12.2 10.2 -0.2 -1.4 1.3 2.0 0.9 1.0 Current account balance (% of GDP) 33.8 23.7 29.1 27.0 21.5 16.5 13.6 -0.4 -3.6 3.2 4.4 1.7 1.7 Net FDI (US$bn) -0.5 0.2 0.3 0.9 0.8 1.1 2.4 0.8 1.9 1.1 1.5 2.2 2.5 Net FDI (% of GDP) -1.0 0.3 0.6 1.4 1.1 1.5 3.2 1.5 5.1 2.7 3.3 4.3 4.3 Current account balance plus FDI (% of GDP) 32.7 24.0 29.6 28.5 22.6 18.0 16.8 1.1 1.4 5.9 7.7 6.0 6.0 Foreign exchange reserves ex gold (US$bn) 6.1 5.2 6.4 10.5 11.7 14.2 13.8 5.0 4.0 5.3 6.5 7.8 9.0 Import cover (months of merchandise imports) 9.6 9.6 11.5 12.4 13.5 16.5 17.8 6.1 5.3 10.0 10.1 10.4 10.6

Debt indicators Gross external debt (US$bn) 3.9 4.5 4.6 7.2 7.3 10.3 10.1 11.8 13.2 n/a n/a n/a n/a Gross external debt (% of GDP) 11.8 14.7 11.8 15.8 13.5 18.5 17.7 24.5 38.7 n/a n/a n/a n/a Gross external debt (% of exports) 12.9 21.7 17.8 20.8 22.4 32.6 35.6 68.1 100.1 n/a n/a n/a n/a Lending to corporates/households (% of GDP) 17.9 24.3 22.0 19.7 22.4 26.5 33.8 40.0 27.2 16.8 16.6 16.6 17.0

Interest & exchange rates Central bank key rate (year-end, %) 8.00 2.00 3.00 5.25 5.00 4.75 3.50 3.00 15.00 15.00 9.00 8.00 8.00 Broad money supply (average, %YoY) 44.0 -0.3 24.3 32.1 20.7 15.0 11.8 -1.3 -1.9 9.0 10.0 9.0 8.0 3m interest rate (Bakibor, average, %) 15.9 15.9 12.1 9.9 7.8 9.7 10.8 9.2 13.0 n/a n/a n/a n/a 3m interest rate spread over US$-Libor (ppt) 1162 1126 1088 909 641 913 1058 899 1302 n/a n/a n/a n/a 2yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/AZN exchange rate (year-end) 0.80 0.80 0.80 0.79 0.78 0.78 0.78 1.56 1.80 1.70 1.55 1.50 1.45 USD/AZN exchange rate (average) 0.82 0.81 0.80 0.79 0.79 0.78 0.78 1.03 1.61 1.72 1.64 1.54 1.48 EUR/AZN exchange rate (year-end) 1.12 1.15 1.07 1.02 1.03 1.07 0.95 1.70 1.89 2.04 2.02 2.03 1.96 EUR/AZN exchange rate (average) 1.21 1.13 1.08 1.11 1.01 1.04 1.03 1.13 1.77 1.97 2.10 2.04 2.00 Brent oil price (annual average, US$/bbl) 59 94 36 78 96 111 113 108 45 55 60 53 55

Source: National sources, ING estimates

Quarterly forecasts 1Q17 2Q17 3Q17 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 1Q20F

Real GDP (%YoY) -0.9 -1.6 0.6 2.0 1.5 2.4 1.4 1.7 2.1 2.0 2.3 2.2 2.2 CPI (eop, %YoY) 14.4 14.2 12.5 7.9 3.0 3.5 3.7 3.5 4.5 5.0 5.3 5.7 6.0 Central bank key rate (eop, %) 15.00 15.00 15.00 15.00 13.00 11.00 10.00 9.00 9.00 9.00 9.00 8.00 8.00 3m interest rate (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/AZN exchange rate (eop) 1.72 1.69 1.69 1.70 1.70 1.65 1.60 1.55 1.55 1.55 1.53 1.50 1.50 EUR/AZN exchange rate (eop) 1.83 1.93 1.99 2.04 2.13 2.11 2.05 2.02 2.03 2.05 2.03 2.03 2.03



40

Bulgaria Ciprian Dascalu, Chief Economist, Romania, Balkans

Forecast summary Country strategy: targets ERM-II this year 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Real GDP (%YoY) 3.0 3.7 3.2 3.5 4.3 3.7 3.5 CPI (%YoY)* 2.8 2.7 2.9 2.3 2.6 2.4 2.9 Policy interest rate (eop, %) 0.00 0.00 0.00 0.00 0.00 0.00 0.25 3m interest rate (%)* 0.02 0.02 0.02 0.02 0.02 0.04 0.25 10yr yield (%)* 1.13 1.20 1.20 1.25 1.30 1.30 1.50 USD/BGN* 1.63 1.56 1.53 1.53 1.50 1.53 1.47 EUR/BGN* 1.96 1.96 1.96 1.96 1.96 1.96 1.96


Activity Presidential: Nov-21 S&P BBB- BBB- Fiscal Loose Parliamentary: Apr-21 Moody’s Baa2 Baa2 Monetary Loose Local: Oct-19 Fitch BBB BBB

Bulgaria meets the nominal Maastricht criteria and aims to enter the ERM-II mechanism by July. While PM Borissov found support for its ERM-II bid, it could prove more difficult to get the guarantees for EUR adoption. With low real convergence (the lowest GDP per capita in the EU), low institutional integration (still under EC supervision on justice and outside the Schengen space), such guarantees are hard to get, in our view. Adopting the euro without achieving higher total factor productivity growth (via structural reforms) might limit the convergence process and leave the country vulnerable to shocks in the future, similar to countries exposed by the European debt crisis which triggered internal devaluation. Nevertheless, ERM-II represents another anchor for prudent public policies.


Services the main driver in the current phase of the cycle Good momentum, despite below consensus 4Q17 GDP

Net exports dragged 4Q GDP lower, which due to carry over effect represents a downside risk for the 2018 growth outlook. Of the full year 3.6% GDP growth, private consumption contributed 3.2ppt, gross fixed capital formation (GFCF) added 0.7ppt and net exports subtracted 1.9ppt. We expect GDP growth at 3.7% this year on the back of a pick-up in investment on EU funds and fiscal impulse with a -1.0% of GDP budget deficit target vs a 1.1% surplus in 2017. External demand is expected to remain robust and there is room for the manufacturing sector to accelerate further, after posting a 6.0% expansion in 2017 (vs 4.1% in 2016) with order book levels reported by manufacturers at close to post-GFC highs.

Source: NSI, ING

Private consumption driving growth (% chg) Domestic demand driven by labour market tightening Domestic demand is likely to remain strong as suggested by sales of

non-food items, up by 9.7% YoY in 2017. Though this poses some downside risks to GDP via higher imports, it supports domestic investments to accommodate the growing demand. Labour market tightening with unemployment at post-GFC lows (5.6%) pushed wage growth into double digits, with private sector wages leading the hikes. Wages are being driven by labour shortages, with 43% of companies in the manufacturing sector reporting labour as a factor limiting production. Moreover, inflation is starting to bite into nominal income gains supporting consumption over savings.

Source: NSI, ING

BGARIA well through ROMANI & flat to REPHUN BGARIA to remain structurally rich versus ROMANI

No international bond sales are planned in 2018, with no redemptions from international markets and fiscal pressures muted. Recent underperformance in part reflected local investors (large holders of external debt) switching from Bulgarian to Romanian external exposure. The good fiscal led to a series of rating agency upgrades, with only S&P keeping the country at the lowest investment grade. ERM-II should be another mechanism in securing prudent policies and hence is ratings positive. Contemporaneous fundamentals support BGARIA through ROMANI, although we’d buy into the spread now offered in the 27’s and 28’s.

Source: Bloomberg, ING estimates Padhraic Garvey, Global Head of Debt and Rates Strategy


Buy ROMANI 2.375 27 and Sell BGARIA2.625 27 27 March 2018 75bp 45bp 90bp

-3.0

-1.0

1.0

3.0

5.0

1Q12 4Q12 3Q13 2Q14 1Q15 4Q15 3Q16 2Q17

Industry ConstructionPrivate services Public servicesOthers GDP (%YoY, gross)

-6.0-4.0-2.00.02.04.06.08.0

2010 2011 2012 2013 2014 2015 2016 2017Private consumption GFCFNet exports OthersGDP (%, YoY)

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

EUR REPHUN BBB- POS EUR ROMANI BBB- STABLE EUR BGARIA BBB- STABLE

%


41

Bulgaria 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 6.0 -3.6 1.3 1.9 0.0 0.9 1.3 3.6 3.9 3.6 3.7 3.5 3.1 Private consumption (%YoY) 3.4 -4.5 1.3 2.0 2.9 -2.5 2.7 4.3 3.5 4.8 3.8 3.5 2.2 Government consumption (%YoY) 1.8 -5.9 2.0 2.2 -2.0 0.6 0.1 1.4 2.2 2.7 3.9 2.8 2.5 Investment (%YoY) 22.0 -17.7 -17.7 -4.4 1.8 0.3 3.4 2.7 -6.6 3.8 3.9 3.8 4.0 Industrial production (%YoY) 0.5 -18.3 1.9 5.9 -0.2 -0.1 1.8 2.7 2.6 3.9 3.5 2.9 2.5 Unemployment rate (year-end, %) 5.6 6.8 10.3 11.3 12.3 13.0 11.4 9.2 7.6 6.3 6.0 5.7 5.5 Nominal GDP (BGNbn) 73 73 75 81 82 82 84 89 94 99 104 110 114 Nominal GDP (€bn) 37 37 38 41 42 42 43 45 48 50 53 56 58 Nominal GDP (US$bn) 54 52 55 55 54 55 57 50 53 58 68 75 78 GDP per capita (US$) 17 20 20 22 19 21 20 21 23 22 22 22 22 Gross domestic saving (% of GDP) 66.4 68.6 67.8 64.8 65.6 65.5 59.2 55.0 52.3 51.6 51.0 50.0 50.0

Prices CPI (average, %YoY) 12.3 2.8 2.4 4.2 3.0 0.9 -1.4 -0.1 -0.8 2.1 2.4 2.9 3.3 CPI (year-end, %YoY) 7.8 0.6 4.5 2.8 4.2 -1.6 -0.9 -0.4 0.1 2.8 2.3 3.5 3.2 Wage rates (nominal, %YoY) 26.5 11.8 6.4 5.8 6.6 6.0 6.0 6.8 8.0 8.3 8.6 8.9 6.2

Fiscal balance (% of GDP) Consolidated government balance 1.6 -4.1 -3.1 -2.0 -0.3 -0.4 -5.5 -1.6 0.0 1.1 -1.0 -1.0 -1.0 Consolidated primary balance 2.4 -3.3 -2.4 -1.2 0.5 0.4 -4.6 -0.7 0.9 1.0 0.8 1.0 1.0 Total public debt 13.0 13.7 15.5 15.3 16.7 17.0 27.0 26.0 29.0 25.7 24.3 22.8 21.5

External balance Exports (€bn) 15.2 11.7 15.6 20.3 20.8 22.3 22.1 23.0 24.1 25.3 26.6 27.9 29.3 Imports (€bn) 25.1 16.9 19.2 23.4 25.5 25.8 26.1 26.4 26.2 26.0 25.9 25.7 25.6 Trade balance (€bn) -9.9 -5.2 -3.7 -3.2 -4.7 -3.6 -4.0 -3.4 -2.1 -0.7 0.7 2.2 3.7 Trade balance (% of GDP) -26.6 -13.9 -9.6 -7.6 -11.2 -8.5 -9.4 -7.5 -4.3 -1.4 1.3 3.8 6.4 Current account balance (€bn) -8.2 -3.1 -0.7 0.1 -0.4 0.5 0.0 0.0 2.6 1.2 1.2 1.2 1.4 Current account balance (% of GDP) -22.0 -8.3 -1.7 0.3 -0.9 1.3 0.1 0.0 5.4 2.4 2.3 2.1 2.4 Net FDI (€bn) 6.7 2.4 1.2 1.5 1.3 1.4 1.2 2.5 0.7 0.9 0.9 1.0 1.0 Net FDI (% of GDP) 18.1 6.5 3.1 3.6 3.1 3.3 2.7 5.5 1.4 1.8 1.8 1.7 1.7 Current account balance plus FDI (% of GDP) -3.9 -1.8 1.3 3.9 2.3 4.6 2.8 5.5 6.8 4.2 4.0 3.8 4.1 Foreign exchange reserves ex gold (€bn) 11.9 11.9 11.6 11.8 13.9 13.3 15.2 19.0 22.4 22.2 24.3 26.5 28.9 Import cover (months of merchandise imports) 5.7 8.5 7.2 6.0 6.6 6.2 7.0 8.6 10.3 10.2 11.3 12.4 13.6

Debt indicators Gross external debt (€bn) 37.2 37.8 37.0 36.3 37.7 36.9 39.3 33.3 34.0 32.6 33.2 33.9 34.6 Gross external debt (% of GDP) 100 101 97 88 90 88 92 74 71 65 62 60 60 Gross external debt (% of exports) 245 323 238 179 182 166 178 145 141 129 125 121 118 Lending to corporates/households (% of GDP) 66.4 68.6 67.8 64.8 65.6 65.5 59.2 55.0 52.3 51.6 51.0 50.0 50.0

Interest & exchange rates Central bank key rate (year-end, %) n/a n/a n/a n/a n/a n/a n/a n/a 0.00 0.00 0.00 0.25 0.75 Broad money supply (average, %YoY) 8.8 4.2 6.4 12.2 8.4 8.9 1.1 8.8 7.6 7.7 8.1 8.5 8.9 3m interest rate (Sofibor, average, %) 7.1 5.7 4.1 3.8 2.3 1.1 0.8 0.5 0.2 0.1 0.0 0.3 1.0 3m interest rate spread over Euribor (ppt) 2.5 4.5 3.3 2.4 1.7 0.9 0.6 0.6 0.4 0.4 0.4 0.4 0.5 2yr yield (average, %) 5.3 5.7 4.7 3.7 2.7 1.5 1.6 1.0 0.5 0.2 0.2 0.3 0.7 10yr yield (average, %) 5.8 7.5 6.1 5.3 4.6 3.5 3.4 2.8 2.3 1.7 1.3 1.5 1.9 USD/BGN exchange rate (year-end) 1.40 1.37 1.46 1.51 1.48 1.42 1.61 1.79 1.86 1.63 1.50 1.45 1.45 USD/BGN exchange rate (average) 1.34 1.39 1.37 1.46 1.51 1.48 1.47 1.76 1.77 1.70 1.53 1.47 1.45 EUR/BGN exchange rate (year-end) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 EUR/BGN exchange rate (average) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96



Real GDP (%YoY) 3.6 3.9 3.8 3.0 3.7 3.2 3.5 4.3 3.8 3.3 3.6 3.9 3.0 CPI (eop, %YoY) 1.9 1.9 2.1 2.8 2.7 2.9 2.3 2.6 2.9 3.2 3.5 3.5 3.2 Central bank key rate (eop, %) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.25 0.25 3m interest rate (eop, %) 0.11 0.11 0.10 0.02 0.02 0.02 0.02 0.02 0.10 0.20 0.3 0.45 0.45 10yr yield (eop, %) 1.73 1.76 1.47 1.13 1.20 1.20 1.25 1.30 1.45 1.50 1.60 1.65 1.70 USD/BGN exchange rate (eop) 1.84 1.71 1.66 1.63 1.56 1.53 1.53 1.50 1.49 1.48 1.47 1.45 1.45 EUR/BGN exchange rate (eop) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96



42

Croatia Valentin Tataru, Economist, Romania, Balkans


Real GDP (%YoY) 2.0 2.6 2.5 2.4 1.8 2.3 2.5 CPI (%YoY)* 1.3 1.7 2.3 2.1 1.8 1.7 1.8 Policy interest rate (eop, %) 0.30 0.30 0.30 0.30 0.30 0.30 0.70 3m interest rate (%)* 0.59 0.55 0.50 0.50 0.50 0.45 0.60 10yr yield (%)* 2.44 2.25 2.35 2.40 2.40 2.36 2.68 USD/HRK* 6.21 5.94 5.78 5.74 5.66 5.75 5.46 EUR/HRK* 7.46 7.43 7.40 7.35 7.36 7.36 7.26


Activity Presidential: Dec-2019 S&P BB BB Fiscal Tighter Parliamentary: Sep-2020 Moody’s Ba2 Ba2 Monetary Neutral Local: May-2021 Fitch BB+ BB+

The Croatian economy has been growing over the past three years and we see no major reasons to doubt that this trend will continue. Nevertheless, there is an opportunity to step up reforms in key areas such as the labour market and in public administration, and also to consolidate recent fiscal discipline which in turn will help to further bring down high public debt ratios. Uncertainties related to Agrokor’s restructuring might still pose some risks but, looking at the bigger picture, the favourable external conditions, increased absorption of the EU funds and investments should be supportive for growth in the near future. Benefiting from its “safe destination” status and a structural upgrade, tourism is likely to reach new highs.


Consumption drives economic growth (% chg) GDP: growing but still dependant on private consumption Strong domestic demand remained the main driver of economic

growth in 2017, with the private consumption component posting its highest expansion since 2007. While this will likely remain the main driver for 2018, the investment component should start to pick-up gradually, mainly on the increased absorption of EU funds which will start to filter through the economy. Decelerating internal demand should help net exports move into positive territory in terms of contribution to GDP. The continuing improvement in current account despite an overall deteriorating trade balance should help to consolidate external debt below 80% in 2018, supported also by Kuna appreciation.

Source: Eurostat, ING

Labour market imbalances despite high jobless rate Labour market has the potential to become Achilles heel The European Commission (EC) has named Croatia among the

countries experiencing excessive economic imbalances, citing the labour market as a main source of these imbalances. The unemployment rate fell towards 11% in 2017 and is expected to be in single digits this year, mainly driven by a shrinking working age population, on aging, and on negative migration. Meanwhile, the percentage of manufacturing companies citing labour as a factor limiting production has reached 34% in 4Q17 (4Q16: 12.3%). The labour market participation rate, below 70%, remains one of the lowest in EU. On this topic, reforming the pension system and discouraging early retirement are among top EC recommendations..

Source: EC, Eurostat, ING

CROATI USD lines versus CROATI EUR lines swapped to USD EUR lines look cheap. Stay long USD lines vs RUSSIA

A €750m Eurobond is maturing on 9 July and c.€100m from IFI loans is coming due. We expect this to be rolled over in line with the MinFin’s long-term strategy and favourable market conditions should favour such a roll-over. In the near-term, it remains to be seen how debt restructuring at the largest Croatian company settles as the deadline for an agreement under current special legislation is nearing. In terms of government lines, no new issues are expected imminently. Outstanding lines when swapped identify value in EUR lines. Meanwhile USD lines continue to converge back to RUSSIA, and we target a brief return to zero in the 23’s.



Buy CROATI 5.5 4/23 and Sell RUSSIA 4.875 9/23 27 March 2018 9bp Zero bp 15bp

-5.0

0.0

5.0

1Q12 4Q12 3Q13 2Q14 1Q15 4Q15 3Q16 2Q17Private consumption Public consumptionInvestments Net exportsOthers GDP (%YoY)

0.010.020.030.040.0

0.05.0

10.015.020.025.0

Labour market tightness (vacancy rate / unemployment rate)

Labour as a factor limiting the production for industry (%, rhs)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

USD outright EUR swapped to USD

%


43

Croatia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 2.4 -6.3 -1.7 -0.2 -3.3 -0.7 0.4 2.3 2.8 2.7 2.3 2.5 2.1 Private consumption (%YoY) 1.3 -7.4 -1.5 0.3 -3.0 -1.8 -1.6 1.1 3.3 3.6 2.8 2.3 2.2 Government consumption (%YoY) -0.7 2.1 -1.6 -0.3 -1.0 0.3 -0.8 -1.4 1.3 1.7 1.7 1.0 1.0 Investment (%YoY) 9.2 -14.4 -15.2 -2.7 -3.3 1.4 -2.8 3.8 5.1 4.2 5.0 6.6 7.0 Industrial production (%YoY) 0.8 -9.0 -1.5 -1.2 -5.5 -1.7 1.2 2.6 4.9 1.9 3.9 5.1 5.0 Unemployment rate (year-end, %) 8.6 9.3 11.8 13.7 15.8 17.4 17.2 16.1 13.4 11.1 9.2 7.5 7.0 Nominal GDP (HRKbn) 348 331 329 333 331 331 331 339 349 360 378 397 405 Nominal GDP (€bn) 48 45 45 45 44 44 43 45 46 48 51 55 58 Nominal GDP (US$bn) 71 63 60 63 57 58 57 49 51 56 66 73 78 GDP per capita (US$) 16,400 14,700 14,100 14,600 13,300 13,600 13,500 11,600 12,200 13,400 16,000 17,700 19,500 Gross domestic saving (% of GDP) 23.4 21.3 21.0 20.2 19.7 19.8 20.8 22.4 23.0 23.2 23.3 23.2 23.3

Prices CPI (average, %YoY) 6.1 2.4 1.0 2.3 3.4 2.2 -0.2 -0.5 -1.1 1.1 1.7 1.8 2.2 CPI (year-end, %YoY) 2.9 1.9 1.8 2.1 4.6 0.3 -0.5 -0.6 0.2 1.3 1.7 1.9 2.3 Wage rates (nominal, %YoY) 6.8 3.0 -0.5 1.5 1.0 0.8 0.2 -3.9 1.2 3.9 4.0 4.1 4.2

Fiscal balance (% of GDP) Consolidated government balance -2.8 -6.0 -6.2 -7.8 -5.3 -5.3 -5.1 -3.3 -0.9 -0.9 -0.9 -0.7 -0.5 Consolidated primary balance -0.8 -3.7 -4.0 -5.0 -2.1 -2.1 -1.7 0.2 2.3 2.0 1.7 2.0 2.3 Total public debt 39.6 49.0 58.3 65.2 70.7 81.7 85.8 85.4 82.9 80.3 77.4 74.5 71.2

External balance Exports (€bn) 9.6 7.5 8.9 9.6 9.6 9.6 10.4 11.5 12.3 14.1 16.2 18.5 21.2 Imports (€bn) 20.8 15.2 15.1 16.3 16.2 16.5 17.1 18.5 19.7 21.9 24.3 27.1 30.1 Trade balance (€bn) -11.2 -7.7 -6.2 -6.7 -6.6 -6.9 -6.7 -7.0 -7.4 -7.8 -8.2 -8.5 -8.8 Trade balance (% of GDP) -23.3 -17.1 -13.7 -15.0 -15.0 -15.8 -15.4 -15.7 -16.0 -16.2 -15.9 -15.6 -15.3 Current account balance (€bn) -4.3 -2.4 -0.6 -0.4 -0.1 0.4 0.9 2.2 1.2 1.5 1.0 1.0 1.2 Current account balance (% of GDP) -8.9 -5.2 -1.3 -0.8 -0.1 1.0 2.1 5.0 2.6 3.1 1.9 1.8 2.1 Net FDI (€bn) 3.7 2.3 1.1 1.0 1.2 0.7 2.3 0.2 1.7 1.6 1.6 1.7 1.7 Net FDI (% of GDP) 7.6 5.0 2.4 2.3 2.6 1.7 5.3 0.4 3.7 3.3 3.2 3.1 3.0 Current account balance plus FDI (% of GDP) -1.4 -0.2 1.0 1.5 2.5 2.7 7.4 5.4 6.3 6.4 5.1 4.9 5.0 Foreign exchange reserves ex gold (€bn) 9.1 10.4 10.7 11.2 11.2 12.9 12.7 13.7 13.5 15.7 16.7 17.7 19.2 Import cover (months of merchandise imports) 5.3 8.2 8.5 8.2 8.3 9.4 8.9 8.9 8.2 8.6 8.2 7.8 7.7

Debt indicators Gross external debt (€bn) 40.6 45.6 46.9 46.4 45.3 45.8 46.4 45.4 41.7 40.0 39.0 38.4 37.8 Gross external debt (% of GDP) 84 101 104 104 103 105 107.0 102 90 83 76 70 65 Gross external debt (% of exports) 423 608 527 483 472 477 446 395 339 284 241 207 178 Lending to corporates/households (% of GDP) 69.8 77.5 79.7 81.0 82.2 78.7 77.2 74.3 68.2 70.4 72.0 73.8 75.4

Interest & exchange rates Central bank key rate (year-end, %) 6.00 6.00 6.00 6.00 6.00 6.00 6.00 0.50 0.30 0.30 0.30 0.70 1.40 Broad money supply (average, %YoY) n/a -0.9 2.0 5.7 3.6 4.0 3.1 5.1 4.6 2.1 2.9 4.0 3.8 3m interest rate (Zibor, average, %) 7.2 9.0 2.4 3.2 3.4 1.5 1.0 1.2 0.9 0.6 0.5 0.6 1.3 3m interest rate spread over Euribor (ppt) 2.5 7.7 1.6 1.8 2.8 1.3 0.8 1.2 1.1 0.9 0.8 0.5 0.5 2yr yield (average, %) n/a n/a n/a n/a n/a 4.0 3.5 2.5 1.6 1.1 0.3 1.0 1.6 10yr yield (average, %) 6.0 7.8 6.3 6.5 6.1 5.0 4.3 3.6 3.5 2.7 2.4 2.7 2.9 USD/HRK exchange rate (year-end) 5.00 5.21 5.51 5.38 5.86 5.73 5.80 6.94 7.20 6.20 5.63 5.37 5.26 USD/HRK exchange rate (average) 4.91 5.24 5.44 5.31 5.83 5.70 5.78 6.92 6.85 6.49 5.75 5.46 5.19 EUR/HRK exchange rate (year-end) 7.36 7.30 7.38 7.54 7.56 7.63 7.66 7.64 7.56 7.44 7.32 7.25 7.10 EUR/HRK exchange rate (average) 7.22 7.34 7.29 7.44 7.52 7.58 7.63 7.61 7.53 7.46 7.36 7.26 7.00



Real GDP (%YoY) 2.6 3.0 3.3 2.0 2.6 2.5 2.4 1.8 2.3 2.4 2.9 2.3 2.1 CPI (eop, %YoY) 1.1 0.7 1.4 1.3 1.7 2.3 2.1 1.8 1.8 1.9 2.0 2.1 2.2 Central bank key rate (eop, %) 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.40 0.70 0.70 3m interest rate (eop, %) 0.58 0.61 0.60 0.59 0.55 0.50 0.50 0.50 0.50 0.50 0.60 0.60 0.60 10yr yield (eop, %) 3.03 2.96 2.59 2.44 2.25 2.35 2.40 2.40 2.60 2.65 2.70 2.70 2.75 USD/HRK exchange rate (eop) 6.99 6.48 6.28 6.21 5.94 5.78 5.74 5.66 5.61 5.53 5.45 5.46 5.37 EUR/HRK exchange rate (eop) 7.45 7.41 7.42 7.46 7.43 7.40 7.35 7.36 7.35 7.30 7.25 7.26 7.25



44

Czech Republic Jakub Seidler, Chief Economist Czech Republic

Forecast summary Country strategy 4Q17F 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Real GDP (%YoY) 5.2 4.5 2.8 3.2 3.8 3.5 3.4 CPI (%YoY)* 2.4 1.9 2.0 2.0 1.9 1.9 2.2 Policy interest rate (eop, %) 0.50 0.75 1.00 1.00 1.25 1.25 1.75 3m interest rate (%)* 0.76 0.90 1.18 1.20 1.48 1.10 1.67 10yr yield (%)* 1.72 2.00 2.10 2.20 2.30 2.10 2.50 USD/CZK* 21.29 20.32 19.69 19.53 19.08 19.69 18.60 EUR/CZK* 25.51 25.40 25.20 25.00 24.80 25.15 24.69


Activity Presidential: 2024 S&P AA- AA Fiscal Looser Parliamentary: 2022 Moody’s A1 A1 Monetary Tighter Local: 2018 Fitch A+ A+

The Czech economy grew by 4.5% last year, at the second fastest pace of the last ten years. The strong economic activity was broad-based, driven by renewed investment, solid household consumption and foreign demand. Domestic demand should be the main growth-factor this year, with the tight labour market pushing wages up. Though the GDP print is expected to be slightly lower this year, domestic consumption will remain strong, with some demand-driven inflationary pressures building. As such, CPI will gradually return above the target, after declining below in Feb-18 due to lower food prices, a stronger CZK and a higher base from the previous year. As CZK might not bring enough tightening - with the current more dovish CNB rate forecast - we still expect room for two hikes in 2H18.


Real GDP growth structure (ppt of YoY growth, SA adj) Macro digest

Czech GDP growth reached 4.5% in 2017, after 2.5% in 2016. Growth in 2017 was evenly spread among household consumption (1.8ppt), renewed investment activity (1.5ppt) and foreign trade (1.1ppt). While household consumption has been stable in the last three years, growing at c.4% YoY, the investment cycle related to tapping of EU-funds was the main reason behind swings in GDP. This year, EU investments might again be a more important factor as part of the funds must be tapped by the end of 2018 (see box on the next page). Increased import intensity of investments and higher domestic demand will increase imports and so reduce the contribution of net foreign exports to GDP growth. GDP growth should moderate slightly this year and move below 4%. The level of drawing on EU investment funds is a source of uncertainty for GDP growth in both directions. Still, the domestic economy should continue to be strong, supported by household consumption pushed by accelerating wage dynamics.

The unemployment rate fell below 2.4% in Dec-2017, a historic low and also the lowest among EU countries. Job vacancies have been gradually increasing and approached 240,000 at the beginning of this year, 50% higher than the highs seen before the financial crisis in 2008. As such, number of job vacancies will exceed the number of registered unemployed this year, signalling also some structural issues in the Czech labour market and the unwillingness of people to move to get a job (longer-term unemployment is just at the EU average). The tight labour market has become the most important growth barrier for Czech companies, resulting in accelerating wage dynamics. Average wage growth reached 7% in 2017 and is likely to further accelerate this year, partially due to an 11% rise in minimum wage and increases in government sector compensation.

Inflationary pressures mounted in Oct-17, with YoY CPI growth reaching 2.9%. Since then there has been a gradual decline, a result of (a) a higher base from the previous year, when food and restaurant prices started to accelerate (the latter caused by the beginning of online sales registration), (b) a stronger CZK, which could subtract c.0.4ppt from YoY CPI growth, assuming standard 10% pass-through on a 6-month horizon. The February CPI print reached 1.8%, surprising both the market and the CNB on the downside. This was, however, caused mainly by lower food prices. Their contribution to YoY inflation dynamics fell from 1.3ppt in Oct-17 to 0.4ppt in Feb-18. Still, service prices are growing by 2.4% YoY and solid wage dynamics provide support to demand-driven inflation this year and next. As such, inflation should return back to the 2% target in coming months, though food and fuel prices offer their usual uncertainty.

Source: CZSO

Key activity indicators (%YoY)

Source: CZSO

Structure of inflation (ppt)

Source: CZSO, CNB

-3

-1

1

3

5

7

Change in Inventories Foreign TradeGross Fixed Capital Formation Final Cons. ExpenditureYoY GDP growth (%)

2.3

3.3

4.3

5.3

6.3

-4

0

4

8

Real wages IP (3m-mav)Retail sales (3m-mav) Unemployment rate (rhs)

-1

0

1

2

3Indirect taxes Food prices

Core inflation Fuel prices

CPI (YoY, %)


45

Prague, +420 257 474 432 [email protected]

Fiscal policy outlook by MinFin and the CNB Total debt to GDP about to decline

2016 2017 2018 2019 2020 The state budget ended with a weak deficit of CZK6bn in 2017 but, as municipalities most likely generated surpluses due to lower investment activity in 2017, the total government balance should end with a solid surplus of c.1% of GDP. Official fiscal projections are favourable, seeing even higher surpluses in coming years. This is on the back of favourable income revenues from corporate and, mainly, personal tax as well as VAT. Still, mandatory spending is gradually increasing and mainly investment activity should surge this year, generating higher spending and somewhat lower surpluses then forecasted by the CNB and MinFin. Still, total debt to GDP is about to decelerate gradually to close to 32% in 2019. The highest uncertainty is related to intensity of EU-fund tapping, see below.

MinFin Gov. deficit (% of GDP) 0.7 1.1 1.3 1.6 1.7 Structural deficit (% of GDP) 0.8 0.5 0.4 0.7 0.8 Total debt (CZK bn) 1755 1743 1754 1778 1791 Debt to GDP (%) 36.8 34.7 33.1 32.1 30.9

CNB Gov. deficit (% of GDP) 0.7 1.6 1.6 1.8 n/a Debt to GDP (%) 36.8 34.7 32.1 29.8 n/a

Source: MinFin, CNB

Tapping of the EU-funds across EU countries Tapping of EU-funds in the new financial period

The EU-funds programme has become an important driver of government and private sector investment (see the CNB Inflation Report 2016/IV). Intense tapping of funds in 2015 resulted in a strong 3.4ppt contribution of total investment to YoY GDP growth. In the new 2014-20 financial perspective, the Czech economy received EU-funds of EUR23.8bn (the 9th biggest of EU countries). So far, tapping EU funds has been gradual and at the beginning of 1Q18 the Czech economy had received just 15% of the total amount. As part of the funds should be withdrawn by the end of 2018 due to the N+3 rule, acceleration of investment activity is likely this year. While this should be less intense than in 2015, when un-invested funds would have been lost, investments will rise this year.

Source: cohesiondata.ec.europa.eu as of as 7 March

Banking loans to the real sector (% YoY) Credit activity to decelerate slightly this year Activity continues to be solid in all credit segments, although some

deceleration was observed in 2H17. For loans to households, this was mainly related to new CNB macro-prudential measures focusing on the residential market and limiting loan-to-value ratios and warning against co-financing property using consumer loans (see our Directional Economics EMEA report of October 2017). Despite these measures, 2017 still saw a record high from the perspective of newly provided loans. We expect some deceleration this year on the CNB measures, but also gradually increasing interest rates. Loans to non-financial corporations have been relatively subdued given the strong economic performance, suggesting a liquidity surplus among Czech corporates. FX-loans are becoming more popular, reaching a share of 30% in 2017. Source: CNB

Election results vs new 2018 pools Political situation unclear, early elections still less likely Since January, when ANO leader and Prime Minister Andrej Babis

lost a confidence vote in parliament, there has been no significant progress in forming the new government. Traditional parties are more in favour of discussions with ANO, but mainly reject Babis as PM due to the charges he faces over EU subsidy funds. On the other hand, Babis is not under time pressure and is fully backed by President Zeman. Early elections are not supported by Zeman or by other parties. With most facing financial constraints for new election campaigns, ANO (led by billionaire Babis) would most likely gain more support, as recent polls show. As such, negotiations could last longer than expected, but the main outcome is clear and ANO will be the main political power in the years ahead.

Source: CVVM as of as February 26

0

20

40

60

80

100

0

10

20

30

40

50

FI IE LU AT GR SE PT FR EE LT DK CY LV DE UK BE HU NL

RO PL BG CZ SK SI ES HR MT IT

Total allocation of the EU-fundsin 2014-2020 (EURbn, rhs)

Share of payments from thetotal allocation

-202468

1012

Non-financial corp. Consumer loans Housing loans

0

5

10

15

20

25

30

35

Oct-2017 election results

Feb-2018 post el. pool

5% treshold for entering the Parliament


46

Czech Republic Strategy

FX – spot vs forward and INGF FX strategy (with Petr Krpata, Chief EMEA FX and IR Strategist)

We are short EUR/CZK (see FX Trader) as well as short USD/CZK, with the latter being our top trade for 2018 (see 2018 FX Outlook). CZK remains undervalued vs EUR (see page 24) and the hike-prone CNB should push EUR/CZK lower via further interest rate increases. At the February meeting, the CNB renewed its projection for EUR/CZK expecting it to average 24.60 in 4Q18. However, the forecast assumes no hikes during 2018 (ie, tightening of monetary conditions is projected to be delivered primarily via the FX channel). We have a hard time seeing EUR/CZK moving lower in the absence of hikes. Should EUR/CZK remain flat through 2Q18 (the quarter during which the CNB expects non-negligible CZK strength equivalent to the two 25bp hikes), we expect the CNB to raise rates in early 3Q18 at the latest to deliver the needed tightening of monetary conditions via higher rates, which will in turn push EUR/CZK lower. However, as tightening of monetary conditions will be achieved via both FX and rates channels, the end-2018 koruna level won’t be required to be as strong as anticipated in the CNB’s February forecast. This is because interest rate hikes will deliver a partial tightening. We thus look for EUR/CZK to be at 24.80 (vs CNB forecast of 24.60). All in all, either CZK strengthens on its own (unlikely in the absence of hikes) or the CNB will push it higher via rate hikes (our base case). Note that a lack of CZK strength would create pro-inflationary risks. We expect EUR/CZK forward points to continue grinding higher (primarily driven by the widening interest rate differential), with the 12m segment likely moving towards the 250 level and EUR/CZK showing an implied yield of modestly in excess of 1% by 4Q18.

Source: Bloomberg, ING Bank

CPI sensitivity with respect to CZK appreciation

Source: CZSO, ING Bank

Local curve (%) Fixed income strategy (with Petr Krpata, Chief EMEA FX and IR Strategist) We have re-engaged into CZK payers (the 1y2y CZK paying leg of our

narrowing 1y2y PLN-CZK spread recommendation) as we believe the market is currently under-pricing the pace of CNB tightening cycle. We look for four rate hikes by end-2019 (most likely equally distributed between the years 2018 and 2019 or the second hike being delivered in very early 2019) compared to market pricing of 30bp and 72bp worth of hikes by end-18 and -19, respectively. Unlike the NBP or NBH, we believe the CNB wants to hike and the current EUR/CZK stability is a welcomed outcome which will allow the central bank to continue its hiking cycle in order to further exit the zero lower bound and build a war chest for rainy days. We prefer to pay front end rates (up to 3y) given the lower correlation with the core yields. 1y2y CZK is the sweetspot segment to pay given the degree of uncertainty whether CNB delivers one or two hikes this year.

We look for some modest flattening of the 2s5s and 2s10 part of the IRS curve, as upward pressure on the back from rising core yields should be more than offset but increasing front-end IRS rates in response to market pricing in a more hawkish CNB tightening cycle. In contrast, the CZGB curve should modestly steepen as the front end CZGBs are compressed by the post FX interventions over-liquidity (with 2y CZGB yield closely following the CZK currency basis) thus limiting its reaction function to the CNB tightening cycle.

Non-resident holdings of CZGB are gradually declining, reaching 38% in Jan-18. Normalisation towards the pre-intervention level is unlikely, however, with CZGB included in the JPM-emerging country index and attracting new non-speculative demand.

Source: Bloomberg, ING Bank

Foreign holders of CZGB (%)

Source: MinFin

Trade Recommendations Entry date Entry level Exit level S/L

Short USD/CZK via 12-month downside seagull 5 December 2017 21.61 19.50 Narrowing 1y2y PLN-CZK spread 13 March 2018 0.69% 0.39% 0.82%

24.525.025.526.026.527.027.528.028.5

ING f'cast Mkt fwd

-0.5

0.5

1.5

2.5

3.5

Dec-

15

Mar

-16

Jun-

16

Sep-

16

Dec-

16

Mar

-17

Jun-

17

Sep-

17

Dec-

17

Mar

-18

Jun-

18

Sep-

18

Dec-

18

Mar

-19

Jun-

19

Sep-

19

Dec-

19

CPI with CNB's expected CZK appreciation

CPI without CZK appreciation

0.000.250.500.751.001.251.501.752.002.252.502.75

Now -3 Months +3 Months

0

200

400

600

800

-82

1222324252

01/1

503

/15

05/1

507

/15

09/1

511

/15

01/1

603

/16

05/1

607

/16

09/1

611

/16

01/1

703

/17

05/1

707

/17

09/1

711

/17

01/1

8

CZK bn (rhs) The share of foreign holders


47

Czech Republic 2008 2009 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F 2019F 2020F

Activity Real GDP (%YoY) 2.5 -4.7 2.1 1.8 -0.8 -0.5 2.7 5.4 2.5 4.5 3.5 3.4 3.2 Private consumption (%YoY) 2.8 -0.6 1.0 0.3 -1.2 0.5 1.8 3.8 3.6 4.0 4.2 3.8 3.1 Government consumption (%YoY) 1.2 2.8 0.5 -3.2 -2.0 2.5 1.1 1.9 2.0 1.6 1.9 1.3 1.3 Investment (%YoY) 2.4 -9.7 1.0 0.9 -3.0 -2.5 4.0 10.4 -2.4 5.8 6.5 4.5 3.6 Industrial production (%YoY) -1.5 -13.2 8.6 6.1 -0.7 0.1 5.0 4.7 3.6 5.7 3.7 3.3 2.9 Unemployment rate (year-end, %) 4.7 7.4 6.9 6.5 7.1 6.7 5.8 4.5 3.5 2.3 2.2 2.0 0.0 Nominal GDP (CZKbn) 4,020 3,932 3,958 4,030 4,059 4,097 4,313 4,598 4,771 5,050 5,335 5,628 5,915 Nominal GDP (€bn) 161 149 157 164 161 158 157 169 176 192 212 228 244 Nominal GDP (US$bn) 235 206 207 228 208 209 208 187 195 217 271 303 327 GDP per capita (US$) 22,699 19,742 19,808 21,717 19,730 19,916 19,745 17,716 18,484 20,439 25,538 28,547 30,846 Gross domestic saving (% of GDP) 33.3 30.4 30.2 31.0 31.2 30.6 32.0 33.1 32.7 33.5 33.4 33.5 34.0

Prices CPI (average, %YoY) 6.4 1.1 1.5 1.9 3.3 1.4 0.4 0.3 0.7 2.5 1.9 2.2 2.1 CPI (year-end, %YoY) 3.6 1.0 2.3 2.4 2.4 1.4 0.1 0.1 2.0 2.4 1.9 2.1 2.0 Wage rates (nominal, %YoY) 7.9 3.4 2.2 2.5 2.5 -0.1 2.9 3.2 3.7 7.0 8.2 5.2 4.8

Fiscal balance (% of GDP) Consolidated government balance -2.0 -5.5 -4.2 -2.7 -3.9 -1.2 -1.9 -0.6 0.7 0.9 0.3 0.2 0.0 Consolidated primary balance -1.1 -4.3 -3.1 -1.4 -2.5 0.1 -0.6 0.4 1.6 1.7 1.0 0.9 0.7 Total public debt 28.3 33.6 37.4 39.8 44.5 44.9 42.2 40.0 36.8 34.9 33.6 32.4 31.4

External balance Exports (€bn) 85.2 72.2 87.0 99.2 104.3 103.0 110.3 115.6 118.0 128.6 133.8 139.2 144.5 Imports (€bn) 86.0 69.7 85.5 96.1 99.3 96.6 102.3 108.7 108.9 119.5 125.1 130.5 135.5 Trade balance (€bn) -0.8 2.4 1.6 3.1 4.9 6.4 8.0 6.9 9.1 9.1 8.6 8.7 9.1 Trade balance (% of GDP) -0.5 1.6 1.0 1.9 3.0 4.1 5.1 4.1 5.1 4.8 4.1 3.8 3.7 Current account balance (€bn) -3.1 -3.5 -5.8 -3.5 -2.5 -0.8 0.3 0.4 2.7 1.9 1.6 1.2 0.9 Current account balance (% of GDP) -1.9 -2.3 -3.7 -2.1 -1.6 -0.5 0.2 0.2 1.5 1.0 0.8 0.5 0.3 Net FDI (€bn) 1.5 1.4 3.8 1.9 4.8 -0.2 2.9 -1.8 5.2 5.2 2.5 3.0 2.0 Net FDI (% of GDP) 0.9 0.9 2.4 1.1 3.0 -0.2 1.9 -1.1 3.0 2.7 1.2 1.3 0.8 Current account balance plus FDI (% of GDP) -1.0 -1.4 -1.3 -1.0 1.4 -0.7 2.0 -0.9 4.5 3.7 1.9 1.9 1.2 Foreign exchange reserves ex gold (€bn) 26.5 28.9 31.7 30.8 33.9 40.7 45.1 59.6 80.9 123.1 132.6 140.5 146.0 Import cover (months of merchandise imports) 3.7 5.0 4.4 3.8 4.1 5.1 5.3 6.6 8.9 12.4 12.7 12.9 12.9


Interest & exchange rates Central bank key rate (year-end, %) 2.25 1.00 0.75 0.75 0.05 0.05 0.05 0.05 0.05 0.50 1.25 1.75 2.00 Broad money supply (average, %YoY) 14.1 0.6 2.2 4.1 4.6 5.0 6.6 8.4 6.6 8.6 7.6 6.6 5.5 3m interest rate (Pribor, average, %) 4.04 2.19 1.31 1.19 1.00 0.46 0.36 0.31 0.29 0.41 1.10 1.67 2.14 3m interest rate spread over Euribor (ppt) -59.7 96.3 50.2 -20.1 42.5 23.6 14.7 32.8 55.3 73.7 143.4 179.5 159 2yr yield (average, %) 4.0 2.7 1.6 1.7 0.9 0.3 0.2 -0.1 -0.3 -0.2 0.8 1.2 1.7 10yr yield (average, %) 4.6 4.7 3.9 3.8 2.8 2.1 1.6 0.7 0.4 1.1 2.1 2.5 2.9 USD/CZK exchange rate (year-end) 19.22 18.47 18.69 19.74 19.01 19.89 22.86 24.87 25.70 21.25 19.08 18.15 17.70 USD/CZK exchange rate (average) 17.07 19.06 19.10 17.69 19.55 19.56 20.76 24.59 24.44 23.31 19.71 18.60 18.09 EUR/CZK exchange rate (year-end) 26.85 26.44 25.02 25.59 25.10 27.34 27.66 27.02 27.02 25.51 24.80 24.50 23.89 EUR/CZK exchange rate (average) 24.96 26.45 25.29 24.59 25.13 25.98 27.53 27.28 27.03 26.33 25.18 24.69 24.20


Quarterly forecasts 1Q17 2Q17 3Q17F 4Q17F 1Q18F 2Q18F 3Q18F 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 1Q20F

Real GDP (%YoY) 3.0 4.6 5.1 5.2 4.5 2.8 3.2 3.8 3.6 3.5 3.3 3.0 3.1 CPI (eop, %YoY) 2.6 2.3 2.7 2.4 1.9 2.0 2.0 1.9 2.3 2.2 2.1 2.1 2.1 Central bank key rate (eop, %) 0.05 0.05 0.25 0.50 0.75 1.00 1.00 1.25 1.25 1.50 1.50 1.75 1.75 3m interest rate (eop, %) 0.28 0.30 0.47 0.76 0.90 1.18 1.20 1.48 1.48 1.73 1.73 1.98 1.98 10yr yield (eop, %) 0.90 1.09 1.34 1.72 2.00 2.10 2.20 2.30 2.40 2.50 2.60 2.70 2.80 USD/CZK exchange rate (eop) 25.38 22.86 22.00 21.29 20.32 19.69 19.53 19.08 18.93 18.71 18.50 18.15 18.03 EUR/CZK exchange rate (eop) 27.04 26.13 25.99 25.51 25.40 25.20 25.00 24.80 24.80 24.70 24.60 24.50 24.35



48

Hungary Péter Virovácz, Senior Economist, Hungary


Real GDP (%YoY) 4.4 3.8 3.5 4.1 4.2 3.9 3.1 CPI (%YoY)* 2.1 2.4 2.6 2.7 2.8 2.6 3.1 Policy interest rate (eop, %) 0.90 0.90 0.90 0.90 0.90 0.90 0.90 3m interest rate (%)* 0.03 0.02 0.02 0.02 0.02 0.02 0.02 10yr yield (%)* 2.02 2.60 2.65 2.70 2.75 2.54 2.90 USD/HUF* 258.3 249.6 242.2 239.1 233.1 240.8 224.4 EUR/HUF* 310.1 312.0 310.0 306.0 303.0 308.2 298.4


Activity Presidential: 2022 S&P BBB- BBB- Fiscal Looser Parliamentary: 2018 Moody’s Baa3 Baa3 Monetary Looser Local: 2018 Fitch BBB- BBB-

GDP growth accelerated to 4.0% YoY in 2017, its second highest rate of the past 11 years. However, Hungary is slightly lagging regional peers. Net exports were a drag on growth, due to the pick-up in imports on strong domestic demand and one-off limitations in export activity. Investments posted their highest growth rate since 1995. We see 3.9% YoY GDP growth for 2018 with strengthening net exports and weakening domestic use. The fiscal stance will remain accommodative in 2018-19 mainly due to tax cuts, but deficit targets look safe. The NBH is keen to keep the monetary stance loose, preserving relative stability in EUR/HUF and HGB/IRS spreads vs core markets. The NBH doesn’t need to worry on inflation as it will remain within its tolerance band, but above 3%, in 2019.


Contribution to YoY GDP growth (ppt) Macro digest

GDP growth accelerated to 4.0% YoY in 2017, a growth rate rarely seen in the past decade. The fourth quarter figure (4.4% YoY) was higher than the yearly average, thus we can expect a significant positive carry-over effect in 2018. Despite the strong economic activity, Hungary still lags its regional peers.

As regards the main drivers behind economic activity on the production side, demand increased significantly for market services, which contributed 1.8ppt to the overall growth figure, matching last year’s contribution. Value added in construction showed a remarkable jump (32% YoY) due to the accelerated absorption of EU funds, ongoing capacity enhancements in manufacturing and a booming housing market. Against this backdrop, construction added 1ppt to GDP growth, higher than the contribution of industry (0.9ppt). Agriculture was a 0.3ppt drag on growth, due to the base effect of the record yields in 2016 and bad weather in 2017.

On the expenditure side, investments jumped 17% YoY, a performance not seen since 1995, translating into a 3.2ppt growth contribution. Final consumption picked up on the significant increase in real disposable income and the elevated propensity to consume, adding 2.5ppt to overall economic growth. Moderated industrial production combined with strong domestic demand (with its remarkable import ratio) translated into a significant negative contribution from net exports (-1.4ppt).

In 2018, the big picture might remain the same, with some shift in the growth structure. We expect the contribution of domestic demand to weaken somewhat due to the base effect. On the external demand side, we expect new manufacturing capacities to enhance export production. We see a high probability of net exports becoming a slightly positive contributor to the GDP growth in 2018.

Headline CPI came in at 2.4% YoY on average in 2017, a significant pick-up after 0.4% inflation in the previous year. Price pressure strengthened mainly on food, alcoholic beverages and tobacco (supply shocks and tax changes). Energy and fuel prices also drove inflation higher. Core CPI increased from 1.4% to 2.3% YoY, remaining well below the NBH 3% inflation target. Underlying CPI indicators, such as the demand-sensitive index, also remained subdued despite double-digit real net wage growth in 2017. Looking forward, we expect inflation to bottom out in 1Q18 and then increase only gradually, reaching an average of 2.6% in 2018. We agree with the NBH that inflation is likely to reach the target only in 2019. Our forecast pencils in above-target 3.1% inflation, but the NBH has emphasised its willingness to tolerate an overshoot.

Source: Hungarian Central Statistical Office

Key activity indicators (swda; 2010 = 100%)

Source: Eurostat, Hungarian Central Statistical Office, ING

Headline and underlying measures of inflation (% YoY)

Source: National Bank of Hungary

-4-202468

Final consumption GFCFInventories Net exportsGDP

708090

100110120130

Retail sales Construction outputIndustrial production Economic Sentiment Index

-1.5-1.0-0.50.00.51.01.52.02.53.0

CPI Core infl. ex. indirect taxesDemand sensitive infl. Sticky price infl.


49

Budapest, +36 1 235 8757 [email protected]

Budget and structural balance of gen. government (%) Stable budget with temporarily higher financing needs

The disciplined fiscal loosening in 2017 was better than planned as the deficit came in at 2% of GDP. Government expenditures and revenues increased remarkably. Expenditures rose due to significant pre-financing of EU funds, which boosted financing needs (cash-flow based deficit) but did not count against the accrual based (Maastricht) deficit. Despite the targeted VAT cuts and the decrease in social contribution tax, revenues increased in 2017 due to favourable economic conditions and the tighter labour market. The government – ahead of 2018 general elections – continues loosening (with another round of tax cuts and wage settlements), but keeping a close eye on the deficit target, set at 2.4% of GDP in 2018 and 1.8% in 2019.

Source: AMECO, ING, Ministry for National Economy

Benchmark policy rate and interest rate corridor NBH focuses on relative stability Following the HGB and HUF IRS selloff after the first MIRS tender in

January 2018, the NBH intends to keep IRS and HGB spreads (predominantly vs Germany) around recent levels. The 3m Bubor should be flat. We expect the NBH to be successful on both fronts (though spreads will be more tricky to contain). The curve should steepen from the long-end, due to higher core yields being driven up by strengthening re-rating across Europe.

The key risk to our view is a mix of a sell-off or meltdown in the HUF and HGB markets, which would in our view change the current NBH ultra loose stance (translating into emergency tightening). However, this is a risk rather than a central scenario, which contains a flat Bubor until end-2019 and a flat base rate until 1H20.

Source: Bloomberg

Wage growth (% YoY, 3m-mav) Tight labour market pushes wages higher

The Hungarian labour market has never been tighter. The number of unemployed is below 175k, extremely low compared to the almost 54k job vacancies in the business sector. In addition to the labour shortage, the government raised minimum wages by 15-25% for both unskilled and skilled labour and implemented public sector wage settlements. Against this backdrop, real net wage growth came in at 10.3% YoY in 2017. Looking forward, the second round of minimum wage increases (this time by 8-12%), ongoing wage settlements and the still tight labour market should drive up real net wages by another 7.5% in 2018, boosting household consumption and making companies’ life harder due to the rising ULC. However, the latter is contained by the 2.5ppt cut in social contribution tax.

Source: Bloomberg, ING

Voter preferences – Feb/Mar 2018 poll results Governing parties have stable lead ahead of elections According to recent polls, the governing parties have a strong lead

ahead of the general election on 8 April. Fidesz/KDNP – somewhat unusually – is not focusing on material topics in the campaign, rather playing on popular fears such as migration and external influence (Brussels, Soros). This is working as Fidesz/KDNP has more support among active voters than their two biggest challengers combined. Jobbik, now a centre-right party, seems to be the biggest opponent as parties on the left are fragmented. Recently, we have seen some collaboration within the opposition, which might be enough to prevent another supermajority, especially taking into consideration the high number of undecided voters. However, our base case scenario is a comfortable simple majority for Fidesz/KDNP.

Source: kozvelemenykutatok.hu

-6

-4

-2

0

2

Budget balance Structural balanceMaastricht criteria MTO

f'cast

-0.5%0.0%0.5%1.0%1.5%2.0%2.5%

Key policy rate Interest rate on O/N loanInterest rate on O/N deposit Bubor 3-m

-10-505

101520

Public Private Total

32%

11% 9%

36%

50%

17%13% 2%

0%

10%

20%

30%

40%

50%

Fidesz/KDNP Jobbik MSZP/Dialogue Undecided

Among the total adult population Among active voters


50

Hungary Strategy

FX – spot vs forward and INGF FX strategy (with Petr Krpata, Chief EMEA FX and IR Strategist)

The Hungarian forint has been one of the most stable currencies across the globe. The National Bank of Hungary (NBH) played tough, drawing lines in the sand and markets learned the lessons. Since 2015, EUR/HUF has moved broadly within the +/- 2% range around the 310 ‘gravity line’. The NBH was tested only once, when EUR/HUF touched 302 in August 2017. The NBH reacted quickly, announcing further loosening with a focus on the long end of the curve. Since the announcement and the start of the monetary policy IRS (MIRS) tenders and the mortgage bond buying programme (a quantitative easing), the HUF is moving within a tighter range: 308-314.

We expect EUR/HUF to continue hovering around its gravity line of 310 in the short-term, with the accommodative NBH policy offsetting the positive impact from the current account surplus (estimated to be around 3% this year). Moreover, we doubt that we should expect a major move in HUF before the April election.

Once the general elections are behind us (with Fidesz/KDNP winning comfortably being the base case), we look for a back-loaded HUF strength in 2H18 (towards EUR/HUF 303) as the current flattening programmes are likely to be nearing the end, while the mix of a strong Hungarian C/A surplus, an upbeat economic outlook, the positive credit story (and possible rating upgrades) work in favour of HUF. As per page 24, HUF remains modestly cheap against EUR.

The persistent and healthy current account surplus is key to our view of an orderly downside pressure on EUR/HUF. We expect the C/A to remain robust due to increased export capacities.

Source:

Evolution of gross external debt (% of GDP)


Local curve (%) Fixed Income strategy (with Petr Krpata, Chief EMEA FX and IR Strategist) 1y1y HUF forward swap receiver is one of our highest conviction CEE

trades. The NBH remains inherently dovish: the subdued inflation further strengthens its case while any pre-mature sharp rise in Bubor would lead to material currency strengthening as well as negatively affect floating rate mortgage paying households (an issue Romania is currently facing following the start of NBR tightening). Too strong HUF is something the NBH wants to avoid given its focus on the balance sheet. With our revised call for flat Bubor until end-2019 (vs 60bp hikes priced in by the market), we target 0.24% level on the 1y1y HUF receiver from here. We expect the NBH to start raising Bubor only after (and with some delay) the ECB’s first depo rate hike. As we expect the first ECB depo hike to be delivered in summer 2019, the NBH should only start rising Bubor from 2020 onwards.

Following the HGB and HUF IRS sell-off after the first MIRS tender in January, we continue to expect the back-end to stabilise from here. The ongoing MIRS tenders (and their healthy discounts which increase mechanically with any rises in 5y and 10y HUF IRS rates) provides a back-stop. More material increases or decreases in back-end HUF rates and yields should be largely a function of core yields as the NBH now targets a stable spread between 10y HGB and bund. We look for a well-behaved 2s10s HUF IRS steepening as (a) the front-end remains anchored by NBH; (b) the back end grinds higher along with the core rates (which we expect a rise this summer).

Asset swaps at the long end are wide and we position for some tightening. HGB 27A vs 10y IRS to decline towards the 35bp level.

Source:

Steepness of the local curve (bp)



Receive 1y1y HUF forward swap 16 February 2018 0.49% 0.24% 0.61% ASW tightening (HGB 27A vs 10y IRS) 27 March 2018 49bp 35bp 60bp

295

300

305

310

315

320

325

ING f'cast Mkt fwd Mkt consensus

020406080

100120140160

f'cast

1.5

2.0

2.5

3.0

3.5

4.0

4.5

ING f'cast Mkt consensus (median)

50

100

150

200

250

10Y-5Y spread 10Y-3Y spread (rhs)


51

Hungary 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 0.9 -6.6 0.7 1.7 -1.6 2.1 4.2 3.4 2.2 4.0 3.9 3.1 2.5 Private consumption (%YoY) -1.1 -6.8 -2.7 0.7 -2.4 0.2 2.8 3.6 4.2 4.7 4.0 3.1 2.9 Government consumption (%YoY) 3.1 3.2 2.3 0.0 -0.3 6.5 9.8 0.2 0.6 -0.4 2.1 0.5 0.0 Investment (%YoY) 1.0 -8.3 -9.5 -1.3 -3.0 9.8 12.3 1.9 -10.6 16.8 8.1 4.4 -1.4 Industrial production (%YoY) 0.0 -17.8 10.6 5.6 -1.8 1.1 7.7 7.4 0.9 4.8 8.1 4.0 2.4 Unemployment rate (year-end, %) 8.1 10.5 10.9 10.8 10.7 9.2 7.2 6.2 4.5 3.8 3.7 3.6 3.5 Nominal GDP (HUFbn) 27,194 26,425 27,225 28,305 28,781 30,247 32,592 34,324 35,420 38,183 40,665 43,186 45,562 Nominal GDP (€bn) 108 94 99 101 99 102 106 111 114 123 132 145 157 Nominal GDP (US$bn) 159 132 132 142 128 135 139 122 125 142 172 192 211 GDP per capita (US$) 15,659 12,956 13,008 14,037 12,804 13,591 14,108 12,344 12,652 14,656 17,794 20,070 22,153 Gross domestic saving (% of GDP) 17.7 19.5 21.0 21.3 21.3 24.9 24.9 25.1 24.5 24.4 24.5 24.1 23.5

Prices CPI (average, %YoY) 6.1 4.2 4.9 3.9 5.7 1.7 -0.2 -0.1 0.4 2.4 2.6 3.1 3.0 CPI (year-end, %YoY) 3.5 5.6 4.7 4.1 5.0 0.4 -0.9 0.9 1.8 2.1 2.8 3.2 3.0 Wage rates (nominal, %YoY) 7.4 0.6 1.3 5.2 4.7 3.4 3.0 4.3 6.1 12.9 10.0 6.0 5.0

Fiscal balance (% of GDP) Consolidated government balance -3.6 -4.6 -4.5 -5.5 -2.3 -2.6 -2.1 -1.6 -1.8 -2.0 -2.4 -1.8 -1.5 Consolidated primary balance 0.0 -0.6 -0.7 -1.7 1.9 1.7 1.7 1.9 1.3 0.2 -0.2 -0.1 -0.1 Total public debt 71.6 77.8 80.2 80.5 78.4 77.1 76.6 76.7 76.0 74.0 71.9 69.9 68.0

External balance Exports (€bn) 73.4 59.1 71.4 80.0 80.0 81.3 84.5 90.5 93.0 100.6 108.9 117.0 124.4 Imports (€bn) 73.7 55.4 65.9 72.9 73.3 74.7 78.2 81.9 83.3 92.5 99.4 106.3 111.5 Trade balance (€bn) -0.3 3.7 5.5 7.1 6.7 6.6 6.3 8.6 9.7 8.1 9.5 10.7 12.9 Trade balance (% of GDP) -0.3 4.0 5.6 7.0 6.7 6.4 5.9 7.8 8.6 6.5 7.2 7.4 8.2 Current account balance (€bn) -7.6 -0.8 0.3 0.8 1.8 3.9 1.6 3.8 7.0 3.6 4.4 3.8 3.3 Current account balance (% of GDP) -7.0 -0.8 0.3 0.7 1.8 3.8 1.5 3.5 6.1 2.9 3.3 2.6 2.1 Net FDI (€bn) 3.1 1.3 1.2 1.6 3.9 1.9 5.0 1.9 2.9 4.0 3.5 2.6 1.9 Net FDI (% of GDP) 2.9 1.4 1.2 1.5 4.0 1.9 4.8 1.7 2.6 3.2 2.7 1.8 1.2 Current account balance plus FDI (% of GDP) -4.2 0.6 1.5 2.3 5.7 5.7 6.3 5.2 8.7 6.1 6.0 4.4 3.3 Foreign exchange reserves ex gold (€bn) 23.6 28.5 32.3 35.1 31.8 32.6 33.7 30.0 24.0 22.6 21.6 21.1 20.9 Import cover (months of merchandise imports) 3.8 6.2 5.9 5.8 5.2 5.2 5.2 4.4 3.5 2.9 2.6 2.4 2.2


Interest & exchange rates Central bank key rate (year-end, %) 10.00 6.25 5.75 7.00 5.75 3.00 2.10 1.35 0.90 0.90 0.90 0.90 1.00 Broad money supply (average, %YoY) 10.0 8.8 2.8 2.5 -1.3 4.1 4.1 4.7 4.6 9.6 12.3 6.0 2.5 3m interest rate (Bubor, average, %) 8.9 8.6 5.5 6.2 7.0 4.3 2.4 1.6 1.0 0.1 0.02 0.02 0.39 3m interest rate spread over Euribor (ppt) 422 742 469 480 643 410 220 163 126 44 35 15 -16 3yr yield (average, %) 9.4 9.3 6.7 7.0 7.5 4.8 3.6 2.1 1.5 0.9 0.7 1.0 1.4 10yr yield (average, %) 8.2 9.1 7.3 7.6 7.9 5.9 4.8 3.4 3.1 3.0 2.5 2.9 3.4 USD/HUF exchange rate (year-end) 189.5 189.1 208.3 240.1 220.8 216.0 260.3 288.3 295.7 258.3 233.1 218.5 214.8 USD/HUF exchange rate (average) 170.9 200.4 205.5 199.4 224.4 223.2 233.8 281.7 283.1 268.9 240.8 224.4 215.6 EUR/HUF exchange rate (year-end) 264.8 270.8 278.8 311.1 291.3 296.9 314.9 313.1 311.0 310.1 303.0 295.0 290.0 EUR/HUF exchange rate (average) 251.3 280.6 275.4 279.2 289.4 296.9 308.7 309.9 311.5 309.2 308.2 298.4 291.0



Real GDP (%YoY) 4.3 3.3 3.9 4.4 3.8 3.5 4.1 4.2 3.3 3.3 3.0 2.8 2.5 CPI (eop, %YoY) 2.7 1.9 2.5 2.1 2.4 2.6 2.7 2.8 2.9 3.0 3.1 3.2 3.0 Central bank key rate (eop, %) 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 3m interest rate (eop, %) 0.18 0.15 0.04 0.03 0.02 0.02 0.02 0.02 0.02 0.02 0.02 0.02 0.15 10yr yield (eop, %) 3.29 3.09 2.58 2.02 2.60 2.65 2.70 2.75 2.85 2.90 2.95 3.05 3.20 USD/HUF exchange rate (eop) 289.8 270.3 263.4 258.3 249.6 242.2 239.1 233.1 229.8 225.8 221.8 218.5 214.8 EUR/HUF exchange rate (eop) 308.7 308.9 311.2 310.1 312.0 310.0 306.0 303.0 301.0 298.0 295.0 295.0 290.0



52

Kazakhstan Dmitry Polevoy, Chief Economist, Russia & CIS


Real GDP (%YoY) 3.9 4.5 3.4 3.1 2.6 3.4 2.7 CPI (%YoY)* 7.1 6.5 6.0 5.8 5.2 6.1 5.1 Policy interest rate (eop, %) 10.25 9.50 9.25 8.75 8.50 8.50 8.00 3m interest rate (%)* 11.25 10.50 10.25 9.75 9.50 10.25 9.15 10yr yield (%)* n/a n/a n/a n/a n/a n/a n/a USD/KZT* 332.7 320.0 310.0 315.0 315.0 318.5 305.0 EUR/KZT* 399.4 400.0 396.8 403.2 409.5 407.7 405.7


Activity Presidential: 2020 S&P BBB- BBB- Fiscal Tighter Parliamentary:2021 Moody’s (P)Baa3 WR Monetary Looser Local: Fitch BBB BBB

The 2017 growth story was even better than our long-standing positive view and this, together with higher oil price, keeps us constructive on the 2018 outlook. We upgrade our GDP call from 2.9% to 3.4%. Lower CPI inflation, expanding lending, prudent monetary policy and properly-tuned fiscal stance (with lower planned deficit but a focus on state-driven spending on infrastructure and development projects) will keep domestic demand growing. Exports should also keep expanding, but stronger growth in imports is likely to dampen the overall net export contribution. With a promising KZT outlook and the 2017 measures to tackle banking sector fragility, overall risks look manageable. The sovereign creditworthiness will stay strong, supporting sovereign/quasi-sovereign debt attractiveness.


GDP growth and major contributors (%YoY) 2017 growth momentum set to sustain this year

4% GDP growth in 2017 beat even our above-consensus call and the positive momentum is likely to remain over 2018. Net exports seem to have added c.2ppt with final consumption and investments sharing the rest nearly equally. The short-term growth indicator rose to 5.7% over 3M to Feb-17 vs 3.5% in 4Q17, suggesting GDP is accelerating further, helped by higher oil prices and stronger domestic demand. Consumption should accelerate on slowing CPI, rising real wages and strong retail lending expansion. Investments to outperform on the ongoing state capex programme, energy sector investments and higher private capex on easier financial conditions. Net exports may be less supportive on imports recovery.

Source: CEIC, ING

Current accn’t/fiscal balance, Oil Fund (12M rolling, % GDP) External/fiscal balances should be stronger in 2018

Higher oil price and weak KZT sped the BoP adjustment: the C/A gap fell from US$8.9bn to US$4.7bn in 2017, yet under lower F/A surplus of US$4.3bn vs US$8.6bn and higher Errors&omissions. At the ING view on oil, the C/A gap may shrink further in 2018 with a supportive capital flows balance (new debt issuance, FDIs, speculative capital). The fiscal story looks also in check with the gov’t plan assuming a gap of 1.1% of GDP under a US$45/bbl oil price assumption. This looks conservative at the current US$65-70/bbl, so revenue set to surprise to the upside. Spending is seen 15% lower vs 2017 due to bank support inflating them last year. Oil Fund transfers are seen lower too, all reminding investors of the solid fiscal stance.

Source: CEIC, ING

FX – spot vs forward and INGF We still like KZT, sovereign debt After a modest 5.8% gain in 2017, the 3.7% KZT growth vs USD in

2018 fits well with our positive view on KZT. This mostly stems from the expected BoP stability, decent GDP growth and prudent fiscal and monetary policies keeping the carry in check. So, we stick to our long-KZT idea with a target of 310/USD, but slightly adjusted the intra-year profile to the oil prices. Local bond yields do not look that enticing with Euroclear/Clearstream story developing slowly. As for sovereign US$ bonds, KAZAKS belly and long-end trades 15-20bp through RUSSIA, which may be justified given Russia’s weaker GDP outlook, lower sovereign funds, primary supply and geopolitical risks. Yet, any widening could be an opportunity for a pair-trade.



Short USD/KZT Feb-16, updated Jun-16 348 310 348 (initial 365)

-3%

0%

3%

6%

9%

12%

15%

-10%

0%

10%

20%

30%

Domestic demand InventoriesNet exports GDP, %YoY (rhs)

-10.0%-7.5%-5.0%-2.5%0.0%2.5%5.0%7.5%10.0%

15%20%25%30%35%40%45%50%

National Oil Fund State budget balance (rhs)Current account balance (rhs)

150

200

250

300

350

400

ING f'cast Mkt fwd


53

Kazakhstan 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 3.3 1.2 7.3 7.4 4.8 6.0 4.2 1.2 1.1 4.0 3.4 2.7 2.9 Private consumption (%YoY) 7.8 0.6 11.8 12.0 10.1 10.6 1.1 1.8 1.2 1.0 2.8 1.5 1.7 Government consumption (%YoY) 2.6 1.0 2.7 11.9 13.5 1.7 9.8 2.4 2.3 2.2 2.2 2.0 2.1 Investment (%YoY) 1.0 -0.8 3.8 3.4 9.9 5.5 4.4 4.2 3.0 5.7 7.4 4.6 6.0 Industrial production (%YoY) 2.2 1.6 9.7 3.6 0.6 2.3 2.5 -1.5 -1.1 7.2 4.3 3.5 3.7 Unemployment rate (year-end, %) 6.7 6.6 5.8 5.4 5.3 5.2 5.1 5.1 5.0 4.9 4.8 4.8 4.8 Nominal GDP (KZTbn) 16,053 17,008 21,816 28,243 31,015 35,999 39,676 40,884 46,971 51,567 56,517 60,098 64,476 Nominal GDP (€bn) 65 57 83 105 121 127 136 100 121 138 139 148 165 Nominal GDP (US$bn) 95 80 111 147 156 169 180 110 133 158 177 197 222 GDP per capita (US$) 6,217 5,161 7,061 9,116 9,566 10,208 10,699 6,481 7,715 9,008 9,969 10,926 11,681 Gross domestic saving (% of GDP) 45.4 40.8 43.8 47.3 43.5 39.9 40.8 34.6 33.8 35.5 33.7 33.6 33.0

Prices CPI (average, %YoY) 17.3 7.3 7.4 8.5 5.2 6.0 6.7 6.7 14.5 7.4 6.1 5.1 5.3 CPI (year-end, %YoY) 9.5 6.4 8.0 7.4 6.1 4.9 7.5 13.5 8.5 7.1 5.2 5.5 5.0 Wage rates (nominal, %YoY) 16.4 10.9 14.7 15.9 13.5 6.8 10.6 5.2 10.0 6.0 8.0 6.8 6.4

Fiscal balance (% of GDP) Consolidated government balance -2.1 -2.9 -2.4 -2.1 -2.8 -1.9 -2.7 -2.2 -1.4 -2.8 0.0 -0.5 -0.7 Consolidated primary balance -1.7 -2.5 -2.0 -1.7 -2.1 -1.4 -2.1 -1.5 -0.8 -2.1 1.1 0.6 0.4 Total public debt 8.7 13.0 14.0 11.5 12.3 12.2 14.2 22.7 25.0 27.1 26.1 25.6 25.1

External balance Exports (US$bn) 72.0 43.9 61.4 87.5 92.1 85.5 80.3 46.5 37.3 49.3 52.1 57.0 61.7 Imports (US$bn) 38.5 29.0 32.9 40.7 47.4 50.8 43.6 33.8 28.1 31.8 34.6 38.9 40.9 Trade balance (US$bn) 33.5 15.0 28.5 46.8 44.7 34.7 36.7 12.7 9.2 17.5 17.5 18.2 20.8 Trade balance (% of GDP) 35.2 18.7 25.7 31.9 28.6 20.5 20.4 11.5 6.9 11.1 9.9 9.2 9.3 Current account balance (US$bn) 6.3 -4.1 1.4 10.2 1.1 1.2 6.3 -5.1 -8.9 -4.7 -1.7 -1.5 0.7 Current account balance (% of GDP) 6.6 -5.1 1.3 7.0 0.7 0.7 3.5 -4.6 -6.7 -3.0 -0.9 -0.8 0.3 Net FDI (US$bn) 14.8 10.7 3.7 8.6 11.9 8.0 4.7 3.4 13.5 3.5 8.4 6.6 8.9 Net FDI (% of GDP) 15.5 13.3 3.3 5.8 7.6 4.7 2.6 3.1 10.1 2.2 4.7 3.3 4.0 Current account balance plus FDI (% of GDP) 22.2 8.2 4.6 12.8 8.3 5.4 6.1 -1.5 3.4 -0.7 3.8 2.6 4.3 Foreign exchange reserves ex gold (US$bn) 17.9 20.6 25.2 25.2 22.1 19.2 21.8 20.3 19.9 20.1 21.0 22.0 23.0 Import cover (months of merchandise imports) 5.6 8.5 9.2 7.4 5.6 4.5 6.0 7.2 8.5 7.6 7.3 6.8 6.7

Debt indicators Gross external debt (US$bn) 107.7 111.7 118.2 125.2 136.9 149.9 157.4 153.7 167.0 170.0 174.3 179.0 187.0 Gross external debt (% of GDP) 113 140 107 85 88 89 88 139 125 108 98 91 84 Gross external debt (% of exports) 150 254 193 143 149 175 196 331 448 345 335 314 303 Lending to corporates/households (% of GDP) 46.5 44.9 33.0 29.9 30.9 30.4 29.7 31.0 27.1 24.6 24.8 24.6 25.2

Interest & exchange rates Central bank key rate (year-end, %) 10.00 7.00 7.75 7.50 5.50 5.50 5.50 16.00 12.00 10.25 8.50 8.00 7.50 Broad money supply (average, %YoY) 35.4 19.5 13.3 15.0 7.9 10.2 10.5 33.8 15.6 -1.7 7.8 8.8 8.0 3m interest rate (KazPrime, average, %) 8.5 8.3 4.1 1.8 2.5 6.5 7.1 10.4 15.5 11.5 10.3 9.2 8.5 3m interest rate spread over US$-Libor (ppt) 426 366 285 96 111 593 690 1019 1552 1179 1058 928 798 2yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/KZT exchange rate (year-end) 120.9 148.4 147.4 148.5 150.4 154.4 182.4 340.6 333.7 332.7 315.0 290.0 290.0 USD/KZT exchange rate (average) 168.6 212.7 197.0 192.4 198.5 212.9 220.7 370.1 351.9 326.1 318.5 305.0 290.0 EUR/KZT exchange rate (year-end) 169.2 212.2 197.5 193.0 198.6 211.5 220.7 371.3 350.9 399.4 409.5 391.5 391.5 EUR/KZT exchange rate (average) 247.9 297.8 263.9 269.4 256.1 283.1 291.3 407.1 387.1 374.2 407.7 405.7 391.5 Brent oil price (annual average, US$/bbl) 59 94 36 78 96 111 113 108 45 55 60 53 55



Real GDP (%YoY) 3.6 4.9 4.0 3.9 4.5 3.4 3.1 2.6 2.0 2.7 3.0 3.1 3.2 CPI (eop, %YoY) 7.7 7.5 7.1 7.1 6.5 6.0 5.8 5.2 4.8 4.9 5.3 5.5 5.7 Central bank key rate (eop, %) 11.00 10.00 10.25 10.25 9.50 9.25 8.75 8.50 8.50 8.25 8.00 8.00 7.75 3m interest rate (eop, %) 12.00 11.50 11.25 11.25 10.50 10.25 9.75 9.50 9.25 9.00 9.00 9.00 8.75 10yr yield (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/KZT exchange rate (eop) 314.1 322.0 340.4 332.7 320.0 310.0 315.0 315.0 320.0 310.0 300.0 290.0 290.0 EUR/KZT exchange rate (eop) 334.5 367.9 402.2 399.4 400.0 396.8 403.2 409.5 419.2 409.2 399.0 391.5 391.5 Brent oil price (quarter average, US$bbl) 55 51 52 62 67 60 57 57 50 52 55 55 55



54

Poland Rafal Benecki, Chief Economist, Poland

Forecast summary Country strategy 1Q18F 2Q18F 3Q18F 4Q18F 1Q19F 2018F 2019F

Real GDP (%YoY) 5.0 4.8 4.3 3.5 3.6 4.5 3.6 CPI (avg, %YoY)* 1.7 2.2 1.8 1.6 2.2 1.8 2.8 Policy interest rate (eop, %) 1.50 1.50 1.50 1.50 1.50 1.50 1.75 3m interest rate (avg, %)* 1.73 1.73 1.73 1.73 1.73 1.73 1.79 10yr yield (avg, %)* 3.30 3.41 3.48 3.51 3.67 3.42 3.83 USD/PLN (eop)* 3.34 3.25 3.23 3.17 3.15 3.17 3.07 EUR/PLN*(eop) 4.18 4.16 4.14 4.12 4.13 4.12 4.14


Activity Presidential: 2020 S&P BBB+ A- Fiscal Tighter Parliamentary: 2019 Moody’s A2 A- Monetary Neutral Local: 2018 Fitch A- A-

The expected sound GDP dynamics, solid fiscal stance (with 2018 general government deficit at 1.5% of GDP), high coverage of 2018 borrowing needs (50% after 1Q18) and elevated MinFin cash buffer offer solid backing for POLGBs, especially the long end. We see Bund spreads tightening across the curve. The dovish MPC limits appreciation potential for PLN, which has usually served as an “activity currency”. But we see major gains in PLN vs US$. We see limited and late NBP hikes in 4Q19 only. Politics should play a lesser role in 1H18 due to the low risk of introduction of meaningful sanctions against Poland. 2H18 should bring discussion about the 2019 election budget. Market rate hike expectations should hover below 50bp for 2019 over coming months.


GDP structure (%YoY) Macro digest The Polish economy has strong momentum - after solid growth of

4.6% in 2017 we see 4.5% YoY in 2018. Investment recovery has already begun (up by 11.3% YoY in 4Q17), mostly in the public sector. Corporate outlays are recovering slower, dragged by mining and power engineering and the side effects of a rigorous tax policy affecting private sector confidence. Investments should replace consumption as the key growth driver this year, supported by EU-backed projects and multiplier effects facilitating private outlays.

The labour market remains tight, pointing to further rises in wages. Poland is still expected to lag other CEEs in that respect, as earnings growth should reach double digit dynamics only in 4Q18 and 1Q19 (thus sheltering local competitiveness). The supply of foreign labour and the rise in the participation rate among Poles aged 50-69 is keeping wage growth below other CEE economies. Already 1.2m Ukrainians work in Poland and coming years should see a further 200-300,000. new employees according to the Ukrainian Central Bank. Companies are also tapping into Belarus, Georgia, and Moldova.

Rising wages have so far seen surprisingly limited pass-through to prices. The early 2018 rise in the core rate reflected mostly regulatory changes rather than demand pressures. We see the import of Eurozone lowflation and PLN appreciation (mainly vs US$) as major drivers slowing core price rises. Wage increases are also partially offset by productivity. Still, given our upbeat outlook for the labour market, we see core gradually rising in 2018, reaching above 2.0% YoY by year-end. Nonetheless, headline CPI is expected to remain constrained – staying below 2.5% YoY throughout 2018 and dipping below 2% YoY in 4Q18 (reflecting negative base effects in food and PLN appreciation offsetting commodity price rises). In 2019 CPI may reach 3.0%YoY but should stay below the NBP upper bound (2.5%YoY+/-1%). This supports a dovish MPC stance (see next page).

The government plans to enhance the pension system, starting in 2019 with occupational pension funds for the biggest companies and rolling this out to smaller ones until 2021. Enrolment will be automatic with an opt-out clause, suggesting broad reach. Contributions will be financed by employers and employees (at 3.5-8% of salary). The budget burden will be benign – PLN1.2bn in the first year. The OPFs should chiefly invest in POLGBs (at c.PLN3bn in the first year) and in blue-chip WSE stocks due to low management fees.

Local political issues have made it into the international media. Still, due to strong domestic fundamentals and low risk of meaningful economic impact any time soon (at earliest in 2019 as EU budget talks formally finish), this has been largely ignored by markets.

Source: GUS, ING

Wage growth (%YoY) by sector

Source: GUS

Share of mfg companies reporting labour shortage (%)

Source: DG ECFIN

-4

-2

0

2

4

6

2016 2017 2018 2019Priv. Consumption Pub. consumption Fixed InvestmentsInventories Net exports GDP

-5

0

5

10

2009 2011 2013 2015 2017

Enterprise sector TradeConstruction Manufacturing & Utilities

0

20

40

60

80

100


55

Warsaw, +48 22 820 4696 [email protected]

CPI and the main NBP interest rate Late and limited hikes in this cycle

We have shifted the first expected hike to Nov-19 and see 25bp in this tightening cycle only. 4Q17-1Q18 data calmed MPC fears about a tight labour market and its pass-through to CPI. Moreover the MPC anticipates a private investment and credit recovery and does not want to expand the spread to ECB rates. The major argument against tightening next year is if projected CPI stays below the upper bound (2.5+/-1% YoY) even at the peak. Recent MPC members’ comments suggest great tolerance for a transitory overshoot as the Council assumes a CPI peak some time in 2019-20 may coincide with a foreign slowdown, so calming inflationary pressure. Also the MPC is ready to use other instruments such as macro prudential measures to calm any credit expansion or tolerate PLN appreciation.

Source: NBP, GUS, ING

Budget deficit (PLNbn) Budget on track to 1.5% of GDP deficit in 2018

Our optimistic forecast is based on three assumptions:

The tightening of the tax system will further increase the share of public revenue in GDP, by 0.3ppt, albeit at a slower pace than in 2017 (+0.6ppt).

In periods of high economic growth, public expenditure in Poland grows slower than GDP, even if the government tries to maintain fiscal expansion. Fast growth in 2018 will allow coverage of additional expenditures (such as lower retirement age).

EU investments will increase by PLN11bn (35%) compared with 2017, but the deficit of local governments will not exceed 0.2% of GDP.

Source:

Current account/GDP ratio The first CA (12M as percentage of GDP) surplus The current account ended 2017 on a small surplus of 0.06% of GDP,

the first time in the history of Polish transition, despite very sound domestic demand. In 2018 the deficit should reach 0.5% of GDP, due to:

A deterioration in the trade balance as investment recovery requires imports of intermediate and capital goods. Also an increase in commodity prices should play a negative role.

An increase in the services surplus to “moderate”, mainly in transport as the labour shortage problem intensifies.

A wider income deficit due to remittances paid by Ukrainian migrants (€2bn in 2017).

Source: NBP, GUS

Opinion polls in February (%) Political outlook The PiS/ECR combination (with 43.4% support) leads PO/EPP (19.5%),

K15 (not in EP, 6.6%), SLD/PES (6.3%), PSL/EPP (5.5%) and N/ALDE (5.4%). The next elections are for local governments in November.

The Article VII procedure seems to be frozen. Morawiecki’s government is attempting to de-escalate the clash with the EC and some CEE and Baltic states have expressed support for Poland (making sanctions and EU council censure procedure less likely).

For POLGBs market an important reform should be overhaul of OFE pension funds. A government proposal has assumed transfer of 25% of non-equity assets into FUS (I pillar) and 75% into private individual accounts. The timeline for reforms has not been published.

Source: Ewybory.eu

-2

-1

0

1

2

3

4

5

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

NBP Inflation target CPI (%YoY) core CPI (%YoY)

f'cast

‐10

0

10

20

30

40

50

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2013‐2016 2017 2018

-8

-6

-4

-2

0

2

4

2004 2006 2008 2010 2012 2014 2016

CA / GDP CA + KA / GDP

0

10

20

30

40

50

PiS PO K'15 .N SLD PSL


56

Poland Strategy

FX – spot vs forward and INGF FX strategy

EUR/PLN moved back above 4.20 in late 1Q18 – the level prior to massive EU fund sales by MoF in 4Q17. The zloty performance tracked EM sentiment, mostly flat vs CEE counterparts. Strong domestic fundamentals and low risk of meaningful sanctions against Poland in Article VII procedure made local political risks a market non-event.

We expect moderate appreciation of the Polish currency over 2018, with EUR/PLN at 4.10-12 at year-end. The zloty is backed by strong domestic fundamentals (particularly GDP growth) and a sound budget position helping POLGBs inflows. But, contrary to the previous cycle (which suggested that PLN was an “activity currency”), the MPC has kept a more dovish bias than before, implying that an important factor driving PLN higher is less effective in this cycle.

Local political risks are expected to play a minor role for the market, reflecting low risk of meaningful sanctions and government attempts to de-escalate the standoff with the EC. Also some investors shorting Polish assets on the political backdrop last year were hit.

The usually strong (negative) correlation between EUR/US$ and PLN has been weaker recently. Poland has benefited little from portfolio capital returning from US bond market to the Eurozone (possibly reflecting inadequate credit rating and local political risks). 2017 experiences suggest that risks related to US trade policies are likely to undermine demand for the zloty in spite of limited trade links.

Mostly stable Bloomberg, ING forecasts

FX – PLN REER vs HP trend

the Source: Macrobond

Local curve (%) Fixed income strategy

POLGBs’ spreads vs the German curve tightened in early 2018, particularly on the long end. Demand for local assets improved as MoF revealed strong budget figures (and a quickly rising cash buffer - PLN67bn in February 2018 vs PLN26bn a month earlier) and lowered debt issuance. Short POLGBs temporarily underperformed other segments, largely reflecting rising market expectations for NBP rate hikes (temporarily reaching 70bp for 2019).

Scope for Bund spreads tightening in 2Q18 is still present. Total debt supply for 2018 is expected to be considerable given high redemptions (PLN98bn vs PLN74bn a year earlier) but MinFin may reduce net supply as the level of cash buffer looks excessive.

We see further scope for short POLGBs strengthening within a month or two. Markets should price less than 50bp of hikes for 2019 given the MPC stance and 2019 being an election year. Moreover low net borrowing needs should allow the MoF to concentrate on mid-curve issuance, omitting shorter instruments (sought by local financial institutions, as they are exempt from the banking asset tax).

We see a risk of further rises in 10vs5 POLGBs spread in 2H18. This outlook is at risk in the short run, as long bonds on core markets may prove supported by global uncertainty linked to trade and the supply of POLGBs from the 5-10y sector may be contained due to high 2018 borrowing needs already covered and the need to lower the cash buffer. However in the longer run (no later than 2H18) the prospect of tighter ECB and Fed policies (as well as the MoF strategy of extending public debt maturity) should drive long local yields higher.

Source: Bloomberg

Structure of POLGBs holders

Source: MinFin


Short EUR/PLN via 6m leveraged put spread 22 March 2018 4.2270 4.10 Bund spread tightening in the 10Y segment 27 March 2018 270bp 250bp 282bp

3.94.04.14.24.34.44.54.6

ING f'cast Mkt fwd

60

70

80

90

100

110

120

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

HP trend REER +/-1.65 std.dev

1.5

2.0

2.5

3.0

3.5


0.1

0.2

0.3

0.4

0.5

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Banks Foreign Investors Insurance Funds


57

Poland 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 3.9 2.6 3.7 5.0 1.6 1.4 3.3 3.8 2.9 4.6 4.5 3.6 3.2 Private consumption (%YoY) 6.1 3.3 2.5 3.3 0.8 0.3 2.6 3.0 3.9 4.8 3.8 3.5 3.5 Government consumption (%YoY) 5.1 3.6 3.3 -1.8 -0.4 2.2 4.0 2.1 2.0 2.5 3.5 2.8 2.8 Investment (%YoY) 8.4 -1.9 -0.4 8.8 -1.8 -1.1 10.0 6.1 -7.9 5.4 8.8 6.9 5.9 Industrial production (%YoY) 3.9 -3.6 11.0 7.2 1.4 2.3 3.4 4.9 3.0 6.5 4.7 3.8 3.6 Unemployment rate (year-end, %) 9.5 12.1 12.4 12.5 13.4 13.4 11.4 9.7 8.2 6.6 5.5 5.4 5.2 Nominal GDP ({CUR}bn) 1,277 1,362 1,445 1,567 1,629 1,656 1,720 1,799 1,859 1,885 2,114 2,240 2,376 Nominal GDP (€bn) 363 315 362 380 389 395 411 430 425 444 509 542 572 Nominal GDP (US$bn) 534 439 480 529 500 524 546 477 469 501 652 721 773 GDP per capita (US$) 13,833 11,398 12,503 13,793 13,071 13,688 14,234 12,474 12,278 13,360 16,692 18,893 19,837 Gross domestic saving (% of GDP) 13.5 16.3 14.9 16.2 17.7 20.5 20.5 25.2 27.6 28.5 25.0 24.8 25.2

Prices

CPI (average, %YoY) 4.2 3.4 2.6 4.3 3.7 0.9 0.0 -0.9 -0.6 2.0 1.8 2.8 2.9 CPI (year-end, %YoY) 3.3 3.5 3.1 4.6 2.4 0.7 -1.0 -0.5 0.8 2.1 1.6 3.1 2.7 Wage rates (nominal, %YoY) 10.5 4.2 3.6 4.9 3.5 2.6 3.8 3.5 4.1 5.7 8.5 8.2 5.5

Fiscal balance (% of GDP) Consolidated government balance -3.6 -7.3 -7.3 -4.8 -3.7 -4.1 -3.6 -2.6 -2.5 -1.7 -1.5 -1.7 -1.5 Consolidated primary balance -1.5 -4.8 -4.9 -2.3 -1.0 -1.6 -1.5 -0.8 -0.7 -0.9 -0.8 -0.8 -0.5 Total public debt 46.3 49.4 53.1 54.1 53.7 55.7 50.2 51.1 54.1 52.0 50.5 48.8 48.0

External balance Exports (€bn) 113.0 95.4 118.1 132.4 141.0 149.1 158.6 172.2 177.5 197.8 215.7 227.6 237.8 Imports (€bn) 136.5 103.1 129.1 145.7 149.2 149.4 161.9 170.0 174.6 197.3 216.1 230.4 244.2 Trade balance (€bn) -23.5 -7.7 -10.9 -13.3 -8.1 -0.3 -3.3 2.2 2.9 0.5 -0.4 -2.8 -6.4 Trade balance (% of GDP) -6.5 -2.5 -3.0 -3.5 -2.1 -0.1 -0.8 0.5 0.7 0.1 -0.1 -0.5 -1.1 Current account balance (€bn) -24.3 -12.8 -19.5 -19.7 -14.5 -5.1 -8.6 -2.4 -1.2 0.3 -2.1 -2.0 0.8 Current account balance (% of GDP) -6.7 -4.1 -5.4 -5.2 -3.7 -1.3 -2.1 -0.6 -0.3 0.1 -0.4 -0.4 0.1 Net FDI (€bn) 6.7 5.8 6.5 9.8 4.7 3.2 9.8 9.1 5.0 2.0 5.5 7.5 8.5 Net FDI (% of GDP) 1.9 1.9 1.8 2.6 1.2 0.8 2.4 2.1 1.2 0.5 1.1 1.4 1.5 Current account balance plus FDI (% of GDP) -4.9 -2.2 -3.6 -2.6 -2.5 -0.5 0.3 1.6 0.9 0.5 0.7 1.0 1.6 Foreign exchange reserves ex gold (€bn) 44.7 55.2 70.0 75.6 82.5 77.0 82.7 87.2 108.1 100.8 96.4 97.6 109.6 Import cover (months of merchandise imports) 3.9 6.4 6.5 6.2 6.6 6.2 6.1 6.2 7.4 6.1 5.4 6.5 6.5


Interest & exchange rates Central bank key rate (year-end, %) 5.00 3.50 3.50 4.50 4.25 2.50 2.00 1.50 1.50 1.50 1.50 1.75 1.75 Broad money supply (average, %YoY) 18.6 8.1 8.8 12.5 4.5 6.2 8.2 9.1 9.6 4.6 5.0 6.5 6.4 3m interest rate (Wibor, average, %) 6.35 4.34 3.93 4.58 4.87 2.98 2.49 1.74 1.70 1.73 1.73 1.79 1.98 3m interest rate spread over Euribor (ppt) 172 311 312 318 430 276 228 176 197 206 206 192 143 2yr yield (average, %) 5.39 5.22 4.77 4.85 3.14 3.05 1.79 1.62 2.03 1.72 2.11 2.29 2.29 10yr yield (average, %) 6.06 6.13 5.80 5.98 4.94 4.09 3.46 2.69 3.08 3.46 3.42 3.83 4.05 USD/PLN exchange rate (year-end) 2.98 2.85 2.97 3.45 3.09 3.01 3.52 3.92 4.18 3.48 3.17 3.07 3.09 USD/PLN exchange rate (average) 2.39 3.10 3.01 2.96 3.25 3.16 3.15 3.77 3.97 3.76 3.24 3.11 3.08 EUR/PLN exchange rate (year-end) 4.15 4.10 3.98 4.46 4.07 4.15 4.27 4.26 4.42 4.17 4.12 4.14 4.17 EUR/PLN exchange rate (average) 3.52 4.33 3.99 4.12 4.18 4.20 4.19 4.18 4.38 4.24 4.15 4.13 4.15


Quarterly forecasts 1Q17 2Q17 3Q17 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 1Q20F Real GDP (%YoY) 4.1 4.0 4.9 5.1 5.0 4.8 4.3 3.5 3.6 3.7 3.6 3.5 3.1 CPI (eop, %YoY) 2.0 1.5 2.2 2.1 1.7 2.2 1.8 1.6 2.2 2.8 3.2 3.1 3.1 Central bank key rate (eop, %) 1.50 1.50 1.50 1.50 1.50 1.50 1.5 1.50 1.50 1.50 1.50 1.75 1.75 3m interest rate (eop, %) 1.73 1.73 1.73 1.72 1.73 1.73 1.73 1.73 1.73 1.73 1.81 1.98 1.98 10yr yield (eop, %) 3.49 3.32 3.37 3.30 3.30 3.41 3.48 3.51 3.67 3.83 3.99 4.15 4.10 USD/PLN exchange rate (eop) 3.96 3.70 3.65 3.47 3.34 3.25 3.23 3.17 3.15 3.13 3.11 3.07 3.07 EUR/PLN exchange rate (eop) 4.22 4.23 4.31 4.17 4.18 4.16 4.14 4.12 4.13 4.13 4.14 4.14 4.15



58

Romania Ciprian Dascalu, Chief Economist, Romania

Forecast summary Country strategy: increasing vulnerabilities 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Real GDP (%YoY) 6.1 8.8 6.9 6.0 4.8 4.7 4.0 CPI (%YoY)* 0.9 1.8 3.3 4.7 4.6 4.4 3.4 Policy interest rate (eop, %) 1.75 1.75 1.75 2.25 2.75 2.75 3.50 3m interest rate (%)* 0.86 1.58 2.05 2.15 2.40 2.50 3.56 10yr yield (%)* 3.89 4.09 4.32 4.55 4.40 4.43 4.63 USD/RON* 3.96 3.90 3.88 3.73 3.76 3.66 3.49 EUR/RON* 4.55 4.60 4.66 4.66 4.70 4.68 4.64


Activity Presidential: Nov-2019 S&P BBB- BBB- Fiscal Neutral Parliamentary: Dec-2020 Moody’s Baa3 Baa3 Monetary Tighter Local: Jun-2020 Fitch BBB- BBB-

In 2017, Romania grew out of fiscal troubles by posting a 7.0% GDP advance driven mostly by private demand which led to a build-up in inflationary pressures triggering NBR tightening way ahead of peers. 2018 is likely to bring a moderation due to scarce labour resources, higher interest rates and slower advances in real incomes. It was mainly fiscal and wage policies which led to this unsustainable backdrop and fiscal consolidation is rather unlikely as 2019 and 2020 are electoral years. Hence, the correction would come via a suboptimal mix of higher interest rates (negative in real terms) and some nominal currency weakness. We see little chance that the government will restart structural reforms. On the contrary, risks of roll-back of some reforms are on the rise.


GDP growth driven by consumption in the last four years Macro digest: unsustainable growth Romania GDP growth rose by 7% in 2017. 6.4ppt of growth came

from private consumption - leading to a negative net export contribution of -0.8ppt - while fixed investments added 1.2ppt. Hence, the growth picture for 2017 suggests an unsustainable backdrop and recently consumer confidence has moved sharply down. On the supply side, services were the main driver, adding 3.7ppt to growth. Industry contributed 1.9ppt, with construction having a neutral impact on the 7.0% expansion in 2017. The significant positive contribution from agriculture of 0.7ppt is worth noting, as it makes a potential upside surprise from this volatile sector in 2018 somewhat limited.

In 4Q17 consumer sentiment had its worse QoQ drop since the GFC. It continued to decline in 2018. Uncertainties related to fiscal changes affecting income, a weaker currency, higher interest rates and higher inflation are likely causes and we look for weaker consumption ahead. The expected acceleration in investments and absorption of EU funds are unlikely to offset the downturn in consumption, with confidence indicators deteriorating across the board recently. 2018 could see industry performing well on robust external demand, with services likely to slow as consumers reassess their spending priorities. Construction is heavily reliant on state investments which are planned to increase YoY. If budget revenues fall short due to weaker than expected growth, public investment is the usual candidate to fill budget gaps.

4Q17 sequential growth was very weak at 0.6% QoQ, vs the 2.0% average for the previous three quarters. Full-year average QoQ growth came in at 1.7%, implying a negative carry-over effect impacting 2018 growth outlook. We keep our call for 2018 GDP expansion at 4.7%, with the risk balance tilted to the downside. This compares to 4.2% Bloomberg consensus, 5.5% assumed in the state budget plan and 6.1% in the latest official forecast. Budget plans for 2018 are based on optimistic growth assumptions relying heavily on private consumption and improved tax collection. This might lead to corrective measures during the year to keep the deficit within the -3.0% of GDP EDP limits, especially if economic growth disappoints. Such measures could be a further drag to growth prospects. Hence, some kind of pro-cyclical vicious circle appears to lie ahead for fiscal policy. The policy mix is increasing the country’s vulnerability to external shocks and in case of a “black swan” event we expect Romania to be among the first to be downgraded as the authorities have used most of the buffers during the good times.

Source: NIS, ING

Disruption risks: capital targeted by government programme

Source: Conference Board, ING

4Q17: sharpest QoQ drop in consumer confidence post-GFC

Source: EC, ING

-2.8

2.1 1.23.5 3.1 4.0 4.8

7.0

-4-202468

10

2010 2011 2012 2013 2014 2015 2016 2017

Private consumption Public consumptionNet export OthersFixed investments InventoriesGDP (%YoY)

-10.0

-5.0

0.0

5.0

10.0

2004 2006 2008 2010 2012 2014 2016Labor Quantity Labor QualityCapital Total Factor ProductivityGDP

-20

-15

-10

-5

0

5

10

-70-60-50-40-30-20-10

0

1Q08

3Q08

1Q09

3Q09

1Q10

3Q10

1Q11

3Q11

1Q12

3Q12

1Q13

3Q13

1Q14

3Q14

1Q15

3Q15

1Q16

3Q16

1Q17

3Q17

1Q18

Confidence (QoQ, lhs) Confidence (rhs) LT AVG


59

Bucharest, +40 31 406 89 90 [email protected]

Budget execution pattern: heavy December spending Fiscal: “It's the economy, stupid”

After a landslide victory in Dec-16, the PSD-led government strove to deliver its populist electoral promises. It focused on measures to preserve popular support after an unprovoked political crisis and controversial judiciary changes.

In spite of above-forecast growth, revenue boosting measures were needed to meet the deficit target in 2017. The budget plans for 2018 look overstretched - assuming above-consensus economic growth, optimistic revenue collection and understated permanent expenditures. The government is committed to a deficit within the -3.0% of GDP EDP limit. To achieve this, it is likely to take additional steps, implying transfer of national income from capital to labour remuneration as mentioned by the government programme.

Source: MinFin, ING

Are things heading in a good direction in Romania? Politics: “It’s our business! We don’t accept any lessons!” Despite the large street protests and EU warnings, the

parliamentary majority moved ahead with changes in the judiciary system, accepting amendments from the Constitutional Court. Capitalising on PSD errors, President Iohannis is unlikely to call a referendum on the judiciary. The European authorities are unwilling to increase pressure, fearing that Romania might join the Visegrad group. Due to political noise, in the December IRES survey only 17% (an all-time low) of Romanians believe the country is heading in the right direction, from 35% in January 2017. Still, for now there is no political alternative to capitalise on general dissatisfaction and the current government majority is likely to remain until 2020 elections, continuing to promote a nationalist agenda.

Source: IRES

Job creation peaking-off due to labour market mismatch Labour market: limiting growth; no real reforms in sight

Unemployment is at an all-time low of 4.6%. At the same time, job creation is softening while more companies are citing labour as a factor limiting production in the manufacturing sector. Labour market tightness has softened a bit recently. A fall in the vacancy rate is likely as more automation is employed to overcome labour supply limitations. Job creation reached 118K in the 12 months to Dec-2017 after hitting an all-time high of 164K in January last year. The labour force participation rate is one of the lowest in the EU at 68.7% in 3Q17, with no structural reforms to address this issue and boost potential growth. Moreover, over three million Romanians are working abroad, which has had a negative impact of c.0.5ppt on potential growth, according to an IMF study from 2016.

Source: NIS, Eurostat, ING

Front-loading hikes, blurred transmission on liquidity CPI and NBR reaction: “Let’s hope this time it will work”

CPI inflation has surged recently. While there are significant supply side causes including oil prices, administrated prices, higher taxes and base effects, core inflation picked-up as well. Even with additional tightening embedded in the forecast, the NBR sees core inflation outside the target band throughout 2019. The NBR tries to balance two conflicting objectives: raising interest rates to contain inflation expectations and depressing term premia via unsterilized liquidity surplus to prevent a full transmission of hikes into floating rate loans. While this can work for a while, recent history from late 2017 tells us that this policy bears a credibility cost for the central bank. Moreover, the blurred policy transmission is likely to lead to some overestimation of monetary policy efficiency on CPI.

Source: NBR, ING

-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.5

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2014 2015 2016 2017

Good direction

17%

Neither good/wrong

7%

Wrong Direction

74%

Do not know2%

-400

-300

-200

-100

0

100

200

-10.00

0.00

10.00

20.00

30.00

40.00

1Q06 2Q07 3Q08 4Q09 1Q11 2Q12 3Q13 4Q14 1Q16 2Q17

12M job creation (000, rhs)Labour market tightness (%)Labour limiting production (%)Real wage (YoY, %)

0

1

2

3

4

-4

0

4

8

12

16

20

Sep-14 Sep-15 Sep-16 Sep-17 Sep-18 Sep-19

Liquidity possition (RON/bn/day, lhs)

3M ROBOR (%, rhs)

Key rate (%, rhs)

ING forecast


60

Romania Strategy

FX – spot vs forward and INGF FX strategy: mind the carry

The NBR governor has continued to talk down the RON at the last three post-decision press briefings by reiterating that he sees no room for RON gains and that the NBR would allow some increase in volatility. Still, we believe that the NBR favours relatively low volatility versus peers due to higher FX pass-through into inflation and inflation expectations. The main reason behind the NBR rhetoric on currency is likely the fact that the central bank wants to discourage any RON appreciation resulting from higher carry. The governor reiterated that the current level of the currency is close to equilibrium. At the same time, a moderate nominal depreciation of the currency would offset the impact of higher interest rates on broad monetary conditions and competitiveness.

The NBR closely follows the real effective exchange rate (REER). Minutes for the latest meeting highlight the importance of FX pass-through. Moreover, the NBR inflation outlook is dependent on “gradually less accommodative” and “quasi-neutral” monetary conditions in 2019. This should mean that real interest rates should get at least to zero by end 2019. The Inflation Report notes that REER is expect to “diminish and even reverse” its “stimulative stance” for exports. Hence, the central bank sees a REER appreciation. This means that the NBR can allow nominal RON weakness at most equal to the inflation differential versus the main trading partners of c.2.5-3ppt. This broadly translates into an EUR/RON average for 2018 of c.4.68.


ULC REER (2005=100): RON in line with peers

Source: EC, ING

Local curve (%) Fixed income strategy: all about NBR delivering Over the last year the ROMGBs yield curve shifted higher due to

changes in liquidity conditions and in the outlook for inflation and interest rates. Furthermore, a risk premium for a pro-cyclical fiscal policy was always priced-in to a certain extent. The sharp adjustment of the ROMGBs curve higher started in Sep-2017. The initial trigger was the change in liquidity conditions which hit the front-end, followed by fears of NBR falling behind the curve which led to a sell-off in the long-end. In the meantime, in terms of liquidity we are back to the pre-September backdrop, with February surplus at RON19.9bn, up by over RON5bn vs January and the highest level post-GFC. Hence, with NBR again using the deposit facility as its operational instrument, this is supportive for short-dated ROMGBs. We can’t rule out a repetition of a scenario similar to the one from late last year, with short-term interest rates moving sharply higher from the deposit facility to above key rate level. The NBR tightened versus Sep-17 - by 100bp if we consider as reference the deposit facility and c.125bp if we take the 3M ROBOR index relevant for floating rate loans (including outstanding ones). The NBR commitment was viewed as positive by the players in the long end of the ROMGBs curve and, based on expectations that the NBR at some point would tighten the policy via liquidity management instead of rate hikes, we could see the ROMGBs curve flattening. At the current juncture, given the expectations for NBR outlook and spread versus peers, back-end yields seem to price in most of the risks, except maybe a new round of political tensions related to the overhaul of the judiciary system.


Divergent monetary policy already priced in?


Trade Recommendation Entry date Entry level Exit level S/L Buy ROMGB5.8 7/27 and Sell HGB3 10/27 27 March 2018 200bp 150bp 220bp

4.35

4.45

4.55

4.65

4.75

4.85

INGF Mkt FWD

75

85

95

105

115

125

1Q06 2Q07 3Q08 4Q09 1Q11 2Q12 3Q13 4Q14 1Q16 2Q17

BGN CZK HUF PLN RON HRK

2.00

2.50

3.00

3.50

4.00


-50

0

50

100

150

200

0

1

2

3

4

5

6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y

ROMGBs vs Jan-17 (bps) POLGBs vs Jan-17 (bps, rhs)ROMGBs Mar-18 (%) POLGBs Mar-18 (%, rhs)


61

Romania 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 8.5 -7.1 -0.8 1.1 0.6 3.5 3.1 3.7 4.8 7.0 4.7 4.0 3.5 Private consumption (%YoY) 7.6 -8.6 -3.5 1.4 1.7 2.6 4.2 5.8 8.0 10.2 6.5 4.0 1.4 Government consumption (%YoY) 8.0 -1.9 1.2 3.5 4.5 -25.2 1.4 3.3 5.9 -3.8 -6.5 -2.3 3.3 Investment (%YoY) 18.3 -35.1 -0.7 6.1 4.0 -5.6 3.2 7.1 -1.8 5.2 6.9 4.1 7.2 Industrial production (%YoY) 1.9 -5.1 4.9 7.9 2.5 7.5 6.3 3.0 0.7 9.2 8.0 4.7 2.4 Unemployment rate (year-end, %) 5.8 7.1 6.8 7.3 6.8 7.0 6.6 6.6 5.5 4.6 4.3 4.0 4.0 Nominal GDP (RONbn) 524 511 534 565 595 637 668 713 761 856 920 990 1070 Nominal GDP (€bn) 142 120 127 133 134 144 151 160 170 187 196 213 233 Nominal GDP (US$bn) 208 169 182 178 173 190 200 178 188 215 251 284 314 GDP per capita (US$) 10,200 8,200 8,300 9,200 8,500 9,600 10,000 9,000 9,500 11,000 12,700 14,600 16,300 Gross domestic saving (% of GDP) 20.2 20.7 20.7 22.3 21.9 24.8 24.3 22.7 22.7 22.7 22.7 22.7 23.2

Prices CPI (average, %YoY) 7.8 5.6 6.1 5.8 3.3 4.0 1.1 -0.6 -1.5 1.3 4.4 3.4 3.1 CPI (year-end, %YoY) 6.3 4.7 8.0 3.1 5.0 1.6 0.8 -0.9 -0.5 3.3 3.4 3.2 3.0 Wage rates (nominal, %YoY) 22.9 7.7 1.8 4.9 4.9 4.8 5.2 8.3 13.0 14.2 13.1 6.3 4.2

Fiscal balance (% of GDP) Consolidated government balance -5.5 -9.5 -6.9 -5.4 -3.7 -2.1 -1.4 -0.8 -3.0 -2.9 -2.9 -2.9 -2.7 Consolidated primary balance -4.8 -8.0 -5.4 -3.8 -1.9 -0.4 0.3 0.9 -1.5 -1.5 -2.2 -2.4 -1.7 Total public debt 13.2 23.2 29.9 34.2 37.3 37.8 39.4 37.9 37.6 36.9 36.7 37.0 36.9

External balance Exports (€bn) 33.7 29.1 37.4 45.3 45.0 49.6 52.5 54.6 57.4 62.6 68.3 73.0 77.9 Imports (€bn) 57.1 38.9 46.8 54.9 54.6 55.3 58.6 63.0 67.4 75.6 81.8 87.5 92.3 Trade balance (€bn) -23.5 -9.9 -9.5 -9.7 -9.6 -5.8 -6.1 -8.4 -10.0 -13.0 -13.5 -14.5 -14.4 Trade balance (% of GDP) -16.5 -8.2 -7.5 -7.2 -7.2 -4.0 -4.0 -5.2 -5.9 -6.9 -6.9 -6.8 -6.2 Current account balance (€bn) -16.8 -5.8 -6.4 -6.6 -6.4 -1.5 -1.0 -2.0 -3.5 -6.5 -5.6 -5.0 -3.8 Current account balance (% of GDP) -11.8 -4.8 -5.1 -4.9 -4.8 -1.1 -0.7 -1.2 -2.1 -3.4 -2.8 -2.4 -1.6 Net FDI (€bn) 9.5 3.5 2.2 1.8 2.1 2.9 2.7 3.0 4.5 4.6 3.1 3.9 5.5 Net FDI (% of GDP) 6.7 2.9 1.8 1.4 1.6 2.0 1.8 1.8 2.7 2.4 1.6 1.8 2.4 Current account balance plus FDI (% of GDP) -5.1 -1.9 -3.3 -3.6 -3.2 1.0 1.1 0.6 0.6 -1.0 -1.3 -0.5 0.7 Foreign exchange reserves ex gold (€bn) 26.1 27.3 31.6 32.7 31.1 32.5 32.2 32.2 34.2 33.5 34.9 36.5 40.5 Import cover (months of merchandise imports) 5.5 8.4 8.1 7.2 6.8 7.0 6.6 6.1 6.1 5.3 5.1 5.0 5.3


Interest & exchange rates Central bank key rate (year-end, %) 10.25 8.00 6.25 6.00 5.25 4.00 2.75 1.75 1.75 1.75 2.75 3.50 3.50 Broad money supply (average, %YoY) 17.5 8.2 6.2 6.2 4.6 8.8 7.8 10.0 9.7 11.6 12.6 15.0 11.7 3m interest rate (Robor, average, %) 13.0 11.7 6.7 5.8 5.3 4.2 2.5 1.4 0.9 1.1 2.5 3.6 3.5 3m interest rate spread over Euribor (ppt) 8.8 7.1 5.5 5.0 4.0 3.6 2.3 1.2 1.2 1.4 2.8 3.7 3.0 2yr yield (average, %) 11.5 11.1 7.4 7.2 6.3 4.8 3.3 1.9 1.5 1.9 3.8 4.0 4.2 10yr yield (average, %) 8.7 9.8 7.2 7.4 6.7 5.3 4.6 3.5 3.3 3.9 4.4 4.7 4.5 USD/RON exchange rate (year-end) 2.85 2.95 3.20 3.34 3.36 3.26 3.69 4.15 4.32 3.88 3.59 3.41 3.39 USD/RON exchange rate (average) 2.52 3.02 2.94 3.17 3.45 3.35 3.33 4.01 4.06 3.98 3.66 3.49 3.41 EUR/RON exchange rate (year-end) 3.99 4.23 4.28 4.32 4.43 4.48 4.48 4.52 4.54 4.66 4.67 4.60 4.60 EUR/RON exchange rate (average) 3.68 4.24 4.21 4.24 4.46 4.42 4.43 4.45 4.49 4.57 4.68 4.64 4.62



Real GDP (%YoY) 5.7 6.1 8.8 6.9 6.0 4.8 3.9 4.4 4.3 3.8 4.2 3.8 3.5 CPI (eop, %YoY) 0.2 0.9 1.8 3.3 4.7 4.6 4.5 3.4 3.3 3.7 3.3 3.2 3.0 Central bank key rate (eop, %) 1.75 1.75 1.75 1.75 2.25 2.75 2.75 2.75 3.00 3.25 3.50 3.50 3.50 3m interest rate (eop, %) 0.86 0.86 1.58 2.05 2.15 2.40 2.60 2.85 3.10 3.35 3.60 3.60 3.30 10yr yield (eop, %) 3.86 3.89 4.09 4.32 4.55 4.40 4.30 4.45 4.50 4.60 4.70 4.80 4.40 USD/RON exchange rate (eop) 4.27 3.99 3.89 3.88 3.73 3.67 3.67 3.59 3.56 3.52 3.47 3.41 3.41 EUR/RON exchange rate (eop) 4.55 4.55 4.60 4.66 4.66 4.70 4.70 4.67 4.67 4.65 4.62 4.60 4.60



62

Russia Dmitry Polevoy, Chief Economist, Russia & CIS


Real GDP (%YoY) 1.2 2.3 1.5 1.8 2.1 2.0 1.8 CPI (%YoY)* 2.5 2.3 2.0 2.5 3.0 2.4 3.4 Policy interest rate (eop, %) 7.75 7.25 6.75 6.50 6.25 6.25 5.75 3m interest rate (%)* 7.88 7.34 6.80 6.60 6.30 6.98 6.05 10yr yield (%)* 7.64 7.10 6.80 6.60 6.50 6.93 6.30 USD/RUB* 57.57 56.90 57.50 58.20 58.00 57.80 58.60 EUR/RUB* 69.08 68.99 70.44 72.02 72.50 73.98 77.94


Activity Presidential: Mar-24 S&P BBB- BBB Fiscal Tighter Parliamentary: Sep-21 Moody’s Ba1 Ba1 Monetary Looser Local: Fitch BBB- BBB-

Despite weaker GDP growth in 2017, we stick to our 2% call for 2018. We got the expected real wages surge, so consumption is to follow. Investments ended 2017 on a strong footing too, and positive momentum may re-emerge following the elections, as anecdotal surveys show. We now have a higher oil price assumption vs 2017. We also upgrade our 2019 call from 1.5% to 1.8% envisaging some positives from growth-stimulating initiatives of the President/MinEco. Key uncertainty/risks are about their funding sources, including the need to adjust/hike taxes. We believe the tax burden will be untouched as it has long been one of the major growth hurdles for business. No unity among officials is good. Low CPI/stable RUB will see the key rate lower, supporting OFZs. US$ bonds look mostly okay.


GDP and key contributors (%YoY, ppt) Macro digest: Low data quality hides real economic trends

The flash 1.5% GDP growth in 2017 came in weaker than the official “slightly above 2%” forecast and our long-standing 1.7% call (since Jun-16), fuelling concerns on structural hurdles and sanctions. Yet, we see the probability of data revisions for 2017 given the observed discrepancies between some quarterly GDP items and monthly data and/or leading indicators. Specifically, 3M avg. for the PMI composite has been 55.2-55.7 over Dec-17 to Feb-18, ie, at the 2Q17 levels when GDP grew 2.5%. Historically, they have been consistent with a 4-5% growth, which is unlikely to exist, but flags a risk of errors. Detailed GDP data is due in April, so we will adjust our figures later, but now we revisit key assumptions behind our current projections.

First, it seems private consumption returns as one of key GDP drivers. This was our key story behind the 2% GDP call since Jun-17 after factoring in public wage hikes under President Putin’s 2012 decrees. It has played out even stronger than we thought with real wage growth of 10.5% YoY in 2M18. Jan-18 breakdown is the latest available, but it reveals public sector nominal wage spurt to 18.1% (vs 12.2% in private sector) was the reason. Many sectors had below-average growth except oil refinery (a 2.2x jump), construction (16%), IT (14.8%) and finance (21%) all having much stronger pace. Another driver is expanding retail lending at 15% YoY in Feb-18, and the double-digit pace is set to continue in 2018. Pre-2014 consumer confidence completes the positive outlook despite a slowdown in Feb-18 vs Jan-18 due to less aggressive gains in real incomes and uneven sectoral wage growth. Key risk, though, is that real wage gains outpace productivity, and lending grows faster than incomes.

Second, 4Q17 investments growth of 6.4% marks the 2017 high after quarterly data revision and we see it high again in 2018. Capex plans (REB&IEP surveys, DT Consulting multinationals survey) flag improving readiness to invest with extra upside after the elections. A 8.5% drop in pre-tax profits in 2017 is mostly a base-effect, so we see it being supportive. Financial conditions will continue easing on CBR rate cuts, banks liquidity surplus and rising RUB loans/bond flow.

Third, fiscal rule-driven stabilisation of the RUB REER should see non-energy/services exports rising further with the help of global growth and gov’t initiatives to spur non-energy exports. PMI export orders sub-indices back the story. Import growth is here to stay too, but it is seen normalising to lower levels after rallying in 2017.

Mr Putin’s Address flagged a focus on human capital, real estate and infrastructure. The former will take years to see GDP effects, but the latter may pick GDP pace up. We look for details during the revision of official forecasts/budget adjustments to factor it in our forecasts.

Source: CEIC

Key sentiment indicators (Jan-10=1, except Rosstat)

Source: CEIC, Rosstat

Unemployment and key activity indicators (%YoY)

Source: CEIC

-20%-15%-10%-5%0%5%10%15%

-20%-15%-10%

-5%0%5%

10%15%

Domestic demand InventoriesNet exports GDP, %YoY (rhs)

-10-8-6-4-202

0.7

0.8

0.9

1.0

1.1

1.2

PMI manufacturing PMI servicesConsumer confidence Rosstat manuf. (rhs, actual)

4%

5%

6%

7%

8%

9%

-15%

-10%

-5%

0%

5%

10%

15%

IP (SA) Retail+serv. ConstructionReal wage Unempl. (rhs)


63

Moscow, +7 495 771 79 94 [email protected]

Annual CPI inflation vs CBR key rate (%) CPI will likely be closer to 3%, not to 4% in 2018

Headline/core CPI has stayed at rock-bottom at 2.2%/1.9% recently, and even with a gradual acceleration in coming months, it may still be near 2% by Jun-18 on a base effect of last year’s food price spike. 2H18 outlook will remain dependent on agricultural harvest and/or global prices, which are hard to predict. Tariff hikes will be sub-4%, keeping utility inflation near 4%. The story now is about non-food and non-regulated services. The 10.5% growth in real wages in 2M18 reflects the long-awaited catch up in public salaries, but even we (factoring this in since Jun-17) were surprised by the scale of the increase. We share the view that CPI is likely to recover in 2H18-2019, but our updated view is to have it closer to 3% vs the updated CBR’s call of 3-4%, and within 3.3-3.7% in 2019.

Source: CEIC

Fiscal balances (12M-rolling, % of GDP) How the budget is adjusted to Putin’s promises is key The federal/general gov’t budget saw a gap of 1.4/1.5% of GDP in

2017, ie, better than expected. The 2018-20 plan envisages 1.3-0.8% deficits at US$40/bbl oil price (in 2017 US$), so under US$60-65/bbl the federal budget may see a surplus of c.1% of GDP. The fiscal rule effectively restricts gov’t ability to use the windfall revenue, so the only discretion is over non-oil revenues, which may be indeed higher under very conservative MinFin planning and/or higher GDP growth. But Putin’s goals may still require some extra funding sources, so it’s not fully surprising to see the government discussing various tax adjustment ideas (which circulated in 2016-17) just several days after Putin’s re-election. There is no unity on the need to hike/adjust taxes, so the discussion will follow creating some noise for investors.

Source: CEIC, MinFin

Loans/bonds to corporates & loans to households (%YoY) Banks health is needed to succeed in the growth story

We don’t have all the parts in Putin’s puzzle of lifting GDP growth, but his March speech implicitly assumed lending at lower rates will be key. The mix of the fiscal rule FX buying vs intra-year usage of the sovereign fund is likely to put some more RUB into the system, together with the rate cuts seeing downside for borrowing costs. But max. deposit rate is already 6.60% (vs 8% households infl. expectations) pushing deposits growth to 8-9% vs 12-13% in 2017. Money is reportedly being transferred to FI/mutual funds, which offer higher returns via managed bond portfolios and/or structured products. This may keep a shift from loan to bond financing for top-tier corporates intact. Banks will participate too, but managing risk appetite, NPLs and profits will remain key challenges in 2018.

Source: CEIC, CBR, Cbonds

Which topics Putin focused on too much/too little in March 77% is done! Is it now time for changes? Vladimir Putin got 77% in the presidential elections on 18 March

under high turnout, which was targeted by Kremlin advisers. Various measures of “moral suasion” to force public sector employees to come and vote were used to succeed on top of direct violations (yet less than in 2012). There was no real “menu of choices”, but this has been Russian reality for years. Now Mr Putin’s supporters should take a seat and monitor how the given mandate will be used. Better quality of healthcare, education, more affordable real estate and better infrastructure is promised, but we doubt people were aware of the fact that they may ultimately “pay the bill”, if taxes are hiked And the promised welfare may not happen, which could ultimately define the political environment and succession processes/scenario.

Source: Levada Center, surveyed over 7-12 March

0%2%4%6%8%10%12%14%16%18%

0%2%4%6%8%

10%12%14%16%18%

CPI Key rate

-5%-4%-3%-2%-1%0%1%2%

-5%-4%-3%-2%-1%0%1%2%

Federal gov't General gov't MinFin 2018 plan

-10%0%10%20%30%40%50%60%

-10%0%

10%20%30%40%50%60%

FX debt (in US$) RUB debt

0% 10% 20% 30% 40% 50%

MilitaryEconomy

DemographicsBusiness

OtherReal estate/mortgages

HealthcareAgriculture

Road constructionFighting povertyRaising pensions

Cities developmentEducation/culture

EcologyDifficult to answer Too little

Too much


64

Russia Strategy


The RUB has stayed nearly flat YTD vs USD (1%) despite Brent price trading 5% stronger. There has been some volatility in rolling Brent-RUB correlations, but they still look lower than before. Market anxieties about the effects of the adjusted fiscal rule on RUB (when RUB exchange rate is no longer a factor in determining FX purchases) have clearly eased on the back of the usual current account (C/A) seasonality and high oil prices. Indeed, 2M18 BoP data highlighted that the C/A surplus of US$20.8bn came along with US$9.8bn of private capital outflows. The rest – US$11bn – was nearly fully absorbed in the fiscal coffers via the MinFin FX buying, ie implicitly showing that the RUB has been traded close to fair levels.

As for the 2Q-4Q18 outlook, we still think that the fiscal rule will freeze net C/A surplus (C/A less FX purchases) near US$15-18bn in 2018 with US$12-14bn likely accumulated in 1Q18. So, capital flows will be a “marginal” driver for the RUB, and they effectively neutralised the balance in 2M18. What their balance will be going forward is key, but we think there will be no game-changers with the RUB balancing the BoP. We still see RUB levels slightly weaker over 2018 at 57.50-58.50/USD as C/A seasonality still plays its role.

As for other issues, CFTC data flags net speculative RUB-long rallied to the highest level (64% of open interest) since Jan-18 as “shorts” evaporated under range-bound trading, falling volatility and decent carry. Fears of sanctions and geopolitical escalation may keep FX repatriation flows intact, which together with active Eurobonds market and incoming FDI should keep capital flight low.


CFTC net speculative RUB position (% of total interest)

Source: Bloomberg

Local curve (%) Fixed income strategy

Our view on sub-4% inflation in 2018 has finally been shared by the CBR, which confirmed the policy normalisation in 2018. With its 3- 4% CPI forecast in late 2018-19 and the 2-3% real rate estimate, it flags 6-7% nominal rate. The latest meeting confirmed it doesn’t know where the terminal rate level is, so expect “learning by doing”. We cut our Dec-18 key rate call from 6.50% to 6.25% reflecting the view that sub-4% inflation is not a temporary, but a permanent story. We don’t think the CBR will downgrade its CPI target in 2018-19, but it may initiate some expert discussion on it. Making the 2-3% real rate corridor lower or/and narrower might be used to adjust the policy stance without changing the target, but we don’t see this happening unless the CBR sees more hurdles to GDP growth (either from structural issues or gov’t inability to lift the potential rate).

1y1y/2y1y XCCY of 5.60/5.90% looks fair vs our CBR rate view. We would receive 1Y/2Y IRS of 6.96%/6.78% too. In 1-12M FX swaps, 1-3M forward rates in 3-6 months of 5.77-5.53% is not a bet on rates, but rather on basis. It may be fair for 2H18, but paying 3-6M of 6.06-6.23% vs receiving O/N swap as we see no ST stress with FX liquidity.

Our long 10Y OFZ call from Sep-17 hit the 7% target. Although we still see value here on the CBR rate outlook/liquidity surplus, its risk/return profile is worse than before due to external markets risks.

The sovereign rating upgrade finally happened, so now only success in lifting GDP and/or taming geopolitical risks will be next drivers. The MinFin US$1.5/US$2.5bn of US$ debt sale/swap in Mar-18 was a success, and extra US$3bn is due later in 2018, incl. maybe in EUR. US$ bonds don’t look like a strong “BUY”, but we still stay comfortable in staying long RUSSIA on solid fundamentals.


RUSSIA’43 vs KAZAKS’44 (Z-spread, bp)

Source: Bloomberg

Trade Recommendation Entry date Entry level Exit level S/L Receive 2Y RUB IRS 26 March 2018 6.78% 6.05% 6.98%

27

37

47

57

67

77

87

ING f'cast Mkt fwd

-60%-40%-20%

0%20%40%60%80%

Long Short RUB net specul. position

5.5

6.0

6.5

7.0

7.5

8.0


150200250300350400450500

RUS'43 KAZ'44


65

Russia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 5.2 -7.8 4.5 4.3 3.7 1.8 0.7 -2.8 -0.2 1.5 2.0 1.8 2.0 Private consumption (%YoY) 10.6 -5.1 5.5 6.8 7.9 5.2 2.0 -9.4 -2.8 3.4 3.7 1.0 1.8 Government consumption (%YoY) 3.4 -0.6 -1.5 1.4 2.6 0.9 -2.1 -3.1 0.9 -0.9 -1.2 0.0 0.5 Investment (%YoY) 10.6 -14.4 5.9 9.1 5.0 1.3 -1.8 -11.2 0.8 3.6 5.7 5.6 4.8 Industrial production (%YoY) 0.6 -10.7 7.3 5.0 3.4 0.4 1.7 -0.8 1.3 1.0 2.1 2.0 2.2 Unemployment rate (year-end, %) 7.7 8.0 7.0 6.0 5.1 5.6 5.3 5.8 5.4 5.2 5.0 4.9 4.9 Nominal GDP (RUBbn) 41,277 38,807 46,309 60,283 68,164 73,134 79,200 83,233 86,044 90,119 96,185 99,854 105,900 Nominal GDP (€bn) 678 639 847 1034 1310 1213 826 955 1318 1340 1300 1281 1343 Nominal GDP (US$bn) 996 894 1134 1447 1690 1613 1090 1050 1390 1538 1664 1704 1813 GDP per capita (US$) 6,965 6,263 7,950 10,133 11,834 11,277 7,610 7,317 9,664 10,505 11,344 11,593 12,312 Gross domestic saving (% of GDP) 33.3 24.6 29.8 32.5 31.2 28.5 28.6 29.8 29.1 29.5 30.8 31.1 31.6


Fiscal balance (% of GDP) Consolidated government balance 4.9 -6.3 -3.4 1.4 0.4 -1.2 -1.1 -3.4 -3.7 -1.5 1.3 0.9 1.6 Consolidated primary balance 5.3 -5.6 -2.9 2.8 1.0 -0.5 -0.4 -3.0 -3.2 -0.6 2.4 2.0 2.5 Total public debt 6.5 8.3 9.0 9.5 10.5 11.2 15.0 15.2 15.0 13.9 15.8 16.4 16.7

External balance Exports (US$bn) 466 297 393 515 527 522 497 341 282 353 395 389 408 Imports (US$bn) 289 184 246 319 336 341 308 193 192 238 252 257 270 Trade balance (US$bn) 177.6 113.2 147.0 196.9 191.7 180.6 188.9 148.4 90.3 115.3 142.7 131.8 138.2 Trade balance (% of GDP) 17.8 12.7 13.0 13.6 11.3 11.2 17.3 14.1 6.5 7.5 8.6 7.7 7.6 Current account balance (US$bn) 103.9 50.4 67.5 97.3 71.3 33.4 57.5 68.8 25.5 40.2 58.3 46.9 48.3 Current account balance (% of GDP) 10.4 5.6 5.9 6.7 4.2 2.1 5.3 6.6 1.8 2.6 3.5 2.8 2.7 Net FDI (US$bn) 19.1 -6.7 -9.5 -11.8 1.8 -17.3 -35.1 -15.7 10.2 2.0 4.0 5.0 6.0 Net FDI (% of GDP) 1.9 -0.7 -0.8 -0.8 0.1 -1.1 -3.2 -1.5 0.7 0.1 0.2 0.3 0.3 Current account balance plus FDI (% of GDP) 12.4 4.9 5.1 5.9 4.3 1.0 2.1 5.1 2.6 2.7 3.7 3.0 3.0 Foreign exchange reserves ex gold (US$bn) 412.5 416.7 443.0 454.0 486.6 469.6 339.4 319.8 317.6 356.1 405.0 438.0 475.0 Import cover (months of merchandise imports) 17.1 27.2 21.6 17.1 17.4 16.5 13.2 19.9 19.9 18.0 19.3 20.5 21.1


Interest & exchange rates Central bank key rate (year-end, %) n/a 6.00 5.00 5.25 5.50 7.50 17.00 11.00 10.00 7.75 6.25 5.75 5.50 Broad money supply (average, %YoY) 0.8 17.7 31.1 21.0 12.2 14.7 1.5 11.3 9.2 10.5 11.0 12.0 12.0 3m interest rate (MosPrime, average, %) 11.1 11.5 4.1 5.5 7.2 6.9 10.5 13.8 11.2 9.4 7.0 6.1 5.6 3m interest rate spread over US$-Libor (ppt) 684 687 285 468 576 633 1028 1359 1117 964 731 618 508 2yr yield (average, %) 7.5 9.3 5.9 6.7 6.9 6.2 9.0 11.6 9.2 7.7 6.7 6.2 6.2 10yr yield (average, %) 7.6 11.2 7.6 8.6 8.2 7.5 9.5 11.1 8.9 7.9 6.9 6.3 6.0 USD/RUB exchange rate (year-end) 29.38 30.24 30.54 32.13 30.56 32.89 58.25 72.93 61.22 57.57 58.00 58.00 58.50 USD/RUB exchange rate (average) 41.44 43.39 40.82 41.66 40.34 45.35 72.67 79.27 61.91 58.60 57.80 58.60 58.42 EUR/RUB exchange rate (year-end) 41.13 43.25 40.92 41.76 40.34 45.07 70.48 79.49 64.63 69.11 75.40 78.30 78.98 EUR/RUB exchange rate (average) 60.92 60.74 54.70 58.33 52.03 60.31 95.93 87.19 65.26 67.24 73.98 77.94 78.87 Brent oil price (annual average, US$/bbl) 59 94 36 78 96 111 113 108 45 55 60 53 55



Real GDP (%YoY) 0.5 2.5 1.8 1.2 2.3 1.5 1.8 2.1 1.2 2.0 1.8 1.8 2.7 CPI (eop, %YoY) 4.2 4.4 3.0 2.5 2.3 2.0 2.5 3.0 3.5 3.8 3.4 3.2 3.2 Central bank key rate (eop, %) 9.75 9.00 8.50 7.75 7.25 6.75 6.50 6.25 6.25 6.00 5.75 5.75 5.50 3m interest rate (eop, %) 10.21 9.23 8.70 7.88 7.34 6.80 6.60 6.30 6.30 6.05 5.80 5.80 5.55 10yr yield (eop, %) 8.29 8.16 7.66 7.64 7.10 6.80 6.60 6.50 6.50 6.25 6.15 6.10 6.00 USD/RUB exchange rate (eop) 56.29 58.93 57.57 57.57 56.90 57.50 58.20 58.00 58.60 59.40 59.00 58.00 58.50 EUR/RUB exchange rate (eop) 59.96 67.33 68.01 69.11 71.13 73.60 74.50 75.40 76.77 78.41 78.47 78.30 78.98 Brent oil price (quarter average, US$bbl) 55 51 52 62 67 60 57 57 50 52 55 55 55



66

Serbia Ciprian Dascalu, Chief Economist, Romania, Balkans

Forecast summary Country strategy: IMF’s poster child 4Q17 1Q18F 2Q18F 3Q18F 4Q18F 2018F 2019F

Real GDP (%YoY) 2.5 3.4 3.1 2.7 2.5 2.9 3.7 CPI (%YoY)* 3.0 1.7 2.0 2.8 2.9 2.4 3.1 Policy interest rate (eop, %) 3.50 3.25 3.00 3.00 3.00 3.00 3.50 3m interest rate (%)* 3.12 3.00 2.70 2.70 2.80 2.80 3.10 10yr yield (%)* n/a 5.00 4.80 4.70 4.70 4.80 4.40 USD/RSD* 99.2 94.4 92.2 91.4 90.0 92.2 86.8 EUR/RSD* 119.1 118.0 118.0 117.0 117.0 118.1 115.5


Activity Presidential: Apr-2022 S&P BB BB Fiscal Loose Parliamentary: Apr-2020 Moody’s Ba3 Ba3 Monetary Loose Local: Mar-2022 Fitch BB BB

Serbia is benefiting from the robust European growth backdrop, although GDP disappointed slightly last year. The country appears to be committed to using the cyclical recovery to reduce the debt overhang and increase the buffers for hard times. IMF assistance helped Serbia’s fiscal consolidation and a new precautionary deal is likely. Part of the decline in Serbia’s debt-to GDP ratio is also attributable to RSD appreciation vs the EUR and to USD weakness. The government is aiming to address the sensitivity of government debt to FX rates going forward, after the NBS managed to boost its inflation-targeting credentials which allowed it to bring local currency interest rates sharply down in recent years.


Private investments picking-up Tight labour market in CEE – the driver for Serbia FDIs

Private investments and household consumption were the main drivers of GDP growth in 2017. Nevertheless growth disappointed last year, but a favourable external backdrop, significant fiscal impulse with targeted budget deficit at -0.6% of GDP from a surplus of 1.2% in 2017 and accommodative monetary policy should boost both private and public demand in 2018. Serbia benefits from a lack of labour supply in neighbouring Romania and Hungary. This helps it to attract foreign investments as the labour market has significant slack with the unemployment rate at 14.7%. Prospects of joining the EU are also supporting investor confidence and are the main driver of structural reforms.

Source: NBS, ING

Inflation outlook is supportive for bond inflows Deploying policies to boost growth NBS interventions since the start of the year have been focussed on

curbing RSD strengthening, accompanied by verbal interventions from the NBS governor. We hold an non-consensus view on the NBS outlook - expecting more easing which should bring more inflows into local currency debt and hence support a firmer RSD. The NBS has tightened its grip on FX, ignoring IMF recommendations, as seen in the increase in frequency of FX interventions and in lower EUR/RSD volatility. It has dismissed any change in the managed floating exchange rate regime. Improving external balances and public finances are likely to persuade the NBS to allow gradual RSD appreciation.

Source: NBS, ING

SERBIA lines alongside CROATI and RUSSIA Still a viable running carry play versus RUSSIA

US$1bn in debt matures on 3 Dec 2018. The finance ministry plans to roll this over, replacing it with EUR denominated debt with maturity of 5Y and/or 10Y. Whether these plans are stuck to will partly depend on market conditions, with pre-funding always and option. That said, refinancing on the local market is not to be ruled out, with a side positive to reduce government debt FX risks. At the same time it is clear that Serbia could do with extending its hard currency curve as existing USD lines have rolled into the sub-5yr maturity. With just two lines left after December’s redemption, a longer tenor line is now needed to re-generate a viable curve.



Buy SERBIA 7.25 9/21 and Sell RUSSIA4.5 4/22 27 March 2018 14bp 5bp 20bp

-6.0

-2.0

2.0

6.0

10.0

1Q10 4Q10 3Q11 2Q12 1Q13 4Q13 3Q14 2Q15 1Q16 4Q16 3Q17HH consumption Private investmentsGovernment Net exportsGDP (%, YoY)

-3.0

0.0

3.0

6.0

9.0

0.0

3.0

6.0

9.0

12.0

15.0

Jan-10 May-11 Sep-12 Jan-14 May-15 Sep-16 Jan-18

Real key rate (%, rhs) Key policy rate (%, lhs)CPI (%YoY, lhs) CORE CPI (%YoY, lhs)

2

2.5

3

3.5

4

4.5

5

5.5

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

USD CROATI BB POS USD RUSSIA BBB- STABLE USD SERBIA BBB- STABLE

%


67

Serbia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 5.4 -3.1 0.6 1.4 -1.0 2.6 -1.8 0.7 2.8 1.9 2.9 3.7 3.6 Private consumption (%YoY) 6.2 0.0 -0.6 0.9 -2.1 -0.6 -1.3 0.5 1.2 2.1 3.0 3.0 2.8 Government consumption (%YoY) 3.9 -1.7 0.1 0.9 1.9 -1.1 -0.6 -1.5 2.7 2.5 2.4 1.1 1.5 Investment (%YoY) 8.2 -22.5 -6.5 4.6 13.2 -12.0 -3.6 5.6 6.1 6.4 5.8 6.9 7.0 Industrial production (%YoY) 1.1 -12.6 1.2 2.5 -2.6 6.1 -7.4 7.3 4.9 4.2 4.5 6.3 6.0 Unemployment rate (year-end, %) 14.7 17.4 20.0 24.4 23.1 22.1 19.2 17.7 16.1 14.3 12.6 9.2 7.4 Nominal GDP (RSDbn) 2,745 2,880 3,067 3,408 3,584 3,876 3,908 4,043 4,262 4,465 4,756 5,070 5,253 Nominal GDP (€bn) 34 31 30 33 32 34 33 33 35 37 40 44 47 Nominal GDP (US$bn) 49 43 40 47 41 46 44 37 38 42 52 58 63 GDP per capita (US$) 6,700 5,800 5,400 6,400 5,700 6,400 6,200 5,200 5,400 6,000 7,400 8,400 9,200 Gross domestic saving (% of GDP) 5.3 3.5 3.5 4.7 4.3 6.9 6.6 9.1 11.6 12.2 12.2 12.1 12.0

Prices CPI (average, %YoY) 12.5 8.2 6.1 11.2 7.3 7.9 2.1 1.4 1.1 3.1 2.4 3.1 3.5 CPI (year-end, %YoY) 8.6 6.6 10.2 7.0 12.2 2.2 1.8 1.6 1.6 3.0 3.0 2.9 3.4 Wage rates (nominal, %YoY) 18.0 -3.1 7.6 11.2 9.0 6.2 1.4 -0.2 3.7 3.9 4.0 4.2 4.5

Fiscal balance (% of GDP) Consolidated government balance -2.6 -4.4 -4.6 -4.8 -6.8 -5.5 -6.6 -3.7 -1.3 1.2 -0.6 -0.7 -0.7 Consolidated primary balance -2.0 -3.6 -3.5 -3.5 -4.9 -3.1 -3.7 -0.4 1.8 3.6 2.5 2.4 2.4 Total public debt 26.1 32.1 40.8 47.0 58.0 61.1 71.8 75.1 72.5 64.9 63.9 61.5 60.0

External balance Exports (€bn) 7.5 6.0 7.4 8.5 8.8 11.1 11.1 12.0 13.4 15.4 17.7 20.3 23.3 Imports (€bn) 15.6 11.5 12.6 14.3 14.7 15.5 15.4 16.4 17.3 19.8 22.7 25.9 29.7 Trade balance (€bn) -8.1 -5.5 -5.2 -5.8 -5.9 -4.4 -4.3 -4.4 -3.9 -4.4 -5.0 -5.6 -6.4 Trade balance (% of GDP) -24.2 -18.0 -17.6 -17.4 -18.6 -12.7 -12.9 -13.1 -11.2 -12.0 -12.4 -12.8 -13.6 Current account balance (€bn) -7.1 -2.0 -2.0 -3.7 -3.7 -2.1 -2.0 -1.6 -1.4 -2.0 -2.3 -2.5 -2.8 Current account balance (% of GDP) -21.2 -6.5 -6.7 -11.1 -11.7 -6.1 -6.0 -4.7 -4.0 -5.4 -5.7 -5.7 -6.0 Net FDI (€bn) 1.8 1.4 1.3 3.5 1.0 1.5 1.5 2.1 2.1 2.8 2.9 3.0 3.1 Net FDI (% of GDP) 5.4 4.6 4.3 10.6 3.2 4.5 4.5 6.3 5.0 7.6 7.1 6.8 6.6 Current account balance plus FDI (% of GDP) -15.8 -2.0 -2.5 -0.5 -8.6 -1.6 -1.5 1.6 1.0 2.1 1.4 1.1 0.6 Foreign exchange reserves ex gold (€bn) 8.8 11.7 11.2 12.3 11.4 11.6 11.1 11.2 11.1 10.4 11.5 12.8 14.0 Import cover (months of merchandise imports) 6.8 12.2 10.7 10.3 9.3 9.0 8.6 8.2 7.7 6.3 6.1 5.9 5.7


Interest & exchange rates Central bank key rate (year-end, %) 17.75 9.50 11.50 9.75 11.25 9.50 8.00 4.50 4.00 3.50 3.00 3.50 4.00 Broad money supply (average, %YoY) 9.8 21.5 12.9 10.3 9.4 4.6 7.6 6.6 11.6 3.6 4.3 5.1 5.3 3m interest rate (Belibor,average, %) 15.6 14.4 10.8 12.9 11.7 10.1 8.3 6.1 3.4 3.4 2.8 3.1 3.9 3m interest rate spread over Euribor (ppt) 11.0 13.2 9.9 11.5 11.1 9.9 8.0 6.1 3.7 3.7 3.1 3.0 3.1 2yr yield (average, %) n/a n/a n/a 14.5 15.1 11.0 10.1 8.2 5.2 4.3 3.7 3.7 4.2 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 4.8 4.4 4.7 USD/RSD exchange rate (year-end) 60.3 68.5 78.7 74.7 88.2 86.2 91.6 110.6 117.6 99.3 90.0 84.4 81.5 USD/RSD exchange rate (average) 55.7 67.2 77.2 72.9 88.0 85.0 88.9 109.8 112.0 105.5 92.2 86.8 83.0 EUR/RSD exchange rate (year-end) 88.6 95.9 105.5 104.6 113.7 114.6 121.0 121.6 123.5 119.1 117.0 114.0 110.0 EUR/RSD exchange rate (average) 81.9 94.1 103.5 102.0 113.6 113.1 117.4 120.8 123.2 121.3 118.1 115.5 112.0



Real GDP (%YoY) 1.1 1.4 2.1 2.5 3.4 3.1 2.7 2.5 2.3 3.2 4.0 4.9 4.2 CPI (eop, %YoY) 3.6 3.6 3.2 3.0 1.7 2.0 2.8 2.9 3.3 3.1 2.7 2.9 3.0 Central bank key rate (eop, %) 4.00 4.00 3.75 3.50 3.25 3.00 3.00 3.00 3.00 3.00 3.25 3.50 3.50 3m interest rate (eop, %) 3.52 3.53 3.30 3.12 3.00 2.70 2.70 2.80 2.85 3.00 3.15 3.40 3.40 10yr yield (eop, %) n/a n/a n/a n/a 5.0 4.8 4.7 4.7 4.4 4.3 4.30 4.50 4.55 USD/RSD exchange rate (eop) 116.3 106.8 100.9 99.2 94.4 92.2 91.4 90.0 88.5 87.1 86.5 84.4 83.7 EUR/RSD exchange rate (eop) 123.9 122.0 119.2 119.1 118.0 118.0 117.0 117.0 116.0 115.0 115.0 114.0 113.0



68

Turkey Muhammet Mercan, Chief Economist


Real GDP (%YoY) 6.9 4.0 5.1 3.9 4.3 4.3 4.5 CPI (%YoY)* 11.9 10.1 10.3 10.2 9.2 10.0 8.6 Policy interest rate (eop, %) 8.00 8.00 8.00 8.00 8.00 8.00 8.00 3m interest rate (%)* 14.61 13.64 13.65 13.53 13.15 13.54 12.54 10yr yield (%)* 11.74 12.60 12.14 12.09 11.43 11.96 11.17 USD/TRY* 3.79 3.90 3.91 4.01 4.10 3.94 4.27 EUR/TRY* 4.55 4.88 5.01 5.13 5.33 5.12 5.76


Activity Presidential: Nov-19 S&P BB BB+ Fiscal Looser Parliamentary: Nov-19 Moody’s Ba2 Ba2 Monetary Tighter Local: Mar-19 Fitch BB+ BBB-

Moody’s has cut Turkey’s credit rating a second time since the failed coup attempt in mid-2016, citing continuing deterioration in institutional strength and rising external vulnerabilities. Despite some efforts recently – with automatic enrolment to private pension schemes, legislation to reduce FX risk of corporates and initial steps to restructure VAT – Turkey needs a more concrete structural reform initiative in the face of downgrade pressures from rating agencies. Regarding key macro indicators, growth remains strong thanks to credit and fiscal impulses while CPI has remained at double digits, albeit less in recent months, with core close to the peak in the current series. The CBT uses a combination of new and old unorthodox policy tools, keeping the effective cost of funding elevated.


GDP growth (% YoY) Macro digest

GDP growth in 3Q17 surprised on the upside, supported by favourable base year impact and counter-cyclical measures introduced by the Government. These measures include the Credit Guarantee Fund (CGF) scheme which supported profitability, asset quality, and capitalization of the Turkish Banking Sector. This had significant impact on investment and steps to boost consumption, thanks to hiring mobilization (contributing to the downtrend in unemployment), macro prudential easing by the Banking Regulation and Supervision Agency (with increasing borrowing ability of households facilitating consumer lending acceleration) and tax cuts on certain consumer durables and furniture. All in all, private consumption and investments were important pillars, while exports were also robust on strength in EU demand. We expect economic activity to soften this year as lending has already lost momentum with the CGF nearing the ceiling. The rate of volume expansion (13w moving avg, FX-adj., annualized) has almost reverted to the level before introduction of the facility. In 2018, utilization of the remaining amount in the CGF implies limited impact on the lending expansion, hinting that the credit impulse would likely turn negative. However, 2018 macro performance is expected to remain solid - the government will maintain fiscal stimulus, likely stepping it up this year, as it has already prepared a new set of incentives with a focus on further stimulating investments in the form of tax supports so as to keep growth competitive. Additional employment incentives - the government will take over the taxes and social security premiums of new employees as it did last year - should also be key this year. We expect 4.3% GDP growth while the authorities' inclination to support growth could push this higher.

The inflation data in December and January show a fall in the headline, with the easing base effects that will continue to support outlook in the coming few months. The February data saw a marginal drop in the annual figure. The lower than expected improvement in the last month is attributable to reviving pressure in food prices on the back of rises in meat and dairy product prices as well as administrative hikes in medical products and despite the fall in transport prices. Core inflation remained sticky and the annual change in the "C" indicator turned out to be 11.94%, down by 0.3ppt vs the previous month. The fall is attributable to core goods while services inflation increased. Given the continuing impact of recent TRY weakness, and deterioration in expectations and pricing behaviour, core inflation is likely to remain in double digits in the near term. Looking ahead, we expect inflation to be elevated and close to the 10% threshold this year, before ending at around 9.2%.

Source: TurkStat, ING Bank

PMI and CUR (seasonally adjusted, 3m-ma, %YoY)

Source: Markit, TurkStat, ING Bank

Inflation (%YoY)

Source: TurkStat, ING Bank

-5

0

5

10

15

Domestic Demand Net Foreign Demand GDP Growth

74.5

75.5

76.5

77.5

78.5

79.5

47

49

51

53

55

57

02/1

3

06/1

3

10/1

3

02/1

4

06/1

4

10/1

4

02/1

5

06/1

5

10/1

5

02/1

6

06/1

6

10/1

6

02/1

7

06/1

7

10/1

7

02/1

8

PMI CUR (rhs)

10.310.7

9.4

11.9

5

7

9

11

13

15

02/16 05/16 08/16 11/16 02/17 05/17 08/17 11/17 02/18

CPI Goods Services Core Inflation (C)


69

Istanbul, +90 212 329 0751 [email protected]

Unemployment vs NPLs (%) Unemployment rate in a downtrend The seasonally adjusted (SA) unemployment rate that has been in a

downtrend since the last month of 2016 declined to single digit territory at 9.9% in December 2017 vs 12% (the highest rate since early 2010) a year before. The latest reading is the lowest since mid-2014 with the exception of a temporary single digit figure in Mar-2016. This was thanks to employment incentives via cuts in social premiums for new hirings and other forms of tax incentives as well as robust activity, with the growth rate likely at its highest in the last four years. In 2018, additional steps by the government to support employment in SMEs and the manufacturing sector, focusing on female and youth employment as well as new incentives to boost investments, should further improve labour market conditions.

Source: TurkStat, BRSA, ING Bank

Breakdown of C/A financing (12m-rolling, US$bn) C/A deficit remains on a widening path The January data saw a significant expansion in the C/A deficit to

c.5.9% of GDP on a 12M rolling basis, up from 3.8% at end-2016. The 12M core C/A balance (excluding energy and gold) that followed an improvement trend from the last months of 2016 until Aug-17, changed direction, attributable to strengthening in domestic demand on accommodative fiscal and quasi-fiscal policies. On the financing front, capital flows financed 83% of the annual C/A deficit in 2017 (vs 69% in 2015), while 17% of financing was with the reserve drawdown (a US$8.2bn decline in reserves vs a marginal US$0.8bn increase in 2016). In January, Turkey faced no difficulty in financing the deficit thanks to strong portfolio flows (also including bond issuance), while official reserves increased by US$4.4bn.


Core budget balance (12m rolling, % of GDP) Fiscal risks to the upside in 2018

The government will likely step up the fiscal stimulus this year, as, in addition to a significant hike in minimum wage and permanent hiring of employees working as sub-contractors, it has a new set of incentives with a focus of further stimulating investments in the form of tax cuts so as to keep growth competitive. However, tax adjustments and likely upward pressure in spending should increase widening pressures in the budget deficit. The 2017 deficit is c.1.5% of GDP, in line with the target set at the end of 2016, though better than the revised estimate at 2.0% in the latest Medium Term Plan (MTP) released in late September. We see the central administration budget deficit-to-GDP ratio at 2.1% (vs 1.9% MTP target) and 2.3% this year and next, respectively, with risks to the upside.

Source: Ministry of Finance, ING Bank

Loan growth (adj. for FX, 13-week moving avg, ann. %) Banking sector strength last year

CGF has had a significant impact in the banking sector with above average growth last year. The lending surge exacerbated stretched TRY loan/deposit ratios. Consumer lending has decelerated lately on the back of tax cut reversals at end-3Q17 along with the impact of base effects. The corporate lending pace also softened to some extent with the CGF facility nearing the ceiling, while negative base effects are also at play. The NPL ratio gradually declined with the contribution of the CGF, not only because of strong volume expansion, but also increasing access of companies to financing, while capitalisation has improved thanks to solid capital generation and low uncovered NPLs as well as regulatory support for the banks. Lastly, CGF also helped profitability, despite higher funding costs.

Source: BRSA, ING Bank

2.7

2.9

3.1

3.3

3.5

8

9

10

11

12

Unemployment Rate (sa, lhs) NPLs

11-2 1

-9 -26 -11 -10 -5

1613 13 13 18 13 11 11

1938 21

21

-10

8 24 28

1719 37 18

2813

1515

2

-21 -10

12

-1

82

9

13 2

1011

1

-40%

-20%

0%

20%

40%

60%

80%

100%

2011 2012 2013 2014 2015 2016 2017 01/18

Resident Flows FDI Portfolio Flows

Borrowing & Other Reserves (- = incr.) Net E&Os

-5

-4

-3

-2

-1

0

03/0

9

09/0

9

03/1

0

09/1

0

03/1

1

09/1

1

03/1

2

09/1

2

03/1

3

09/1

3

03/1

4

09/1

4

03/1

5

09/1

5

03/1

6

09/1

6

03/1

7

09/1

7

02/1

8

-5

5

15

25

35

45

02-1

504

-15

06-1

508

-15

10-1

511

-15

01-1

603

-16

05-1

607

-16

09-1

610

-16

12-1

602

-17

04-1

706

-17

08-1

709

-17

11-1

701

-18

03-1

8

Sector State Banks Private Banks


70

Turkey Strategy

FX – spot vs forward and INGF FX strategy Following a number of measures last November and December,

including liquidity tightening and finally hiking its late liquidity window so as to curb TRY volatility and contain inflationary pressures, the CBT has been on hold this year with improving sentiment and some disinflation in the headline CPI suggesting that policy rates have peaked in the near term. Accordingly, already at the limit of liquidity policy with effective cost of funding aligned with the LLW, liquidity conditions have remained unchanged. Regarding the inflation assessment, the CBT sees that “underlying trend indicators display inertia and core inflation remains elevated”. This can be seen as a signal of caution as it also maintained a tightening bias. Given the CBT’s signal not to alter the policy line until there is a sustainable inflation improvement, the bank will likely maintain the current stance in the near term as long as TRY remains stable, though reviving volatility in recent days is likely a discomfort factor for the bank. We think the bank will likely prefer to wait and see unless ongoing unrest gets out of control which might then require it to call an early MPC. TRY has been vulnerable to shifts in geopolitical risk anticipation, while large external imbalances, persistently high inflation in comparison to CBT rates and residents’ inclination to hold FX deposits have been factors that have long weighed on TRY performance. With higher than expected February inflation, Moody’s downgrade and further widening of the external deficit, TRY weakened again recently. We think high risk adjusted carry and attractive TRY valuation should limit the extent of weakness. The global outlook will remain key for any TRY performance.


CBT policy rate and Interest rate corridor (%)


Local curve (%) Fixed Income strategy Bond yields have remained vulnerable to rising risk anticipation from

geopolitical issues, expected CBT policy following the ongoing downtrend in headline inflation and swings in global risk appetite (with the sell-off in global equities in early February). Moody’s downgrade to 2-notch below investment grade has not helped the appetite for TRY assets either. Accordingly, 10Y bond yields are currently at their highest in 2018 so far at c.12.8%, though still below the 13.18% all-time high realized last November. Given the tight CBT stance, the yield curve has remained heavily inverted with 2v10Y at around -115bp, narrower than the spread realized in January (around -175bp at 9 Jan) with more upward pressure on the long end of the curve. However, foreign investors’ net bond purchases in 2018 have been relatively strong when compared to last year at USD0.4bn (or USD0.7bn excluding repos) despite accelerating sales from early February, translating into a 21.9% share in domestic debt stock. Recent widening in the budget deficit has caused some flow problems with significant increase in the domestic debt rollover ratio to 126% in 2017, the highest since the 2001 financial crisis, while the Treasury targets 110% in 2018. Having a significant cash buffer at the moment, the Treasury aims to undershoot its target for the domestic rollover ratio this year, while the realization has been below 100% in the first two months. Limited supply pressure in the coming three months after heavy borrowing in February is likely to provide relief, while the ongoing selloff should provide better entry points once the dust settles. The long end should also be impacted by core rates that have been under pressure for a while.


Real interest rate (%)

Source: Treasury, CBT, ING Bank

Trade Recommendation Entry date Entry level Exit level S/L Buy TURKGB10.6 26 and Sell RFLB7.75 26 27 March 2018 575bp 500bp 600bp

2.5

3.0

3.5

4.0

4.5

ING f'cast Mkt fwd

60

80

100

120

140

789

10111213

Funding (TRY bn, rhs) BIST O/N Repo RateO/N Borrowing Rate 1W Repo RateO/N Lending Rate Cost of CBT FundingLate Liquidity Window Rate

11.5

12.5

13.5

14.5

15.5


0

1

2

3

4

5

6789

1011121314

Treasury's Borrowing 12M Infl. Exp. Real Rate -rhs


71

Turkey 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 0.8 -4.7 8.5 11.1 4.8 8.5 5.2 6.1 3.2 7.2 4.3 4.5 3.7 Private consumption (%YoY) 0.3 -3.7 10.8 12.3 3.2 7.9 3.0 5.4 3.7 6.5 4.1 4.4 3.6 Government consumption (%YoY) 3.5 8.1 1.7 1.1 6.8 8.0 3.1 3.9 9.5 2.4 3.2 3.6 2.8 Investment (%YoY) -2.7 -20.5 22.5 23.8 2.7 13.8 5.1 9.3 2.2 8.4 5.4 4.0 3.2 Industrial production (%YoY) -0.9 -10.7 13.7 14.7 4.2 7.2 5.7 5.8 3.4 8.9 5.3 5.5 4.5 Unemployment rate (year-end, %) 10.0 13.0 11.1 9.1 8.4 9.0 9.9 10.3 10.9 10.9 10.4 10.1 10.0 Nominal GDP (TRYbn) 995 999 1,160 1,394 1,570 1,810 2,044 2,339 2,609 3,127 3,682 4,218 4,692 Nominal GDP (€bn) 551 450 575 639 666 683 770 784 820 716 719 732 765 Nominal GDP (US$bn) 770 645 770 828 878 939 932 851 861 859 935 989 1032 GDP per capita (US$) 10,931 8,980 10,560 11,205 11,588 12,480 12,112 11,014 10,807 10,697 11,499 12,004 12,378 Gross domestic saving (% of GDP) 20.7 24.9 29.4 26.4 28.0 27.2 26.6 25.5 25.1 25.0 25.6 25.3


Fiscal balance (% of GDP) Consolidated government balance -1.8 -5.3 -3.5 -1.3 -1.9 -1.0 -1.1 -1.0 -1.1 -1.5 -2.1 -2.3 -1.6 Consolidated primary balance 3.3 0.0 0.7 1.8 1.2 1.7 1.3 1.3 0.8 0.3 -0.5 -0.7 -0.3 Total public debt 38.1 43.9 40.1 36.5 32.7 31.4 28.8 27.6 28.3 28.0 28.5 29.8 30.1

External balance Exports (US$bn) 139.7 108.9 120.0 142.0 161.6 161.8 168.9 152.0 150.2 165.7 179.1 193.8 210.1 Imports (US$bn) 192.7 133.8 176.4 231.1 227.0 241.7 232.5 200.1 191.1 224.6 243.5 254.1 276.0 Trade balance (US$bn) -53.0 -24.9 -56.4 -89.1 -65.3 -79.9 -63.6 -48.1 -40.9 -58.8 -64.4 -60.3 -65.8 Trade balance (% of GDP) -6.9 -3.9 -7.3 -10.8 -7.4 -8.5 -6.8 -5.7 -4.7 -6.8 -6.9 -6.1 -6.4 Current account balance (US$bn) -40.4 -12.2 -45.4 -75.1 -48.5 -65.0 -43.6 -32.1 -33.1 -47.2 -50.1 -45.3 -49.4 Current account balance (% of GDP) -5.3 -1.9 -5.9 -9.1 -5.5 -6.9 -4.7 -3.8 -3.8 -5.5 -5.4 -4.6 -4.8 Net FDI (US$bn) 17.0 6.9 7.6 13.7 9.2 9.2 5.5 12.5 10.2 8.1 8.9 10.0 11.2 Net FDI (% of GDP) 2.2 1.1 1.0 1.7 1.0 1.0 0.6 1.5 1.2 0.9 1.0 1.0 1.1 Current account balance plus FDI (% of GDP) -3.1 -0.8 -4.9 -7.4 -4.5 -5.9 -4.1 -2.3 -2.7 -4.5 -4.4 -3.6 -3.7 Foreign exchange reserves ex gold (US$bn) 70.1 69.6 80.7 78.3 100.3 112.0 106.3 95.7 92.1 84.1 82.5 82.7 84.8 Import cover (months of merchandise imports) 4.4 6.2 5.5 4.1 5.3 5.6 5.5 5.7 5.8 4.5 4.1 3.9 3.7


Interest & exchange rates Central bank key rate (year-end, %) 15.00 6.50 6.50 5.75 5.50 4.50 8.25 7.50 8.00 8.00 8.00 8.00 8.00 Broad money supply (average, %YoY) 26.7 13.0 19.1 14.8 10.2 22.2 11.9 17.1 18.3 15.7 18.7 15.5 12.2 3m interest rate (TRLibor,average, %) 17.6 10.2 7.4 8.8 8.9 6.9 10.1 10.9 10.1 12.7 13.5 12.5 11.4 3m interest rate spread over US$-Libor(ppt) 1287 877 718 847 836 659 989 1062 927 1135 1150 986 869 2yr yield (average, %) 19.3 11.4 8.4 9.1 8.1 7.6 9.2 9.8 9.7 11.8 12.9 11.7 10.7 10yr yield (average, %) n/a n/a 9.8 9.6 8.5 8.3 9.3 9.4 10.1 11.0 12.0 11.2 10.5 USD/TRY exchange rate (year-end) 1.51 1.51 1.55 1.91 1.78 2.13 2.32 2.92 3.53 3.79 4.10 4.40 4.67 USD/TRY exchange rate (average) 1.29 1.55 1.51 1.68 1.79 1.93 2.19 2.75 3.03 3.64 3.94 4.27 4.55 EUR/TRY exchange rate (year-end) 2.21 2.11 2.21 2.55 2.31 2.82 3.19 3.53 3.92 4.29 5.15 5.81 6.22 EUR/TRY exchange rate (average) 1.81 2.22 2.02 2.18 2.36 2.65 2.65 2.98 3.18 4.37 5.12 5.76 6.14 Brent oil price (annual average, US$/bbl) 72.9 97.3 61.8 79.9 112.1 112.4 109.6 99.4 52.1 43.3 54.1 59.8 53.0



Real GDP (%YoY) 5.3 5.4 11.1 6.9 4.0 5.1 3.9 4.3 4.0 4.7 4.4 4.8 3.1 CPI (eop, %YoY) 11.3 10.9 11.2 11.9 10.1 10.3 10.2 9.2 8.9 8.7 8.5 8.1 7.9 Central bank key rate (eop, %) 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 3m interest rate (eop, %) 12.12 12.71 12.81 14.61 13.64 13.65 13.53 13.15 12.87 12.59 12.30 12.02 11.73 10yr yield (eop, %) 10.93 10.53 10.97 11.74 12.60 12.14 12.09 11.43 11.31 11.19 11.07 10.95 10.73 USD/TRY exchange rate (eop) 3.63 3.52 3.56 3.79 3.90 3.91 4.01 4.10 4.18 4.25 4.33 4.40 4.47 EUR/TRY exchange rate (eop) 3.92 3.94 4.28 4.55 4.88 5.01 5.13 5.33 5.47 5.61 5.76 5.94 6.03



72

Ukraine Dmitry Polevoy, Chief Economist, Russia & CIS


Real GDP (%YoY) 2.2 3.0 2.8 2.7 2.6 2.8 2.9 CPI (%YoY)* 13.7 12.6 11.5 9.7 8.5 11.2 8.2 Policy interest rate (eop, %) 14.50 17.00 17.00 17.00 16.00 16.00 12.00 3m interest rate (%)* n/a n/a n/a n/a n/a n/a n/a 10yr yield (%)* n/a n/a n/a n/a n/a n/a n/a USD/UAH* 28.07 27.00 28.00 28.50 30.00 28.31 29.90 EUR/UAH* 32.07 32.40 33.60 34.20 37.50 32.56 37.67


Activity Presidential: May-19 S&P B- B- Fiscal Looser Parliamentary: Sep-19 Moody’s Caa2 WR Monetary Tighter Local: Fitch B- B-

After the nearly 16% drop over 2014-15, the resumption of 2.1-2.3% GDP growth in 2016-17 was clearly a positive, but the economy stands 12% below the pre-crisis level. Hence, officials shouldn’t be complacent about the expected 3-3.5% GDP growth in 2018-19. Hikes in min. wages and other social spending helped consumption, and will likely continue to do so. Investment is set to ease after a strong recovery, while still growing. Major direct and indirect risks come from the uncertain outlook for the country’s cooperation with the IMF. While this doesn’t look to be overriding at this stage, it is still crucial for setting investor perception for sovereign risk, especially given where US$ papers trade now. The solid anti-inflationary NBU stance keeps local bonds a “BUY”, conditional on UAH stability.


GDP growth and major contributors, (%YoY) Macro digest 4Q17 GDP data saw a mild slowdown to 2.2% YoY from the upwardly

revised 2.4% in 3Q17, echoing weaker key sector output (KSO) at 0.8% YoY vs 1.8% before. Despite this easing, this is a very strong outcome on the high base effect of 4Q16. Momentum seems to have firmed in Jan-18 with KSO growth accelerating to 5.2% YoY vs 3.5% in Dec-17, assuming a pick up to 3.1% growth on a 3-month average basis.

The breakdown suggests the success was a mix of an extended rally in domestic demand (10.5ppt) and a drag from net exports (-6.5ppt) and inventories (-1.1ppt). Private consumption added 6.5ppt in 4Q17 (10.7% YoY) alongside 0.7 ppt from public consumptions (3.2%). Strong consumption was due to a 19% YoY rise in real wages and improved consumer confidence (the GFK index rose to 60+ in 4Q17 vs 9M17 avg. of 57). Investments added 3.2ppt on the back of very solid 16.7% YoY.

As for production, IP stagnated in 4Q17 after a 0.6% drop in 3Q. This was due to drops in the mining sector (-5% vs -6.3% in 3Q) and utilities (-9.1% vs -6%) masking solid manufacturing performance (4.4% vs 3.1%). All major consumer and investment-related subsectors accelerated. In 2017, IP growth in Ukraine excluding Donbass grew 3.7%. Agriculture underperformed at -2.7% in 12M17 vs -0.7% in 9M17 on lower wheat, corn and sunflower harvests after bad weather conditions.

The official forecast for 2018 GDP stays at 3%/3.6%, while the NBU has recently revised its growth projections to 3.4%/2.9%YoY from the initial 3.2%/3.5% set for 2018/19. Effectively, the economy is now expected to grow by 6.3% over two years vs 6.8% expectations in the previous NBU forecast, reflecting weaker mid-term growth momentum from fiscal policy and stalling structural reforms.

We upgraded 2018 GDP growth from 2.5% to 2.8% while having 2.9% in 2019 unchanged. Consumption is to lead further, after the extra 16% minimum wage hike in Jan-18, higher social spending (with hikes in military pensions in 2018/20, in civil pensions in 2019) and growing lending. An extra 12% rise in min. wage could be agreed on in Apr-18. Yet, the GFK consumer confidence gauge eased in Jan-18 and CPI stays high. Construction growth stalled in Jan-18 at -1% on a high base, but lower 4Q confidence (in transport too) flags weaker momentum into 2018. High commodity prices look supportive for exports, but Bloomberg consensus sees them flat-to-weaker going forward. Corporate profit dynamics should moderate and lending growth acceleration looks limited by tighter NBU policy. Resuming IMF funding will likely be one of the drivers of household/business mood.

Source: CEIC, ING

Key activity and income indicators (%YoY)

Source: CEIC

Industrial production by key sectors (%YoY)

Source: CEIC

-30%

-20%

-10%

0%

10%

20%

-40%

-20%

0%

20%

40%

Domestic demand Net exportsInventories GDP (rhs, %YoY)

4%

6%

8%

10%

12%-60%

-40%

-20%

0%

20%

40%

60%

Agriculture Real wages Retail tradeInvestments Construction Unempl. (rhs, inv.)

-30%-25%-20%-15%-10%-5%0%5%10%15%20%

-30%-25%-20%-15%-10%

-5%0%5%

10%15%20%

Mining Manufacturing Total


73

Moscow, +7 495 771 79 94 [email protected]

CPI inflation vs NBU key rate (%YoY) NBU prefers to stay hawkish

CPI inflation likely peaked in Jan-18 at 14.1% YoY and fell to 14% in Feb-18. Core CPI edged lower from 9.8% to 9.7%. This was due to stronger UAH, lower growth in food prices (incl. for meat/milk and vegetables) mostly offsetting higher price pressures on some non-foods and services on a fast recovery in consumer demand. In response to heightened CPI, extra inflation risks from the delayed IMF tranche, rising inflation expectations and fiscal easing, the NBU has raised the key rate four times since Oct-17 to 17% now. The NBU is likely to stay on-hold in the near-term as the policy looks tight enough to curb CPI risks and push it back to the 6% ±2ppt target. The NBU Chair appointment is good for credibility. We see CPI at 8-8.5% by Dec-18, so the NBU may start gradual rate cuts in 4Q.

Source:

Fiscal balances (12M-rolling, % of GDP) Solid 2017 budget due to one-offs, 2018 back to normal

The gov’t budget in 2017 saw a gap of 1.5% of GDP vs the 3% IMF target with revenues/outlays up 30%/26%. The solid performance was driven by one-offs: confiscated ex-President Yanukovitch funds, extra NAFTOGAZ dividends and NBU transfers. For 2018, the budget law expects 18.5%/17.5% growth in revenues/expenditures at a gap of 2.46% of GDP, as proposed by the IMF. Tax revenues could rise 21% on higher VAT (including for imports), excise and personal and corporate income taxes. Key spending priorities were defence and national security, public governance, infrastructure and healthcare. The adjusted 2018 plan hasn’t been officially approved by the IMF, which is crucial. Key 2018 risks include the external debt servicing outlook and natgas tariff-hike-related adjustments to subsidies.

Source: CEIC

Natural gas consumption and import (12M-rolling, bcm) Gazprom-Naftogaz fight and talk to continue

After a quiet 2016-17, early 2018 saw an escalation in the long-lasting Russia-Ukraine dispute over tariffs on gas/transit, with the Stockholm arbitrage court ordering Gazprom to pay US$2.6bn. Gazprom declined to pay, refused a prepayment for gas supply, and initiated contract termination via Stockholm. In this case Ukraine blamed Gazprom as an unreliable supplier, while Russia stressed the need for the Nord Stream II project. The EU legal ruling removed some hurdles to the NSII, which Russia wants to have to cut transit via Ukraine. This is key risk for Ukraine still buying “reversed” Russian gas from CEE and earning FX on transit. Both have time to find a solution before the contract expires in 2019, and NSII-old route co-existence is possible if pragmatism wins over heavy politics.

Source: CEIC, Ukrstat

Rating of potential candidates for presidency (% of votes) Politics: no changes, risks of turbulence or/and populism Ahead of upcoming presidential/parliamentary elections in 2019

risks of political turbulence and/or populism remain, with active domestic politics and recent cases on Saakashvili and Savchenko. A Rating Group survey found 90%+ of respondents saw the political situation as tense or critical, citing the Donbass conflict, corruption and low wages and pensions as key concerns. The gap between society preferences and the political establishment is wide: Timoshenko leads as potential Presidential candidate with an 18% approval, followed by Poroshenko (15%) and Boyko (11.5%). This has always been there, but in 2018 may collide with stalling reform momentum, which risks no extra IMF funding and negative spillover effects on fiscal policy and gov’t ability to service external debt.

Source: Rating Group survey, Feb-18

0%10%20%30%40%50%60%70%

0%10%20%30%40%50%60%70%

CPI CPI, ex-utilities NBU rate

-7%-6%-5%-4%-3%-2%-1%0%1%

-7%-6%-5%-4%-3%-2%-1%0%1%

Central gov't General gov't

05101520253035

0

10

20

30

40

50

60

Import, rhs Consumption

0% 20% 40% 60%

Y. Tymoshenko

P. Poroshenko

Y. Boyko

A. Gritsenko

O. Lyashko

V. Rabinovich

A. Sadovyi

Others

May-14 Elections Feb-18 Poll


74

Ukraine Strategy


UAH has gained 6.7% YTD vs USD after standing nearly flat in 2017. The sharp weakness over September-January (from 25.5 to nearly 29/USD) was a reminder of historical seasonality which is still embedded into household/business expectations irrespective of the reasons behind the move (weaker C/A and IMF-related concerns). But stronger global prices for major export items, higher food exports and no political turbulence helped UAH to recover, which allowed the NBU to proceed with selective easing of FX controls.

There are fundamental and idiosyncratic factors to focus on when thinking of UAH outlook. In terms of fundamentals, the real effective exchange rate of hryvnia (REER) has approached its strongest levels since early-2014, and with the expected positive inflation differential external competitiveness will be eroding. Our estimates suggest that to have the REER stable at current levels, the nominal UAH rate should slowly weaken to 28.5-29/USD in 2018-19. This differs from our short-term current account/BoP based fair UAH estimates, which jumped to 27.30-31.30/USD in Dec-Jan-18.

Better than expected global prices for major export items helped the C/A in early 2018, but a cold winter partly offset the gains via higher and more expensive natgas imports. Continuing growth in domestic demand will fuel imports, especially if UAH stays flat. Ukraine plans to issue US$2bn in the US-backed bonds will help to manage ext. debt payments in 2018 (US$2.4bn/US$2bn in principal/ interest). But there is US$2.4bn due in local FX bonds. So, while the delayed IMF tranche might not be disastrous for 2018, it is key for sentiment. The new law on currency control will ease FX operations, if approved.

Source: ING

UAH dynamics in NEER and REER terms (Dec-99=1)

Source: NBU

Ukraine sovereign Z-spread (bp) Fixed Income strategy With the authorities delaying crucial IMF reforms, the NBU has still

been committed to prudent monetary policy via raising the policy rate from 12.50% to 17%. This has kept upward pressure on yields of tradable 1-3Y local sovereign bonds at 16-17%, making them one of the highest-yielders in the local EM space. Inflation did accelerate to 16%, making the real yield very slim, but the most active foreign investors were buying this not due to real yield considerations, but mostly as a high-carry trade. The only hurdle was the need to have a proper local setup, but it was possible to overcome or trade the bonds via structures. With inflation set to slow to single-digits and the NBU likely resuming rate cuts in late 2018, we see local UKRGB bonds as attractive, despite the remaining risks to UAH stability.

After some rally in early 2018, US$ Eurobonds resumed falling. The scale of the adjustment still looks limited in terms of Z-spreads given these have only approached the levels of late-2017. Due to the aforementioned risks on the fiscal side (and some others), which drive IMF reluctance to resume its tranches, Ukrainian bonds may be more fragile than other EM peers in an environment of expected Fed tightening and overall uncertainty. As such, there might be room for further widening of Z-spreads from current levels. So, the bonds remain a high-yield tactical and speculative trade, especially taking into account political risks.

Our Sep-17 recommendation (sell UKRAIN’27 at 7.40%, target 7.75%, S/L 7.25%) hit S/L in Oct-17 and then flattened, but the recent spread widening highlights embedded macro/political risks.

Source: Bloomberg

External debt payments (US$bn)

Source: MinFin

5

10

15

20

25

30

35

ING f'cast Mkt fwd

0.00.20.40.60.81.01.21.4

0.00.20.40.60.81.01.21.4

REER NEER

0

200

400

600

800

1000

1200

UKR'19 UKR'24 UKR'27

0

2

4

6

8

10

12

Ext. debt principal Ext. debt couponDom. debt principal Dom. debt coupon


75

Ukraine 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (%YoY) 2.3 -14.8 4.1 5.5 0.2 0.0 -6.6 -9.8 2.4 2.5 2.8 2.9 3.4 Private consumption (%YoY) 13.1 -14.9 7.0 15.7 8.4 6.9 -8.3 -20.7 2.1 7.8 4.5 3.2 3.0 Government consumption (%YoY) 1.1 -2.4 4.2 -2.9 4.5 -0.9 1.1 1.7 -0.5 3.3 2.1 1.5 1.0 Investment (%YoY) -1.2 -50.5 3.2 8.5 5.0 -8.4 -24.0 -9.2 20.4 18.2 4.9 5.3 6.7 Industrial production (%YoY) -5.0 -20.6 12.2 8.0 -0.7 -4.3 -10.1 -13.0 2.8 0.4 2.4 3.0 3.2 Unemployment rate (year-end, %) 7.5 9.4 8.4 8.2 8.0 7.6 10.6 9.5 9.7 9.5 9.4 9.3 9.2 Nominal GDP (UAHbn) 948 913 1,079 1,300 1,405 1,465 1,587 1,989 2,385 2,983 3,408 3,793 4,222 Nominal GDP (€bn) 87 78 97 121 124 138 76 64 82 98 105 101 104 Nominal GDP (US$bn) 120 114 135 162 173 178 101 85 91 108 120 127 138 GDP per capita (US$) 2,604 2,488 2,959 3,552 3,807 3,914 2,360 1,984 2,130 2,553 2,844 2,999 3,275 Gross domestic saving (% of GDP) 19.7 15.4 16.8 15.8 13.1 9.3 9.9 14.1 15.8 14.4 13.4 13.3 13.8

Prices CPI (average, %YoY) 25.2 15.9 9.4 8.0 0.6 -0.3 12.1 48.5 14.9 14.4 11.2 8.2 7.7 CPI (year-end, %YoY) 22.3 12.3 9.1 4.6 -0.2 0.5 24.9 43.3 12.4 13.7 8.5 8.0 7.5 Wage rates (nominal, %YoY) 33.7 5.5 17.6 17.7 14.8 7.9 6.0 20.5 23.6 37.1 21.0 13.5 11.0

Fiscal balance (% of GDP) Consolidated government balance -1.2 -3.8 -6.2 -1.6 -3.5 -4.7 -4.3 -1.6 -2.5 -1.5 -2.5 -2.5 -2.3 Consolidated primary balance n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a Total public debt 20.0 34.7 40.0 36.4 36.7 39.9 69.4 82.7 80.9 71.8 74.3 76.8 79.1

External balance Exports (US$bn) 67.0 39.7 51.4 68.4 68.8 63.3 53.9 38.1 36.4 43.3 46.9 47.6 49.0 Imports (US$bn) 85.5 45.4 60.7 82.6 84.7 77.0 54.4 37.5 39.2 49.6 53.0 55.2 56.8 Trade balance (US$bn) -18.6 -5.7 -9.3 -14.2 -15.8 -13.7 -0.5 0.6 -2.8 -6.3 -6.1 -7.6 -7.8 Trade balance (% of GDP) -15.5 -5.0 -6.9 -8.8 -9.1 -7.7 -0.5 0.7 -3.1 -5.9 -5.1 -6.0 -5.6 Current account balance (US$bn) -12.8 -1.7 -3.0 -10.2 -14.3 -16.5 -4.6 0.2 -3.8 -3.8 -4.1 -4.7 -5.0 Current account balance (% of GDP) -10.7 -1.5 -2.2 -6.3 -8.2 -9.3 -4.5 0.2 -4.2 -3.5 -3.4 -3.7 -3.6 Net FDI (US$bn) 9.9 4.7 5.8 7.0 7.2 4.1 0.3 3.0 3.3 2.3 2.0 1.9 2.5 Net FDI (% of GDP) 8.2 4.1 4.3 4.3 4.2 2.3 0.3 3.5 3.6 2.1 1.7 1.5 1.8 Current account balance plus FDI (% of GDP) -2.4 2.6 2.1 -2.0 -4.1 -7.0 -4.2 3.8 -0.6 -1.4 -1.7 -2.2 -1.8 Foreign exchange reserves ex gold (US$bn) 30.8 25.6 33.5 30.4 22.7 18.8 6.6 12.4 14.6 17.7 17.0 16.0 15.0 Import cover (months of merchandise imports) 4.3 6.8 6.6 4.4 3.2 2.9 1.5 4.0 4.5 4.3 3.9 3.5 3.2


Interest & exchange rates Central bank key rate (year-end, %) 12.00 10.25 7.75 7.75 7.50 6.50 14.00 22.00 14.00 14.50 16.00 12.00 11.00 Broad money supply (average, %YoY) 29.9 -5.5 23.1 14.2 13.1 17.6 5.3 3.9 10.8 9.3 13.2 12.0 12.0 3m interest rate (average, %) 18.1 21.7 10.2 11.6 20.4 11.0 17.6 24.5 20.4 18.0 n/a n/a n/a 3m interest rate spread over US$-Libor (ppt) 1382 1706 898 1079 1901 1043 1738 2430 2039 1826 n/a n/a n/a 2yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a 18.00 15.20 16.00 16.50 13.00 12.00 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/UAH exchange rate (year-end) 8.05 8.01 7.97 8.00 8.05 8.24 15.82 24.03 27.10 28.07 30.00 30.00 31.00 USD/UAH exchange rate (average) 7.89 7.99 7.97 8.02 8.10 8.24 15.67 23.44 26.30 27.56 28.31 29.90 30.50 EUR/UAH exchange rate (year-end) 11.75 11.21 11.40 10.72 10.47 10.88 21.67 29.08 29.54 29.47 36.00 39.00 41.85 EUR/UAH exchange rate (average) 10.89 11.74 11.16 10.75 11.34 10.63 20.83 30.94 28.93 30.32 32.56 37.67 40.57



Real GDP (%YoY) -1.4 2.6 2.4 2.2 3.0 2.8 2.7 2.6 2.2 2.7 3.1 3.5 3.7 CPI (eop, %YoY) 43.3 15.6 16.4 13.7 12.6 11.5 9.7 8.5 8.3 8.1 8.1 8.0 7.8 Central bank key rate (eop, %) 14.00 12.50 12.50 14.50 17.00 17.00 17.00 16.00 15.00 14.00 13.00 12.00 11.50 3m interest rate (eop, %) 18.00 n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/UAH exchange rate (eop) 27.07 26.01 26.64 28.07 27.00 28.00 28.50 30.00 29.50 30.00 30.00 30.00 30.50 EUR/UAH exchange rate (eop) 29.41 27.31 28.37 32.07 32.40 33.60 34.20 37.50 37.47 39.00 39.30 39.60 40.57



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Research Analyst Contacts Developed Markets Title Telephone Email

London Mark Cliffe Head of Global Markets Research 44 20 7767 6283 [email protected] James Knightley Chief International Economist 44 20 7767 6614 [email protected] James Smith Economist, Developed Markets 44 20 7767 1038 [email protected] Jonas Goltermann Economist, Developed Markets 44 20 7767 6909 [email protected] Carlo Cocuzzo Economist 44 20 7767 5306 [email protected]

Chris Turner Global Head of Strategy and Head of EMEA and LATAM Research

44 20 7767 1610 [email protected]

Petr Krpata Chief EMEA FX and IR Strategist 44 20 7767 6561 [email protected] Viraj Patel Foreign Exchange Strategist 44 20 7767 6405 [email protected]

Padhraic Garvey Global Head of Debt and Rates Strategy 44 20 7767 8057 [email protected] Juan Carrion Head of High Yield Research 44 20 7767 8379 [email protected]

Amsterdam Maarten Leen Head of Macro Economics 31 20 563 4406 [email protected] Teunis Brosens Senior Economist, Eurozone 31 20 563 6167 [email protected] Bert Colijn Senior Economist, Eurozone 31 20 563 4926 [email protected] Raoul Leering Head of International Trade Analysis 31 20 563 4407 [email protected] Joanna Konings Senior Economist, International Trade Analysis 31 20 576 4366 [email protected] Timme Spakman Economist, International Trade Analysis 31 20 576 4469 [email protected]

Marieke Blom Chief Economist, Netherlands 31 20 576 0465 [email protected] Marcel Klok Senior Economist, Netherlands 31 20 576 0465 [email protected]

Jeroen van den Broek Head of DM Strategy and Research 31 20 563 8959 [email protected] Maureen Schuller Head of Covered Bond Strategy and Financials

Research 31 20 563 8941 [email protected]

Martin van Vliet Senior Rates Strategist 31 20 563 8801 [email protected] Benjamin Schroeder Senior Rates Strategist 31 20 563 8955 [email protected] Hamza Khan Head of Commodities Strategy 31 20 563 8958 [email protected] Warren Patterson Commodities Strategist 31 20 563 8921 [email protected] Oliver Nugent Commodities Strategist 31 20 563 8892 [email protected] Suvi Platerink Kosonen Senior Credit Analyst, Banks 31 20 563 8029 [email protected] Nadège Tillier Senior Credit Analyst, Utilities 31 20 563 8967 [email protected] Hendrik Wiersma Senior Credit Analyst, TMT 31 20 563 8961 [email protected] Job Veenendaal Credit Analyst, Consumer Products and Retail 31 20 563 8956 [email protected] Marina Le Blanc Credit Analyst, Insurance 31 20 563 8094 [email protected] Roelof-Jan van den Akker Head of Technical Analysis 31 20 563 8178 [email protected]

Brussels Peter Vanden Houte Chief Economist, Belgium, Eurozone 32 2 547 8009 [email protected] Julien Manceaux Senior Economist, France, Belgium, Switzerland 32 2 547 3350 [email protected] Philippe Ledent Senior Economist, Belgium, Luxembourg 32 2 547 3161 [email protected] Steven Trypsteen Economist, Spain, Portugal 32 2 547 3379 [email protected] Charlotte de Montpellier Economist, Switzerland 32 2 547 3386 [email protected]

Frankfurt Carsten Brzeski Chief Economist, Germany, Austria 49 69 27 222 64455 [email protected] Inga Fechner Economist, Germany, Austria 49 69 27 222 66131 [email protected]

Milan Paolo Pizzoli Senior Economist, EMU, Italy, Greece 39 02 55226 2468 [email protected]

Emerging Markets Title Telephone Email

New York Gustavo Rangel Chief Economist, LATAM 1 646 424 6464 [email protected]

London Nicholas Smallwood Senior Emerging Markets Credit Analyst 44 20 7767 1045 [email protected]

Czech Rep Jakub Seidler Chief Economist, Czech Republic 420 257 47 4432 [email protected]

Hong Kong Iris Pang Economist, Greater China 852 2848 8071 [email protected]

Hungary Péter Virovácz Senior Economist, Hungary 36 1 235 8757 [email protected]

Philippines Joey Cuyegkeng Senior Economist, Philippines 632 479 8855 [email protected]

Poland Rafal Benecki Chief Economist, Poland 48 22 820 4696 [email protected] Piotr Poplawski Senior Economist, Poland 48 22 820 4078 [email protected] Jakub Rybacki Economist, Poland 48 22 820 4608 [email protected] Karol Pogorzelski Economist, Poland 48 22 820 4891 [email protected]

Romania Ciprian Dascalu Chief Economist, Romania 40 31 406 8990 [email protected] Valentin Tataru Economist, Romania 40 31 406 8991 [email protected]

Russia Dmitry Polevoy Chief Economist, Russia and CIS 7 495 771 7994 [email protected] Egor Fedorov Senior Credit Analyst, Russia and CIS 7 495 755 5480 [email protected]

Singapore Rob Carnell Chief Economist & Head of Research, Asia-Pacific 65 6232 6020 [email protected] Prakash Sakpal Economist, Asia 65 6232 6181 [email protected]

Turkey Muhammet Mercan Chief Economist, Turkey 90 212 329 0751 [email protected]


77

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Sofia Tel: 359 2 917 6400 Taipei Tel: 886 2 8729 7600 Tokyo Tel: 81 3 3217 0301 Warsaw Tel: 48 22 820 4696

Research offices: legal entity/address/primary securities regulator

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Authority, Romanian National Bank Budapest ING Bank NV Hungary Branch, Dozsa Gyorgy ut 84\B, H - 1068 Budapest, Hungary. National Bank of Hungary Frankfurt ING-DiBa AG, Theodor-Heuss-Allee 2, 60486 Frankfurt, Germany. Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) Hong Kong ING Bank NV, Hong Kong Branch, 8/F, Three Pacific Place, 1 Queens’ Road East, Hong Kong. Hong Kong Securities and Futures

Commission Istanbul ING Bank AS, ING Bank Headquarters, Resitpasa Mahallesi Eski Buyukdere Cad. No.8, 34467 Sariyer, Istanbul, Turkey. Capital Markets

Board London ING Bank NV London Branch, 8-10 Moorgate, London EC2R 6DA, United Kingdom. Financial Conduct Authority Manila ING Bank NV Manila Branch, 20/F Tower One, Ayala Triangle, Ayala Avenue, 1226 Makati City, Philippines. Philippine Securities and

Exchange Commission Milan ING Bank NV Milano, Via Arbe, 49, Milano, Italy, 20125. Commissione Nazionale per le Società e la Borsa Moscow ING Bank (Eurasia) JSC, 36, Krasnoproletarskaya ulitsa, 127473, Moscow, Russia. The Central Bank of Russia New York ING Financial Markets LLC, 1133 Avenue of the Americas, New York, United States,10036. Securities and Exchange Commission Prague ING Bank NV, Prague Branch, Českomoravská 2420/15, Prague 9, Czech Republic. Czech National Bank Singapore ING Bank NV Singapore Branch, 1 Wallich Street, 12-01 Guoco Tower, Singapore 078881. Monetary Authority of Singapore Warsaw ING Bank Slaski SA, Ul. Pulawska 2, Warsaw, Poland, 02-566. Polish Financial Supervision Authority

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